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For Family Dollar, Wal-Mart Threat Is More Serious Than Expected

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FDO will be very disadvantaged against competition from Wal-Mart's Neighborhood Markets and the Wal-Mart Express concept in the next three to four years.

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I finally came up with a somewhat appropriate analogy for the Dollar General (NYSE:DG) vs. Family Dollar (NYSE:FDO) battle in the dollar-store arena: Kroger (NYSE:KR) vs. the other supermarket chains -- such as Safeway (NYSE:SWY) and SuperValu (NYSE:SVU) -- about a decade ago.

Ten years ago Kroger realized that, like the proverbial one of two campers running from the bear, it did not have to outrun the bear, only the other camper. So it cut its untenably high prices vs. Wal-Mart (NYSE:WMT) and gained market share and operating leverage as the other supermarkets maintained their prices and margins. Kroger is now in a somewhat stable position vs. Wal-Mart's supercenters, while Safeway and SuperValu are not.

As background, I refer readers to my last two notes: Wal-Mart's Neighborhood Markets Pose Threat to Dollar Stores and Family Dollar Stores: The Prices Are Too High, and So Is the Stock.

I have argued that FDO's prices, at 3%+ over Dollar General, are too high. Consistently disappointing same-store sales numbers at 4-5% below DG's results over the past two quarters have borne that out. That price differential, I have stated, will cause FDO to be very disadvantaged against competition from Wal-Mart's Neighborhood Markets and the Wal-Mart Express concept in the next three to four years.

Now, looking at Wal-Mart data from its recent investor conference in Arkansas, Family Dollar -- and to a lesser extent, Dollar General -- will be facing a much tougher competitive environment faster than I expected. My worst-case scenario was that a Neighborhood Market (NM), typically 35-40,000 square feet, would displace six dollar stores, at 8-10,000 square feet per outlet. Wal-Mart told analysts recently that the NM format equals 10 dollar stores in terms of sales. While I did not estimate how many dollar stores would be displaced by Wal-Mart Express, because the company did not previously stress growth in that area, I did expect that stores opened by another competitor, Aldi, would displace 1.5 times the dollar store square footage. My expectation was low again -- way low. Wal-Mart said that each Walmart Express outlet, at about 15,000 square feet, sells as much as three to five dollar stores, and that's with prices about 4% above Aldi's.

Wal-Mart also announced that it was accelerating NM expansion and expected to open more than 700 stores by fiscal year 2017; a previous estimate suggested it would open 500 stores by 2016. The company also said that Neighborhood Market stores are extremely effective versus dollar stores because Wal-Mart's outlets have a pharmacy, and because they offer a wider assortment of products at lower prices. I would look for next year's meeting to reveal some big expansion numbers on the Wal-Mart Express concept, which is only 20 units now.

This quote is from my the article mentioned above on dollar store saturation:

Assuming that dollar store square footage grows at a 6.5% growth rate, and using a displacement of four dollar stores by one Neighborhood Market, I found that the saturation level is reached two years earlier, in calendar 2015, instead of 2017 where it would have reached saturation without an increase in dollar stores.

In the 'worst case' scenario, if a Neighborhood Market were to displace six dollar stores, the saturation point would come almost another year earlier.

Adjusting this expectation for the much stronger threat that Wal-Mart's smaller concepts seem to be, I would expect secular pressure on Family Dollar's stores to show up in calendar year 2014, and certainly by 2015.

Therefore, what is in the valuation?

Well, if I am right, the $4 estimate for FY14 ending in August could be high, and the Street low of $3.65 for FY15 looks to be a better bet than the consensus of $4.45. If an expansion into California by FDO goes very well, maybe it gets to 2015 before the competitive pressure (saturation point) is reached.

Looking at a three-stage earnings discount model and giving Family Dollar the benefit of the doubt on earnings with the $4.45 Street consensus for FY Aug '15, I use the 11% growth rate from FY14 to FY15, then decay the growth rate in FY16 for the competition. The result is a $47 deserved valuation.

Keep in mind that the differences in sales per square foot, if they hold up, will force FDO to lower its pricing structure in the next three to four years with a hit to the present value of future earnings, something I am not accounting for in my valuation model.
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