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Why Family Dollar Is Overvalued and a Wal-Mart Bid Is Unlikely


It would be more reasonable for Wal-Mart to simply wait for a lower price, if it does anything at all.


The market has added Wal-Mart (NYSE:WMT) to Dollar General (NYSE:DG) as a potential bidder for Family Dollar Stores (NYSE:FDO). This comes after a report from a sell-side analyst saying that Wal-Mart could buy the stock at $82. I think that an acquisition is unlikely now at this $66 price, and that Family Dollar should be sold, based on the competitive fundamentals.

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

To distill the situation before the Wal-Mart Q4 earnings call:

Wal-Mart data showed that Family Dollar -- and to a lesser extent Dollar General -- will be facing a much tougher competitive environment earlier than I had previously expected. Wal-Mart told analysts in October that its Neighborhood Market (NM) format has the equivalent sales of 10 dollar stores. So, a Neighborhood Market is roughly twice as productive in sales per square foot as a dollar store.

Wal-Mart also said that the approximately 15,000-square-foot Wal-Mart Express has the equivalent sales of three to five dollar stores (with prices about 4% above those found at Aldi). Sales per square foot at a Wal-Mart Express would be anywhere from 60% to 166% greater than the average 8,000-square-foot dollar store. Again, huge.

Not surprisingly, Wal-Mart said that it was accelerating NM expansion to 700-plus stores by FY17 (the previous estimate was 500 stores by FY16). Management said that the NM was very effective against dollar stores thanks to assortment, having a pharmacy, and, of course, price. I had expected the next year's meeting to reveal some big expansion numbers on the Wal-Mart Express concept, which was only 20 units then.

Aldi updated and upsized its growth plans, saying that it will ramp up its openings to an 8.4% CAGR for the next five years, a 50% increase in its targeted number of openings for that time period. While Aldi is a completely private-label food store only, it's still a very formidable competitor for a dollar store, as it has historically gone into the same sorts of strip-mall centers as dollar stores, with the same approximate square footage. Given the fact that Wal-Mart's sales per square foot are so much higher than those of a dollar store, the extra 4% price advantage for Aldi over Wal-Mart should allow for an Aldi store to have the same relative sales versus an average dollar store, as do Wal-Mart Express and Neighborhood Market.

Note also that the market for retail real estate is relatively good for Wal-Mart and Aldi, with many of the lowest-quality malls in financial trouble and many retail concepts withdrawing from B malls. And, of course, their stores are good "anchors" for strip-mall centers -- probably better than traditional supermarkets at this point.

After Wal-Mart's analyst meeting in October, I updated my calculations. I found that the expected sales volumes from Wal-Mart's Neighborhood Market combined with Aldi's square footage growth, plus some initial growth in Wal-Mart Express, would now be equal to the sales expected to come from 6.5% weighted average square footage growth of all of the other companies in the dollar store industry in calendar 2014. This would be one year to 1.5 years earlier than I had originally thought.

An important corollary to saturation is that margins will very likely start to fall before the saturation level is reached. So I expected secular pressure on Family Dollar's stores to show up in calendar year 2014 (and certainly by 2015) if, indeed, it wasn't already affecting FDO. Then Wal-Mart management, on its Q4 earnings call, said that it was again upping its Neighborhood Market and Wal-Mart Express growth from 120 to 150 stores per year to 270 to 300 stores -- actually not surprising, given the relatively huge sales per square foot versus dollar store competition, and with a short build-out time of four to nine months.

On the Family Dollar side, there was a $0.01-per-share miss on the November EPS just reported, and management lowered guidance for FY14 from $3.80-$4.15 to $3.25-$3.55 versus a street consensus of $3.98. Comp store sales are expected to be DOWN -- in low single digits versus a previous low-single-digit increase. The COO is also gone, with no replacement yet named.

So there's a lot of work to do, but I wonder if a $3.40 earnings level is really a good valuation base. I can take FY13 EPS of $3.80, cut a 3% pricing differential to Dollar General, then add $5,000 of manager and assistant manager pay increase to its 7,800 stores, where manager turnover has gone to the high 30s percent range from the low 20s in the face of the many operational changes being made. The result would be a halving of FY13 EPS to $1.90, before offsets such as better sales and less shrink, and possibly less needed couponing.

My valuation method is the standard three-stage EPS discount model taught in MBA school. The risk-free rate is 4.2%, which is the 30-year Treasury bond of 3.6% plus 60 bps of leaning against the Fed's quantitative easing. I use a 7% company-specific risk discount for many retailers, including FDO, and a 1.5% terminal growth rate. Because of the Wal-Mart/Aldi juggernaut, I only use a one-year, not a five-year, EPS growth rate. I also question a five-year decline in returns to terminal growth, but I'll give FDO the benefit of the doubt and say that it gets its operations improved and doesn't hit a complete earnings wall.

So, using EPS estimates of $3.25 for FY14 and an 11% (sell-side LT EPS growth estimate) gain to $3.60 in FY15, and then assuming EPS growth starts a five-year decline to a terminal 1.5%, the stock is worth an optimistic $45. That is absent the Dollar General potential acquisition that keeps the stock at $65. However, I believe that DG's management sees the same competitive intensity increase that I do, which would bear on how much it might pay for Family Dollar and when it might be willing to buy it (assuming that's what Dollar General wants to do).

Enter an outstanding sell-side retailing analyst saying that it would make sense for Wal-Mart to acquire Family Dollar with an $82 midrange target for two possible bidders.

The pluses are that geographic overlap isn't bad and would likely get FTC approval without much store divestiture. Family Dollar is found more heavily in urban areas than other dollar stores, which would help Wal-Mart better penetrate cities. There are purchasing and overhead synergies, and comp store sales should pick up almost immediately. One competitor would be taken out.

Negatives are that the Justice Department, prodded by the United Food and Commercial Workers International Union, could well invent antitrust problems, much as when it stopped the US Air/American merger. The average Family Dollar is 7,000 to 9,000 square feet, but Wal-Mart Express, which is hugely more productive, is a 15,000-square-foot concept.

Then there's the productivity itself. Neighborhood Market is the most productive concept, and although I'm sure that it will take lots of sales from dollar stores on price, it's still a supermarket.

Putting myself in Wal-Mart's place, even if I want Family Dollar, I have the means to cut its throat competitively in the short to intermediate term. So why not do nothing now and wait for a lower price?

Also, I believe that Wal-Mart must have examined this acquisition already. The recent announcement of a doubling of its build-out rate indicates that it has passed on the idea.

Dollar General has smart management. It can see the effect of Aldi and Wal-Mart coming over the horizon. It can also wait for a lower price.

Bottom line: In my opinion, FDO stock should be sold.

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