Don’t Be Fooled by This Discount Retailer’s Recent Results

Harsh is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The reaction to discount retailer Family Dollar Stores(NYSE: FDO) recent results was surprising to me. The company met revenue estimates and delivered a beat on the bottom line, and as a result, shares spiked a tad over 7% as investors rejoiced the company’s solid performance in the third-quarter. But then, that’s not the sort of celebration one should indulge in when a company trims its earnings guidance and is facing margin challenges.

I believe that investors were a bit too optimistic and Family Dollar isn’t a good bet when compared to the likes of Dollar General (NYSE: DG) and Dollar Tree (NASDAQ: DLTR), and this clearly reflects in the year-to-date stock price performance of the three companies.

Looking beyond the results

The headwinds that Family Dollar is facing aren’t new and I’d predicted that the company would have a tough time this year. A closer look at its recently released results will confirm the fact that the challenges still exist and might continue to trouble the company going forward.

So, even though Family Dollar managed to grow same-store sales 2.9% and revenue jumped an impressive 9% from the year-ago period, net income declined close to 3%. This indicates that Family Dollar is selling more low-margin items and is keeping traffic intact at the cost of margins. Hence, it wasn’t surprising that its gross margin fell 1.1 percentage points and the trend looks set to continue.

Family Dollar’s focus on selling more consumables, such as tobacco and food products, has been hurting its margins. The company is not witnessing a boost in discretionary spending and the fact that 72.5% of its revenue was derived from sales of consumables, up from 69% last year, is indeed a worrying trend. However, if you are thinking that this is an industry-wide trend, you’re in for a surprise.

Rival Dollar Tree had witnessed greater growth in sales of its discretionary products last quarter than consumables, and so, Family Dollar’s strategy seems questionable as it is not being able to grow its discretionary segment. So, while Family Dollar’s target of opening 500 new stores this year is certainly impressive, it needs to rescue its margins and return to earnings growth, which is not going to happen this year.

And going by the trend of rising consumables sales, it might be difficult for Family Dollar to improve earnings in the near future. Moreover, as Fool analyst Demitrios Kalogeropoulos pointed out, the company will be making capital expenditures to the tune of $600 million on installing freezers and refrigerators to store those consumables. In comparison, Dollar Tree’s expected capital expenditure of $320 million to $330 million in the ongoing fiscal year reveals the difference in strategies.

Who’s the boss?

So, it’s pretty much clear why I think that Family Dollar isn’t the best dollar store to invest in and a look at its peers will further solidify my position. Almost all dollar stores discussed here trade at similar trailing P/E multiples of between 18 and 19, but Family Dollar has the highest PEG ratio of 1.52 while Dollar General and Dollar Tree sport PEG ratios of 1.08 and 1.05, respectively.

Thus, the other two are expected to grow faster than Family Dollar and investors should instead consider them. However, as I’d stated in a previous article, I believe that even Dollar General is witnessing headwinds similar to Family Dollar. Dollar General had to suffer a decline of 89 basis points in its gross margin in the previous quarter as it sold more low-margin items and counted on tobacco products to drive traffic.

Dollar General has also been cutting its guidance and for this reason, I think it won’t make sense to purchase the stock right now until there is further clarity over its direction. So, we are left with just one player to consider -- Dollar Tree -- and this stock passes the test with flying colors. In addition to the positives mentioned above, Dollar Tree is the smallest of the discount stores discussed here and as such, it has more room to grow its business.

But, Dollar Tree isn’t growing its business in a sporadic manner by focusing on low margin items, and it does not sell tobacco products to drive traffic. The company is intent on growing margins and improving earnings and its various initiatives enabled it to increase its full-year earnings guidance to $2.61-$2.77 per share from $2.54-$2.74 per share earlier.

The takeaway

So, Family Dollar’s rise after earnings is nothing more than a damp squib and the company wouldn’t make for a good investment, especially considering the available alternatives. It is focusing more on quantity, and margins are being hurt in the process. An unfavorable product mix would probably continue to pressure margins, and keeping all the factors in mind, it would be best to look at Dollar Tree if you’re looking for exposure to this sector.

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Harsh Chauhan 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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