FDO: The Ultimate Catch-22
With Keith re-shorting FDO last week, here’s some quick insight into why we are (and have been) so fundamentally negative on this name.
At this point in the cycle, it’s no surprise that the weak economy and its disproportionate impact on low and middle income consumers has been a key driver to the dollar stores and deep discounters over the past 12-18 months. The weak macro environment makes this sub-sector of retailing the ultimate Catch-22 when it comes to success. Essentially, as our nation’s economy faltered and less people were employed, retailers like FDO and DG benefited. In other words, one man’s pain is another man’s pleasure. And while morally it’s a bit conflicting to bet on the fragility of the American consumer, we know that placing bets is what the Street is all about. So morals aside, outsized same store sales gains (relative to history) driven by sharp pricing, EBT usage (food stamps), and quite simply necessity have propelled the topline performance of FDO, DG, DLTR, and NDN beyond “normal” levels. Along the way, gross margins and expense leverage have benefitted and EBIT margins have inched their way towards historical highs. This all sounds like a perfect set up, but how long can this last?
Within the context of the cash strapped consumer, Family Dollar has been a relative laggard. Yes, the same store sales did accelerate late in 2008, resulting in historically high sales growth for three of the last five quarters. However, the company has been unsuccessful in maximizing this trend on a consistent year over year basis. For two quarters in a row now, same store sales have been disappointing, missing both company guidance and Street expectations. What is more troubling is that momentum in the most recent quarter slowed on easier comparisons, and now the company faces its toughest compares (through June) in the past seven years! Quite simply, Family Dollar’s pace of share gain has slowed and it’s only going to get tougher. Same store sales are likely to turn flat through the first half of the year, leaving little room for expense leverage, let alone multiple expansion. At the same time FDO (and others) are ramping up unit growth in 2010, which will not only put pressure on the P&L but increase the likelihood for cannibalization and competition. We’re all for being opportunistic, but can the U.S retail landscape really handle an additional 1,100 units annually for the next few years?
To be fair, maybe we’re being too harsh and should consider the other side of the story. Let’s look at the biggest risk factors associated with a negative view on FDO and the space in general:
- The classic Depressionista set up. The economy takes another leg down, leaving more middle and upper middle income consumers in the sweet spot for dollar store shopping. Incremental traffic is getting harder to come by, but a new wave of potential customers seeking deep discount consumables would enable FDO, DG, and others to extend their runs.
- The trade off scenario. The economy improves and along with it sales of higher margin discretionary products pick up. This affords FDO the opportunity to drive higher average transactions and also a more profitable basket. Offsetting this pick up is the likelihood that some portion of the FDO’s middle income customer base sees economic relief as the overall macro backdrop improves. This results in slowing traffic and sales as this consumer begins to shop elsewhere, returning to a routine that likely involves more trips to a Target or a Kroger. In a perfect world, sales slow, margins expand, and the Street is OK with it.
- The growth trumps all thesis. After 4 years of moderating new store growth, management regains confidence that there is ample opportunity to grow the FDO store base. Although expectations are for a modest ramp to 500 new stores per year over the next 2-3 years, management decides to seize the moment and ramp up sooner. With DG and DLTR also growing rapidly, one must really be on board with bullet #1 to get comfortable with over 1,100 new units opening across the U.S each year. There is no other sub-sector of retailing that will see as much square footage growth over the next 3-4 years. We just wonder if growth for the sake of growth can drive multiples at this point.
So at the end of the day that leaves us and Keith (with his re-initiated short position) with a negative bias on FDO shares in the near to intermediate term. We’re carefully watching for the risk factors associated with a name that it is so highly leveraged to the most economically challenged consumer in the U.S economy. For now though, we’re comfortable that the reward for slowing sales far outweighs the risk of the Catch-22.