When I consider my estimate of Wal-Mart's (WMT) Neighborhood Market's future effect on dollar stores, and the prices at Family Dollar Stores (FDO) -- which are 3%+ too high vs. its competitors and which, I believe, were responsible for the recent quarterly earnings disappointment -- I believe that the stock price should be nearer $55, at best.
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In December 2012, I stated that Wal-Mart's Neighborhood Market and the growth of Aldi were going to cut short the growth to saturation of the dollar stores from five to six years in sell-side analyses to nearer three years. I still stand by everything in that analysis. (See also: Wal-Mart's Neighborhood Markets Pose Threat to Dollar Stores.)
The second quarter of FY13, which ended in February, was a disappointment, with a comparable EPS coming in around $1.17 ($1.22 reported) vs. a Street expectation of $1.22. Adjusting for an extra week, the comparison was $1.14 vs. $1.15. Comparable store sales were up 2.9% vs. 4% expected. The gross margin percentage fell 146 bps.
Gross margins have been declining for about six quarters as more consumables are sold (70% of total sales) relative to higher margined discretionary items. Because the payroll tax increase is just starting to affect low-end consumer behavior, and given retail sales numbers, and a much lower than expected Thompson Reuters/University of Michigan Consumer Sentiment Index, it would seem that home and apparel will likely continue the sales weakness of the last two years, unless there is an economic pickup and/or significantly lower gasoline prices.
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While stores have been reset with more consumables SKUs, and other improvements made to FDO's operations, I believe that relative pricing explains most of the disappointments. I found a December 2011 pricing study of consumables by Deutsche Bank comparing Wal-Mart, Dollar General, and Family Dollar in suburban New Jersey and the New York metro area. Simply put, in New Jersey, which is probably an example of pricing in most other places, Wal-Mart has the lowest prices, with Dollar General 3% higher and Family Dollar 3% higher than Dollar General, or 6% over Wal-Mart. This is in-line with older studies I have seen. Also, remember that Target (TGT) prices consistently at DG's level, 3% over Wal-Mart. Aldi is maybe 4% under Wal-Mart.
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That leaves Family Dollar as the obvious highest priced option among its closest competitors, though obviously it will be taking sales from the much higher priced front ends of the drug store chains, which is something that is increasingly more obvious. Overall, experience has shown that consumers notice 5% differentials. But with these low-end consumers and in this environment, I believe that 3% over Dollar General gets noticed.
Indeed that does seems to be happening. Dollar General has been putting up price signage, pointing out that their prices are lower than Family Dollar prices. Possibly in response to this, Family Dollar has for months been distributing fliers with coupons. This bothers me. This essential high/low pricing has been a loser's game for the most of the large supermarket chains vs. Wal-Mart and Target. It seems to be being used again in this case by Family Dollar as a response to a competitive situation that requires across-the-board price cuts.
Now for the New York metro part of the price study: Here, Dollar General had the lowest prices at 2.5% below Wal-Mart (a situation that almost certainly has reversed as Wal-Mart has been cutting prices), and Family Dollar prices were 16% higher than those of Dollar General. Amazing! I believe that this is still going on. I can look at the pricing of a number of different cookies I buy in Boston and in Meriden, Connecticut, which is a part of the sort of suburban sprawl between Hartford and New Haven. Mrs. Freshley's products are $1.30 in Meriden, where they are near a Wal-Mart Supercenter, while they are $1.50 (17% higher) in Boston near the city line in a close-to-normal suburban shopping situation. Stop & Shop and the other supermarket chains do not have 17% higher prices there. What is FDO thinking? I haven't the faintest idea. I do know that my local Family Dollar has prices that are not particularly attractive vs. the local supermarkets in most cases. I believe that the company is probably not getting the sales leverage that it might have expected from its entries into denser urban areas. I am also concerned that FDO will price this way in many of their entry markets in California, thereby not getting the sales growth that they might otherwise get in this big and important expansion for the company.
Moving over to apparel and home goods (discretionary), I have no pricing comparisons to look at. But it does concern me that Family Dollar's prices may be higher or equal to those of Target, if the consumables' relative prices are indicative. It is also concerning that a lot of the sales growth in the dollar store segment has come from families earning over $60,000, most of whom have cars and the ability to get to Target, or who will be able to access smaller in-city Targets in the next few years. When economic conditions finally do turn for much of the dollar stores' customers, I would not take it as a given that Family Dollar's discretionary sales will come back strongly.
To value Family Dollar stock, I estimate a 10% growth rate in EPS. (I am assuming here that gross margin will hold at this level, which might well not happen.) That builds from 6% square footage growth and a 3% comp store sales gain, with 1% of leverage on the SG&A line. But I only believe that that growth rate will hold for about three years before WMT and Aldi start to pressure returns. I also believe that FDO will definitely feel the pressure before DG, which is better positioned. So, my three stage EPS growth model, using calendar year EPS of $3.93 and $4.50, respectively, for 2013 and 2014; a 10% 3-year growth rate; a 4.1% risk free rate (3.1% 30 yr. T-bond plus 100bps to counter the Fed's quantitative easing); and a 6.5% risk premium, results in a $55 price target vs. the present $61 price. That, of course, assumes that gross margin can be held at the present level. Adjusting prices that seem to clearly be too high would require an even lower price target before any analysis of the possibility of faster top line growth.
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