Why 2013 Looks Like a Difficult Year for This Stock

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A daunting task lies ahead for Family Dollar Stores (NYSE: FDO) after the discount retailer welcomed 2013 in an inauspicious manner. The stock took a solid beating last week after reporting its first-quarter numbers, where it missed bottom line estimates by a mile and reduced its full year guidance considerably.

The stock was the pick of the dollar stores in 2012, gaining close to 10% that was better than rivals Dollar General (NYSE: DG) and Dollar Tree (NASDAQ: DLTR). But replicating a performance even close to that might prove to be difficult this year.

One would have ideally expected dollar stores to perform well due to economic certainties, but this hasn’t turned out to be the case if we are to go by performance of others and Family Dollar’s guidance. For instance, Dollar General, the largest dollar store chain in the U.S., had also reduced its fiscal 2012 earnings forecast last month in light of increased competition from the likes of Wal-Mart (NYSE: WMT) and other dollar stores.

As a result of this price war, dollar stores are suffering and Family Dollar is no different. The retailer struggled as holiday spending remained muted this time as the fiscal cliff hounded customers. This led to a fall in spending on high-margin discretionary items and things could get worse this year. The expiration of payroll tax cuts would further weigh on discretionary spending and Family Dollar’s margins as well.

Revenue vs. Margins

These circumstances have led Family Dollar to introduce more low-margin items such as cigarettes, gift cards, magazines etc. in order to drive traffic into stores. This helped the discounter post solid same-store sales growth of 6.6% in the quarter but it did compromise on margin in the process, as gross margin declined from 35.3% last year to 34.1% in the quarter.

Consumables Improving, But Competition Stiff

Sales of low-margin items and consumables would probably continue to drive the company’s top line this year, after an impressive 13% jump in the previous quarter. Consumables, which form around 70-75% of Family Dollar’s sales mix, have been doing well, as evidenced by a 19% jump in the previous quarter. Family Dollar is focused on expanding its consumables assortment, and is expanding its refrigeration capacity further.

The company is also looking to expand its sourcing areas globally. Family Dollar sources most of its items from China, but has been growing its network in countries such as Vietnam, Indonesia, Cambodia and Bangladesh. In addition, the company also managed to double its direct-to-factory purchases in the first quarter. These initiatives should help Family Dollar in lowering costs, but consumer confidence would still play a big role in sales of discretionary items and improvement of earnings.

While there are a number of other positives, such as solid development of its private brands, the overall negativity surrounding discretionary spending takes much of it away. The company is looking to deliver more value to the consumer, and this might mean more price cuts if confidence doesn’t improve. Moreover, stiff competition from Wal-Mart, which is now aggressively selling more merchandise priced $1 or less, and aggressive expansion of Dollar Tree could make things worse for Family Dollar.

Nothing Spectacular

Moreover, there seems nothing compelling in Family Dollar’s valuation either when we stack it up against peers. The company’s trailing P/E of 15.76 is more or less in line with the other retailers discussed in this article. Its PEG ratio of 1.19 also suggests that Family Dollar is expected to grow slower than both Dollar General and Dollar Tree, both of which have PEG ratios less than 1.

The Takeaway

Hence, an investment in Family Dollar might prove to be highly risky as it stands. Even though the company is delivering solid revenue growth, it is coming at the cost of margins and the competition is making life difficult for it as well. Considering these factors, and also tepid consumer spending, it would be wise to watch Family Dollar from the sidelines and see if the company’s strategies are working in its favor or not.

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