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Family Dollar Retains Neutral Rec

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The economy is still in the doldrums, and bargain hunters are going from one shop to another to grab the best deal, with their primary focus being on consumable items. Family Dollar Stores Inc. (FDO), with its low cost options, remains successful in luring budget-constrained consumers amid the economic gloom. However, margins remain under pressure. 

Family Dollar offers general merchandise in four categories––consumables, home products, apparel and accessories, and seasonal and electronics––and sells merchandise at prices from under $1 to $10. 

What the Company Counts On

The company’s strategic initiatives to improve merchandising, marketing and store operations have resulted in sustained growth in the top and bottom lines. Management now expects growth of 9% to 10% in net sales and earnings per share growth of 13.8% to 20.2% for fiscal 2012.

The company remains committed towards better price management, cost containment efforts, effective inventory management, private label offering and expanded operating hours that should augur well for sales. Moreover, in order to enhance the market share, Family Dollar intends to focus on both consumables and discretionary categories.

The company has also been making prudent investments related to store infrastructure; store openings, expansions and relocations; and improvement of distribution centers to drive revenue growth.

Healthy Results

All these initiatives helped Family Dollar to post healthy second-quarter 2012 results. The quarterly earnings of $1.15 per share beat the Zacks Consensus Estimate by a couple of cents, and jumped 17.3% from 98 cents earned in the prior-year quarter on the back of healthy sales witnessed in the Consumables, and Seasonal and Electronics categories, marking the 16th successive quarter of double-digit growth.

North Carolina-based Family Dollar now expects earnings between $1.01 and $1.11 for the third quarter, and in the range of $3.55 to $3.75 per share for fiscal 2012.

The operator of self-service retail discount store chains posted an 8.6% increase in revenue to $2,458.6 million from the prior-year quarter, and reflected sales growth across Consumables (up 12.9%) and Seasonal and Electronics (up 9.4%), offset by Apparel and Accessories (down 5.9%) and Home Products (down 0.5%). However, total revenue fell short of the Zacks Consensus Estimate of $2,461 million.

Rewarding Shareholders

Family Dollar has been actively managing its cash flows, returning bulk of its free cash to shareholders through share repurchases and dividends. In January this year, the company raised its quarterly dividend by 16.7% to 21 cents a share.

Since the inception of dividend program in 1976, the company has raised its dividend every year at a compounded average growth rate of about 16%. During the first-half of fiscal 2012, the company repurchased 1.3 million shares, aggregating approximately $72.1 million.

Margins under Pressure

Family Dollar registered growth in the top and bottom lines, but that was not enough to alleviate the concern about increasing gross margin pressure. It was apparent that the growth in the top line was led by lower-margin consumables category. Consequently, the increase in sales of lower margin merchandises weighed upon the company’s gross margin that contracted 80 basis points to 34.9%.

It is obvious that given the current economy, consumers will focus on basic necessities such as food, which generally carry lower margins. Management at Family Dollar expects gross margin to remain under pressure during fiscal 2012, but expects pressure easing in the second half compared with the first half on account of improved purchase markups and gains from lower markdowns.

Moreover, the company’s customers remain sensitive to macroeconomic factors including interest rate hikes, increase in fuel and energy costs, credit availability, unemployment and high household debt levels, which may negatively impact their discretionary spending, and in turn the company’s growth and profitability.

Challenging Economy & Competition

Consequently, we could see more competitive pricing and new products to attract shoppers. A price war would definitely eat at margins, which in turn would affect the company’s results. In order to remain competitive, Family Dollar may try out innovative ways to win the hearts of target consumers rather than fading away in an unhealthy contest.

Family Dollar operates in the highly competitive discount retail merchandise sector. Peer pressure from the likes of Wal-Mart Stores Inc. (WMT) and Dollar General Corporation (DG) will likely continue to weigh on its results.

Zacks #3 Rank

Given the pros and cons embedded in the stock, we maintain our long-term Neutral recommendation on the stock. Furthermore, Family Dollar shares maintain a Zacks #3 Rank that translates into a short-term Hold rating and correlates with our long-term view.

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