Heavy Wal-Mart Pressure "Breaking" Family Dollar

Family Dollar ("FDO") is experiencing deteriorating fundamentals due to a combination of a challenging macroeconomic backdrop for lower to middle income consumers and intense competition in the discount retailing segment.

At the macro level, weak employment and real income growth for lower and middle income consumers coupled with excess existing leverage (student, mortgage, credit card) are acting as drags on demand. Moreover, reduced fiscal stimulus (ie. food stamps, unemployment benefits) is unable to offset constrained access to credit and diminished income growth.

At the sector level, dollar stores are facing increasing competition from warehouse clubs and other discount retailers. These competitors are exerting pressure on the dollar stores through compelling pricing, superior in-store experiences and better selection. Importantly, many of the competitors have in-store pharmacies, which offers customers a more complete shopping experience. Perhaps the best example of incremental competition is coming from Wal-Mart ("WMT") through its two smaller store formats: Neighborhood Markets ("NM") and Wal-Mart Express ("Express").

Briargreen believes that FDO represents the most compelling short opportunity in the dollar store space for several reasons. First, the company is facing significant operational issues with inventories rising at a much faster pace than same store sales (2.1% increase in average inventory per store versus a 3.8% decline in same store sales in the most recent quarter). Moreover, the company's COO recently resigned. We believe that this was precipitated by issues with the company's distribution systems and merchandise assortments at the store level. As evidence of this assertion, we would encourage those interested to watch an episode of the CBS series, "Undercover Boss" that aired on November 8, 2013. In that episode, the prior COO visited a number of areas within the company and it proved illuminating to Briargreen in terms of the operational difficulties that the company is facing.

Second, the company is facing margin pressure at the gross and operating margin lines as it seeks to stabilize same-store sales and market share. In fact, operating margins declined 236bp y/y in the most recent quarter with slightly over half the decline coming from the gross margin line. Moreover, while FDO's gross margins fell only 20bp y/y in the most recent quarter, the company's gross margins remained roughly 130bp higher than DG despite less scale and a revenue mix that is roughly comparable in terms of consumables (which carry lower gross margins than other product lines). On its recent Q2 FY 14 earnings call, the company explicitly stated that it needs to invest in price (ie. lower gross margins) to re-capture market share. In addition, declining same-store sales are going to cause de-leveraging on the SG&A line (ie. operating margins will decline further). To offset the expense de-leverage, the company is cutting headcount at the corporate level and through store closures, which will add ~$0.25 in EPS on an annualized basis. Interestingly, FDO plans to reduce headcount yet grow its store base against the backdrop of existing operational issues. This does not sound like a good plan from our perspective.

Third, free cash flow is currently significantly negative as the company continues to add stores, albeit at a reduced rate, and operating cash flow is down 17% year-to-date. We would add that FDO currently pays a dividend of $1.24/share on an annual basis (~$140mm total) despite negative FCF. While the company likely has some room to increase leverage (net debt/ltm ebitda is less than 1x excluding capitalized rent) to fill the cash flow gap, the dividend could prove in jeopardy in future quarters. Essentially, Briargreen believes that FDO will have to trade growth for maintaining the dividend in the future and this could provide an incremental catalyst on the short side.

Finally, the combination of operational difficulties and declining margins is resulting in declining returns on invested capital ("ROIC"), which by our estimate compressed over 100bp on an LTM basis versus the prior quarter. While ROIC is above the company's cost of capital (assuming a WACC of 10% as a base case), Briargreen believes returns will compress further particularly as the company continues to add stores with marginal returns on invested capital significantly below the corporate average.

On a valuation basis, despite compressing and significantly inferior ROIC versus its closest competitors (DG, DLTR), and markedly lower revenue and EPS growth, FDO now trades at a premium PE on calendar 2014 estimates. By our estimates, FDO is trading at ~19x calendar 2014 earnings versus its peers, which trade at ~15x 2014 earnings.

We believe that this premium valuation is due to erroneous expectations of significantly improved earnings in future years through a successful turnaround, and perhaps more importantly, hope that FDO will be acquired by DG, WMT or perhaps even the target of a leveraged buyout. Acquisition risk is one of the key risks to this short, in our opinion, but we believe that WMT is more focused on organic growth through its seemingly superior formats and DG will likely wait for FDO's valuation to compress further before possibly contemplating an acquisition.