Will These Retailers Survive the Pressure on Their Margins?

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In India, there is a television commercial that shows that if you get something more than what you expect, you tend to get elated! I believe that's exactly how investors reacted when Family Dollar Stores (NYSE: FDO) reported its third quarter earnings and beat analysts’ estimates by 3%. The positive earnings surprise, after missing the analysts’ expectations three out of four times in the last year, was good enough to send the company's stock soaring 7% in one day. Moving forward, let’s try to find out whether Family Dollar can still keep pleasing its investors in the coming years.

In the recently-reported quarter, Family Dollar Stores’ sales improved 9% compared to the same period last year. The boost in sales can be attributed to a 2.9% rise in comp sales, as well as an extra 129 store locations. The boost in sales was undoubtedly a motivating factor, but what concerns me is the company’s shrinking operating margins. The company currently has an operating margin of 7.37%, while competitors Dollar General (NYSE: DG) and Dollar Tree (NASDAQ: DLTR) have operating margins of 9.33% and 12.59% respectively.

What’s affecting the margins?

Family Dollar’s increase in sales is mainly because of 15% year-over-year increase in the sale of consumable products. As the sales mix shifted more towards lower-margin consumables, it created more pressure on the company's margins. Further, its sale of discretionary goods with high margins has fallen 4%, causing the margins to dwindle more. Going forward, the company’s profitability may be a concern. This would affect its performance in a negative manner.

There are only two ways of earning profit: either sell goods with high mark-up, or cut down on costs. As Family Dollar has marked down its merchandise to promote new assortments of products, it needs to control its costs. The company reduced its inventory per store and decreased its freight expense through better supply chain management. It is continuously putting effort into pulling its margins north, but the downward pressure on selling price seems to be taking the best out of it.

How is the industry giant performing?

Dollar General is the largest player among all dollar stores. It has superior margins to Family Dollar, and its stores having better growth in comp sales too. I believe that the recent increase in comp sales is mainly due to the closure of stores that were not performing well and not an actual increase in store sales.Dollar General’s margins are also shrinking as the company is not able to generate sales from its discretionary product line. Adding to its misery, the sales mix of discretionary products is shifting more towards merchandise that carries lower margins.

Let’s analyze growth

Both Dollar General and Family Dollar have very optimistic growth plans and are opening stores very swiftly. Family Dollar’s management plans to triple the company's store count from its current number. The company currently has 7,800 stores, and if the management goes ahead with its plans then there will be more than 23,000 Family Dollar stores at the end of the expansion. Family Dollar will open 500 more stores this year alone, while Dollar General plans to add 635 new units in 2013. My concern is the pace at which they are growing, especially when margins are reducing day by day. If the margins continue to fall, this growth initiative might lead to some serious issues regarding the sustainability of both the companies.

Dollar Tree makes it look simple

Dollar Tree, a retailer that utilizes a single price point on its merchandise, has constantly focused its business on selling goods at $1 to attract customers. In addition to having the best margins among its peers, the company has concentrated on selling discretionary products and has attracted customers with candies, stationery, and health care products that carry better margins than consumables. While its peers are expanding wildly, Dollar Tree has been smart and methodical with its expansion. The company is keeping its focus on productivity, which should help it to compete better.

Final words

Family Dollar’s management has narrowed its full-year earnings-per-share forecast to $3.77-$3.82, tightening its previous range of $3.73-$3.93. I believe that this is a clear indication that the company will find it difficult to improve its margins in the near future. Even Dollar General is under pressure to improve margins. Going forward, if both these dollar stores fail to improve their margins then sales increases will not be enough to remain profitable.

Dollar Tree seems to be the best company to invest in among its peers. The company's margins and sales are both going strong. Its stock has also performed well this year. I believe that the momentum will continue for Dollar Tree, allowing it to maintain a decent performance into the future.

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tarun bachhawat has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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