Focus Stock: Tough Times Favor Family Dollar Stores

In a difficult economic environment, we look for retailer Family Dollar Stores (FDO; recent stock price, $25) to increase sales to its predominantly lower-income customers by expanding its assortment of daily necessities, including refrigerated and shelf-stable foods, and by improving product quality.

We also expect Family Dollar to benefit from higher-income customers trading down to lower-priced basic goods. In addition, we note easier same-store sales (sales results for stores open more than 13 months) comparisons for the company over the next few quarters and expect to see a lift in average customer transaction value, a same-store sales driver, from Family Dollar's planned acceptance of credit cards in about half of its stores this holiday season.

By providing customers with compelling values and shopping convenience while aggressively managing its cost structure, we expect the company to maintain its historical record of stable sales and earnings growth, which is reflected in its S&P Quality Ranking of A+. From fiscal 2005 (August) through fiscal 2008, earnings per share increased at a compound annual growth rate (CAGR) of 8%. We project 7% EPS growth in fiscal 2009 and a forward three-year CAGR of 12%. We look for the company to generate sufficient free cash flow to fund its operations, growth initiatives, and dividend program.

Prices Range from $1 to $10

The stock carries Standard & Poor's highest investment recommendation of 5 STARS (strong buy).

Based in North Carolina, Family Dollar operates a chain of over 6,500 retail discount stores in 44 states. The company describes its typical customer as a woman in her mid-40s who is the head of her household and has an annual income of under $30,000. Family Dollar stores are operated on a no-frills, self-service basis, and carry an assortment of consumables such as snacks and food, household chemicals, paper products, health and beauty aids, and pet food and supplies; home products, including blankets, housewares and home decor; family apparel and accessories; and seasonal merchandise and electronics.

Unlike some dollar stores that are constrained by a maximum $1 price point, prices in Family Dollar stores range from under $1 up to $10. The once cash-only stores now accept PIN-based debit card payments in most locations. Food stamp and credit-card acceptance is also being rolled out. Family Dollar expects to accept credit cards in about half its stores this holiday season. In our view, broader tender options offer the company an opportunity to improve its share of customer spending as shopping is more convenient and available cash does not limit basket size.

Increasing Its Marketing

Store inventory is made up of both regularly available merchandise, which provides consistency in product offerings, and a frequently changing selection of brands and products that Family Dollar acquires through closeouts and manufacturer overruns at discounted wholesale prices. Low product costs and store overhead enable the company to sell its value-priced merchandise profitably.

Family Dollar's primary growth drivers are same-store sales and chain expansion. In fiscal 2008, same-store sales rose 1.2%, reflecting an increase in average customer transaction value and flat customer traffic, as measured by the company in number of register transactions. By quarter, same-store sales were down 1.0% in the first quarter, flat in the second quarter, up 0.1% in the third quarter, and up 5.6% in the fourth quarter. In our opinion, customers are spending more due to an expanded assortment of consumables and "treasure hunt" items that add an element of excitement and interest to the shopping experience. Family Dollar has also increased its marketing efforts to emphasize the value and shopping convenience it offers.

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