Family Dollar Stores: Discount Stock?

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

Bill Ackman and his hedge fund Pershing Square have been one of the most prolific performers of the past ten years making a net 300% return for investors in the first fund since it's inception in 2004. It is always interesting to go through the portfolios of these "super-investors", see what they are holding, and try and work out why. The position that interests me most, at the moment, is Family Dollar Stores (NYSE: FDO). Pershing Square Capital Management, through its funds, own around 9.6% of FDO, so it is clearly quite a substantial position considering the current market cap of $6.7bn.

The first question we have to ask is how did Family Dollar get where it is today? The easiest way to work this out, I believe, is to split the business up into operating and financial sections. By splitting the business in this way we get an answer to a key question: how good is FDO in its core business, in this case, discount retail stores?

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The table above tracks the past decade of results and suggests that the company has done an excellent job of growing post-tax operating income in the past four years however, its returns, in absolute terms, still aren't too impressive. However, in the case of FDO, it is not quite as simple as this as we have had to make some adjustments.

The most important of these is for operating leases, a significant off-balance sheet item. Operating leases mean total assets are understated, as the assets FDO are leasing are not included on the balance sheet, understates liabilities, for the same reason assets are understated, and understates operating income, as some percentage of rental expenses should be considered a financial rather than an operating expense. This does not change the overall picture of the return on equity but it does significantly change our view of how the company is using operating assets.

So how did the return on net operating assets jump from 8% to just under 11% in the space of four years? FDO achieved this through a mix of improving margins and using its operating assets more efficiently (i.e. getting more sales per unit of operating assets).

On the first point, the company improved the EBITDA margin 219 bps over the past four years largely through improvements in cost of sales. Whilst sales grew 24.4% over the past four years, cost of sales grew by 18.8%. SGA grew at 20.8% over the past four years however, it was the slower growth in cost of sales that led to EBITDA growth of 58.7% over the past four years.

On the second point, we have to look at per store and per sq foot numbers which have also shown huge improvements. Sales per store has increased 14.5% over the past four years and sales per sq foot has improved 13.4%. What is most impressive is that these numbers have been achieved with both stores and sq footage growing 7% and 8% totally. Often this kind of growth isn't achieved efficiently but for it's own sake, FDO bucks this trend. Another important asset is inventory, FDO has improved its utilization here by 7%. All of this is extremely impressive stuff and explains why an astute investor like Ackman is interested.

However, whilst return on net operating assets grew 30.4%, return on equity has improved by just over 100% over the past four years. We know that part of this has been achieved by improving the operating fundamentals of the business but this doesn't explain it all. For example, if we project those operating improvements forward on the 2007 financial position, the return on equity improves by 54.1%. In other words, slightly less than half of FDO's improvement in return on equity has been achieved through changes in the financial position of the company.

Again, operating leases are important here as they make up the vast majority of the company's financial position and, unsurprisingly, operating leases grow with the expansion in number of stores. However, the bigger change has been the growth in long-term debt. The company's financial position (not inc. operating leases) has always been extremely conservative and the company has always funded capex out of retained earnings. The last fiscal year shows net debt of about $580m a far bigger balance than the company has held before. Indeed, according to my data, 2008 was the first year in the company's history that it held a net debt balance.

What is more, the company's more leveraged financial position can be explained by declines in cash balance as well as an increase in debt. FDO has always used dividends and share repurchases to return cash to shareholders but in the past year returned just over $750m, nearly double its largest historical return to shareholders. As the company's financial position is still quite strong (EBIT is still just over 30x interest expense) I would regard this as a positive development and it looks like it will continue.

Whilst improvements in return on equity that have been achieved from operating improvements are certainly preferable, I would argue that gains from a more appropriate financial position are just as valuable. The situation with FDO is the "holy grail" as far as investing situations are concerned. The company is improving operations and moving to a far more "efficient" financial position leading to massive growth in returns for shareholders. One explanation that Ackman has given for his position in FDO has been the potential for an LBO. I don't have modeling skills to work out what kind of price the company could go for in that situation but it seems quite a plausible scenario.

Another explanation he has given is that FDO receives an unjustifiably low valuation relative to its competitors. In his Q3 investor letter, Ackman noted that: "Despite similar unitsize, business models, and historical profitability, Dollar General (NYSE: DG)’s enterprise value per unit today is $1.70 million compared to $1.04 million at FDO, a 63% premium". How does FDO stack up against competitors now?

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We can clearly see that, relative to its main competitors, FDO is still cheap but that appears to be because the company is just not performing as well. Despite the significant improvements of the past four years, FDO is lagging its main competitors. On the metric mentioned by Ackman above, the DG EV/Store premium has narrowed to 53% so the market is still pricing in significant under-performance. On the EBITDA/store measure this gap seems to make sense as the gap with DG is 43% however, in revenue/store terms the gap is only 17.6%. What this suggests, possibly, is that most of the improvement has to come through improving EBITDA margins. It is also worth pointing out briefly that the premium being paid for Dollar Tree (NASDAQ: DLTR) seems quite hefty given the gap in operating metrics with DG.

Whilst FDO has made tremendous progress in improving operations over the past few years, there is more work to do if the valuation gap is going to be closed. I would argue that given current operations, FDO is modestly undervalued providing some room for investors if FDO has trouble implementing these improvements in operations. What is more the return of cash to shareholders and the move towards a more "efficient" financial position is welcome. There is certainly more scope to improve the financial position but it will be an improvement in operating metrics that will bring about the revaluation that Pershing Square is betting on. The company's share price has performed well as the discount retail store model has shown its strength and popularity amongst consumers in tough times but there appears to be real opportunity for it to do even better.

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