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The economy is witnessing an uneven recovery, and amidst such a scenario, bargain hunters have no alternative but to hop several shops in search of the best deal, with their main focus on essential items, such as food. Family Dollar Stores Inc. (FDO - Analyst Report), with its low cost options, remains successful in enticing budget-constrained consumers. Margins, however, 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 ranging from under $1 to $10.

The Company Counts Upon

The company’s strategic initiatives to improve merchandising, marketing and store operations have resulted in sustained growth in the top and bottom lines. Management now expects a growth of 13% to 15% in net sales and an increase of 12.6% to 20.9% in earnings per share in fiscal 2013.

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.

The company is accelerating new store openings. Family Dollar opened 475 stores and renovated, expanded, or relocated 854 stores during fiscal 2012. Through fiscal 2013, the retailer plans to open about 500 new stores and renovate, expand, or relocate 850 stores. The company projects store count to increase at a rate of 5% to 7% over the next 3 to 5 years.

Healthy Results

All these endeavors facilitated Family Dollar in posting impressive fourth-quarter 2012 results. The quarterly earnings of 75 cents per share came in line with the Zacks Consensus Estimate but jumped 13.6% from 66 cents earned in the prior-year quarter on the heels of healthy sales witnessed in the Consumables and Seasonal & Electronics categories, and marked the 18th successive quarter of double-digit growth.

North Carolina-based Family Dollar now projects earnings between 69 cents and 78 cents for the first quarter and in the band of $4.10 to $4.40 per share for fiscal 2013. Management’s target for 3 to 5 years includes double-digit bottom-line growth.

The operator of self-service retail discount store chains posted a 10.8% increase in revenue to $2,364.1 million from the prior-year quarter, and reflected sales growth across Consumables (up 16.1%) and Seasonal & Electronics (up 4.8%) partially mitigated by Apparel and Accessories (down 6.7%) and Home Products (down 1.4%). However, total revenue fell short of the Zacks Consensus Estimate of $2,367 million.

Margins under Pressure

Family Dollar registered growth in the top and bottom lines, but it was insufficient in alleviating the concern regarding 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 20 basis points to 33.8% during the fourth quarter of 2012. Operating margin shriveled 140 basis points to 6.1%. For fiscal 2012, gross margin dropped 60 basis points to 34.9%.

It is obvious that given a dismal economy, consumers will focus on basic necessities such as food, which generally carries a lower margin. Management anticipates gross margin to remain under pressure in fiscal 2013 due to increasing percentage of consumables in sales mix.

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.

Tough Economy & Stiff Competition

The economy is still not completely awakened from the state of hibernation, and buyers remain prudent with respect to their expenditures, purchasing only those items that cater to their basic needs. Thus, we could witness more competitive pricing and new offerings to lure consumers. The onset of a price war will definitely eat away margins, and in turn affect the company’s results. In order to remain competitive, it is better to experiment with innovative ways to win the hearts of target consumers rather than lagging 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 - Analyst Report) will likely continue to weigh on its results.

Holds Zacks #3 Rank

Given the pros and cons of the stock, we maintain our long-term “Neutral” recommendation on it. Moreover, Family Dollar shares also maintain a Zacks #3 Rank that translates into a short-term “Hold” rating.

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