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On Jan 21, we downgraded Family Dollar Stores Inc. (FDO - Analyst Report), the operator of self-service retail discount store chains, to Underperform based on the company’s lower-than-expected first-quarter fiscal 2013 results and a conservative outlook for fiscal 2013.

Why the Downgrade?

Estimates for Family Dollar have been declining ever since it reported soft first-quarter fiscal 2013 results and trimmed its earnings guidance on Jan 3.The earnings of 69 cents a share missed the Zacks Consensus Estimate of 74 cents, and came in at the lower-end of the previously provided guidance range of 69 cents to 78 cents due to gross margin pressure.

Management anticipates fiscal 2013 earnings in the band of $3.95 to $4.20 per share, down from a range of $4.10 to $4.40 forecasted earlier. Consequently, the Zacks Consensus Estimates for fiscal 2013 and 2014 fell by 6.1% and 7.3% to $3.99 and $4.47 per share, respectively, over the last 30 days. With the Zacks Consensus Estimates for both fiscal 2013 and 2014 going down, the company now has a Zacks Rank #5 (Strong Sell).

Cause for Concern

Family Dollar remains concerned about the increasing gross margin pressure. Consumables category now accounts for 73.9% of first-quarter fiscal 2013 sales compared with 70.3% in the prior-year quarter. Consequently, the increase in sales of lower margin merchandises is weighing upon the company’s gross margin that contracted approximately 120 basis points to 34.1% during first-quarter fiscal 2013. Increased discounts and higher inventory shrinkage also hurt the margins. For fiscal 2013, management expects gross margin to remain under pressure.

Family Dollar stated that customers are now becoming more cautious about their discretionary spending, and added that the holiday season appeared tougher than perceived. The company’s December comparable-store sales rose approximately 2.5% on the back of double-digit sales in consumable items.

Discount Store Chains That Warrant a Look

Not all discount store chains are performing as disappointingly as Family Dollar, which we prefer to avoid until we see signs of improvement in the company's performance. Big Lots Inc. (BIG - Analyst Report), Ross Stores Inc. (ROST - Analyst Report) and The TJX Companies Inc. (TJX - Analyst Report) look promising and are expected to continue with their upbeat performances in the coming quarters. These stocks hold a Zacks Rank #2 (Buy).

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