Should You Buy Family Dollar Stores After Earnings?

Source: Thinkstock

Source: Thinkstock

Of the three large publicly traded dollar store chains – Dollar General (NYSE:DG), Dollar Tree (NASDAQ:DLTR), and Family Dollar (NYSE:FDO) — Family Dollar has been the black sheep. While the other two companies have been comfortably growing its sales and profits, Family Dollar has been experiencing weakness, and it has failed to reap the benefits of the growth in the dollar store industry and the consumer’s shift towards discount shopping. This has meant that Family Dollar has traded at about a 15 percent discount to its peers on a price to earnings basis.

Investor pessimism in the name was verified earlier this week when the company released its Q2 2014 earnings results. Profits fell by a whopping 35 percent due to a number of factors:

  • Lower sales, particularly of discretionary items.
  • Store closures due to a harsh winter.
  • An increase in SG&A expenses.

As a result, shares fell 3 percent on Thursday — and this is a lot for a relatively stable company such as a discount retailer. But while investors are pessimistic, is now the time to be a contrarian on Family Dollar and pick up this beaten down stock?

While I would contend that investors should consider paying up for Family Dollar’s “best of breed” peer — Dollar General — I don’t think that Family Dollar is a bad company. It overextended itself, and it is now realizing this and attempting to rectify the situation. Thus, while the numbers may be weak for a few quarters, contrarian investors might be getting an opportunity to pick up the stock of a good company inexpensively. Read on to find out why.

First, Family Dollar’s management has realized that it is overextended — it expanded too quickly.  As a result, it is operating several stores that aren’t generating sales growth and that aren’t benefitting shareholders. Therefore, management has decided to close 370 stores in the next several months. While this will likely take a toll on sales, we should see margins improve.

What is especially appealing about this decision is that the company is making it early. Consider that other companies — like J.C. Penney (NYSE:JCP) — only just realized a few months ago that it needed to close stores while it was losing hundreds of millions of dollars. While Family Dollar will be hurting for a while, it should remain comfortably profitable as it restructures its business.

Second, lower and middle class consumers are shopping at dollar stores and discount stores more frequently. They want to save as much as possible and they are therefore hunting for bargains, which Family Dollar and its peers offer. We can still see the trend in Family Dollar’s numbers even if the company is reporting weak sales, margins, and profits. Consider that while overall sales were down, this decline is due to a decline in discretionary spending. Staple items such as food, as well as tobacco products, are still selling strong.

Third, unlike its peers, Family Dollar returns capital to shareholders in the form of a dividend. While all three companies buy back stock, Dollar General and Dollar Tree do not pay a dividend. Family Dollar’s dividend demonstrates management’s devotion to its shareholders. Furthermore, it will begin to attract investors searching for income as the share price falls and the dividend yield rises.

With the stock trading at a 52 week low the company’s stock trades at about 16.8 times its trailing earnings. Furthermore, earnings are likely to remain somewhat weak given store closures and weak margins. As a result, I think that we could see ongoing weakness in Family Dollar shares for the coming days and weeks. Nevertheless, there is support in the low $50s, and if you like the discount retailer space and you don’t mind gambling a little, that could be a good buy-point.

However, if you are looking for a lower risk discount retailer, Dollar General is a superior choice.

Disclosure: Ben Kramer-Miller has no position in Family Dollar or the other stocks mentioned in this article.

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