3 Reasons to Buy This Retailer

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

Over the past few years, Dollar Stores' outperformance has attracted, and continues to lure, many investors. Despite not being the biggest company in the sector, Family Dollar Stores (NYSE: FDO) has become an appealing investment opportunity since the stock’s risk/reward ratio is quite alluring. We will analyze some of the principal reasons to believe that investing in Family Dollar is a good call.

1) Prospect to narrow gap with Dollar General

Given the existing distance in operating performance between Family Dollar and Dollar General (NYSE: DG), the former's chances for earnings upside are large. Although completely closing the earnings gap between these companies ($2.00 of earnings potential per share) seems unlikely because of the structural and operational disparities, most of the company´s new policies point in the direction that Family Dollar will close that gap. As stated by Credit Suisse, “closing half the gap could add ~30% to earnings, before considering the added benefit from its strong organic store growth.”

Lately, Family Dollar´s Board has been focused on renewing its management and bringing in executives with significant small-box experience. A number of initiatives pointing to increase productivity have been rolled out since the management team renewal, creating interesting prospects for the company´s future.

Remarkable ones include the roll-out of tobacco, an aggressive remodel campaign, and a distribution agreement with McLane. Success of some of these policies already implemented is evident in the progressive reduction of the gap with Dollar General. This trend is expected to continue over the next few years, eventually closing the profits gap.

On the other side, Family Dollar´s disadvantage (Dollar General´s sales per sq. foot are 21% greater than Family Dollar´s, EBIT Margin, 260 bps higher, and its CFROI 851bps bigger) may allow it to imitate some of Dollar General´s most successful growth strategies and even execute them more effectively.

2) New management initiatives

During the last few months, Family Dollar has made several changes within the board, mainly because previous ones had not delivered the expected results. The new administration, with critical small box experience, launched a series of initiatives to boost the firm´s comps.

In the first place, they started a store remodel campaign in 2011, which aims to enhance shops (inside and outside), the creation of a more consistent customer experience, and the establishing of foundations for further assortment expansion. As a result, stores which were majorly remodeled, are currently 10% more profitable than before (and have not lost this performance after cycling the remodel year).

Another important element in Family Dollar´s growth is the roll-out of tobacco. While external analysts, like Credit Suisse, believe that this novelty could boost the comps of each store by approximately 3% during the first year of implementation, Family Dollar estimates that the impact of this product over same-store sales would reach a figure around 6.3%.

Indirect benefits of this initiative can also be found, with the exclusive distribution agreement with McLane being the most relevant. Having tobacco provided the volume required for regular delivery, this contract “allows the company to meaningfully expand refrigerated/frozen food SKUs (…), consolidate its fragmented distribution network, improve in-stocks, offer more consistent assortment, and provide regional clustering.”

Finally, the expansion of food SKUs by 30% in 2012 and HBA SKUs by over 60% represent another important development opportunity, and have already resulted in noticeable improvements in market shares. The likely launch of beer and wine sales in the near future are another element to take into account when evaluating the company’s growth potential.

3) Expansion opportunities

As already mentioned in previous articles, the Dollar Store sector still has plenty of growth opportunities besides the ones mentioned above (tobacco roll-outs, store expansion, and productivity improvements, amongst others). Calculations suggest that at least 15,000 more Dollar Stores can be opened without saturating the market (and that is in the U.S. only). Furthermore, the returns expected for these new stores are quite attractive (see Graph 2), thus motivating investors to put their money down.

<img alt="" src="http://g.fool.com/editorial/images/29525/fdo_new_store_growth_large.png" />

In terms of expansion, I also like Dollar Tree (NASDAQ: DLTR). This company has one of the most unique concepts in retail and a high quality management team that I think will continue to deliver consistent mid-to-high teens earnings growth. Dollar Tree has 4,406 U.S stores, well below Family Dollar (7,442) and Dollar General (10,203), and its management targets 7,000 stores in the U.S. In addition, the company just entered the Canadian market, which has the potential of 1,000 stores according to Credit Suisse.

Conclusion

Family Dollar is an attractive play. It offers exposure to one of the highest growing retail segments, and could outperform its peers considering that it has a new management team that is focused on rolling new initiatives and closing the earnings gap between Dollar General.

I like to invest in stocks where prominent value managers have been placing their funds. In the case of Family Dollar, top managers Leon Cooperman (Omega Advisors), Lee Ainslie (Maverick Capital), and Murray Stahl (Horizons) accumulated Family Dollar at an average price of $64 in the last reported quarter (13F form).


Victor Selva 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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