Risk, Reward Balance Family Dollar

The economy is still looking for remedies, and bargain hunters have no choice but to go from one shop to another to grab the best deal, with their primary focus being on essential items, such as food. Family Dollar Stores Inc. (FDO - Analyst Report), with its low cost options, remains successful in luring budget-constrained consumers amidst unstable economic recovery. 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. For fiscal 2012, management expects growth of 9% to 10% in net sales and 15.4% to 18.6% in earnings per share.

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 its 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 aided Family Dollar in posting healthy third-quarter 2012 results. The quarterly earnings of $1.06 per share jumped 16.5% from 91 cents earned in the prior-year quarter on the back of healthy sales witnessed in the Consumables, and Seasonal and Electronics categories, and marked a 17^th successive quarter of double-digit growth.

However, earnings missed the Zacks Consensus Estimate by a penny.

North Carolina-based Family Dollar expects earnings between 71 cents and 81 cents for the fourth quarter and in the range of $3.60 to $3.70 per share for fiscal 2012.

The operator of self-service retail discount store chains posted a 9.6% increase in revenue to $2,360 million from the prior-year quarter, partially offset by Home Products (down 1.8%). The company reflected sales growth across Consumables (up 12.2%), Seasonal and Electronics (up 15.4%) and Apparel and Accessories (up 1.1%). However, total revenue fell short of the Zacks Consensus Estimate of $2,373 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 the dividend program in 1976, the company has raised its dividend every year at a compounded average growth rate of about 16%. During the first-nine months of fiscal 2012, the company repurchased 1.7 million shares, aggregating approximately $91.6 million. As of May 26, 2012, the company still had $245.7 million at its disposal under its share repurchase program.

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 backed by the lower-margin consumables category.

Consequently, the increase in sales of lower margin merchandises weighed upon the company’s gross margin that contracted 40 basis points to 35.8%. Operating margin shriveled 20 basis points to 8.4%.

It is obvious that given a dismal economy, consumers will focus on basic necessities such as food, which generally carry lower margin. Management expects margins to remain under pressure in the fourth quarter and in the beginning of fiscal 2013.

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

Challenging Economy & Competition

The economy has still not awakened from a state of hibernation and consumers will remain cautious on their spending, buying only those things that fulfill their basic needs. Consequently, we could see more competitive pricing and new products to attract shoppers.

A trigger in price war will definitely eat away margins, and in turn will affect the company’s results. In order to remain competitive, it is better to 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 - Analyst Report) and Dollar General Corporation (DG - Snapshot Report) will likely continue to weigh on its results.

Holds Zacks #3 Rank

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