Blue Team Stock Study
Fred’s Inc (NDQ: FRED)
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Business Summary (from VL): “Fred’s is a self-service discount
store chain serving small-to-medium towns in fourteen southeast/midwestern
states. The company operates 607 units including 25 franchises. About 46% have on-site pharmacies. Has distribution centers in
Caveats: We suggest a key to a buy/no-buy decision (apart from any possible portfolio-wide issues) is to look at the risks, focus on the most significant risks, and try to weigh these. Our assessment is that the stock is a buy, and point out that a focus on just the risks can lead a person to reject any given stock. However, we expect that others could look carefully at this same stock and conclude that the risks are too substantial relative to potential reward.
o Revenue versus Number of Stores plot
o VL page
o S&P page
o M* report
Note that each of these is expanded upon below. This is an html document; just click on any of the risk links, and use the “back” button to come back to here.
1. Increase in debt --- are they borrowing in order to fund new stores?
3. Profitability: low margins
4. Profitability: ROE has dropped off
5. Niche isn’t big enough to sustain growth
6. Competition: Niche isn’t defendable
7. Dependence upon one key supplier (
8. slow recovery of discretionary spending by core customers
9. changes in third-party pharmacy reimbursement policies
An important thing to keep in mind in this highly competitive retail environment is just how Fred’s can compete with both larger stores (Walmart, Target, etc), and with even more local small-town stores. What is Fred’s “niche” ?
From the S&P report (business summary):
“Fred’s aims to meet the general merchandise and pharmacy needs of the small to medium-sized towns that it serves by offering a wider variety of quality merchandise and a more attractive price-to-value relationship than either drug stores or smaller variety/dollar stores. The company seeks to provide a shopper-friendly format that is more convenient than larger sized discount merchandise stores.”
A summary of that summary might be that they try to provide better prices than other local (perhaps even more local) stores --- they can’t compete with Walmart we presume on price --- while being more “convenient” than the bigger guys. By convenient we presume they mean that for their customer base a given Fred’s store is a shorter drive away, plus you don’t have to walk across a football field worth of parking lot and you’re not likely to exhaust yourself walking from one end of a Fred’s store to the other.
Avi did the SSG for the group.
Sales Growth, based on slowing trend, and what Avi has been reading, his inclination was to go with 13%. He scaled it back to VL's estimated rate of 12.5%. For EPS, he used preferred procedure: For Profit Margin, he used 3.5%. Average 3.3%, Current 2.7% - Reading seems to indicate that they feel FRED's can get back to their recent high, which is close to 4%. Avi prefers to be a little conservative. For taxes, he used VL 35% for 08-10. For shares, given that they are increasing, VL had 41 million, he used 42 to give us a little wiggle room and be more conservative. With all that, he came up with 14.7% and $1.32 of EPS. VL projected out $1.65, so Avi was comfortable with these numbers.
With PE's, he used the reverse weighted average of the last 5 years, rounded to the nearest number, which actually equals the 10 year average PEs. Giving a high of 24 and a low of 15. Average is 19.5 - Value Line projects average PE at 20.
For Low Price, Avi used 4Ba.
Discussion of Risks/Downsides/Issues:
LT debt going up. Brian doesn’t see this as a problem: Look at it as a % of capitalization. The highest it ever hit was 16.6% in 2001. Then it dropped to virtually zero the next year (0.6%). Yes, it’s been rising since then, but it’s up to a whopping 7.1% in 2005. The pattern doesn’t concern him as much if the amounts are relatively small.
Avi notes that VL projects LT debt to rise to 50.00 in 2008-2010. This seems to read to him that they will need to borrow to open new stores which are somewhat necessary to their continued growth. With expanding this way comes risk, including rising interest rates.
Avi points to the sales line on the SSG starting to slow in the last year, and suggests that this could be partly as a result of the economic pressures faced by FRED's primary consumers which results in them buying less of items other than the absolute necessities (which also means they are selling more stuff with low profit margins instead of the "luxury" items which have higher profitability). It looks to him that FREDs is somewhat dependent on the economic circumstances of their customers (okay, what he literally said was “upon people like Jason's relatives (you know with pickup trucks up on blocks on their front lawns)”).
Brian points out that sales growth slowed over the last couple of years, and for the most recent year was 10.7% versus a historic average of about 16%. But, look at the attached plot of sales (aka revenues in this case) versus number of stores and EPS (the number of stores also has an ‘E’ in the data points but is the middle line). Note that the growth in stores was also down in the most recent year.
Brian doesn’t believe we have enough data to sort out recent issues from anything that might be longer term.
From the M* report: “Fred's operating margins trail those of its deep-discount peers by a wide margin. In addition, its return on invested capital is far below its weighted average cost of capital, so Fred's does not create shareholder value."
This is obviously a huge factor. This sort of retailing tends to follow a relatively low-margin/high-volume business model. Thus pretty small changes in margins can make a big difference in how much money a company does (or does not) make in total.
Both Brian and Avi question how well the other “peers” really match the niche of Fred’s. If Fred’s is pretty much the same sort of chain of stores as other higher-margined stores, then they’re just flat failing, they don’t match up. But if instead, these are the margins you get when you go after the particular business that Fred’s is going after --- then perhaps we err if we directly compare margins? That’s a tough (but fairly important) question to answer.
Brian notes this text from the M* report: “The company said it has recently implemented new technologies in its stores that should help with cost-containment. Given that Fred's already has the lowest profit margins in deep-discount retailing, we'll be keeping a close eye on how the company manages expenses.”
Most recently, operating margins are down due to “higher store labor, advertising, fuel, and utility costs.” Fuel and utility we can understand; advertising could ultimately pay off (hopefully will).
Avi pulled this from the MD&A part of the 10-K:
"The primary factors which historically have influenced the Company's profitability and success have been its growth in new stores and pharmacies, comparable store sales increases, and improving operating margin through better gross margins and leverage of operating costs. In 2004, the Company faced the challenges of the changing economy and rising fuel costs adversely affecting the low-to-middle income shopper. We experienced a product mix shift toward more basic and consumable product categories, which typically carry lower gross margins, and away from higher margin apparel, home furnishings, and gift products, which are more discretionary to the shopper. This product mix shift had an adverse effect on sales growth, gross margins and store operating expenses throughout most of the year Through most of the year, inventory increased beyond planned levels in the product categories which experienced sales shifts. In the fourth quarter, the Company was successful in reducing inventory to the levels necessary to support new store growth. Additionally, increases in fuel prices negatively affected store supplies and utilities costs, freight costs of merchandise purchases, and distribution costs."
The good news is that it seems that the profitability issues are as a result of shifting economic factors and rising fuel costs. The bad news is that the company really has no control over those factors. It seems to Avi that putting in coolers will help get people in the door to sell more stuff, but if the economy continues to work against FRED's, He is not convinced that it will really help increase sales of the higher margin items. This company seems excessively dependent on a good economy.
More on profit margin changes from Avi’s 10-K review:
“Gross margin as a percentage of sales decreased to 28.1% in 2004 compared to 28.2% in 2003. The decrease in gross margin results primarily from a product mix shift during the third and fourth quarters of the year towards more basic and consumable product categories which typically have lower gross margins than other more discretionary categories such as apparel and home products. We believe a primary reason for this product mix shift was the impact of rising fuel prices on our low-to-middle income shopper. The impact of this product mix shift on the initial margin was approximately .3% for the year. This reduction was offset by the positive impact of better store shrinkage control.”
Selling, General and Administrative Expenses
“Selling, general and administrative expenses were 25.4% of net sales in 2004 compared with 24.5% of net sales in 2003. The increase for the year results from labor expenses and occupancy costs in the stores, higher corporate professional fees associated with our Sarbanes-Oxley 404 internal control compliance work, insurance costs, and fuel price increases affecting distribution costs. During the fourth quarter the Company changed the estimated lives of certain store fixtures from five to ten years. This change resulted in the favorable impact on expenses by approximately $1.3 million."
Their operating costs are also affected by rising fuel costs, but labor costs as well (they are fighting a union - which could make things more expensive), rent costs (occupancy), insurance costs. With low margins, how much of cost increases can they handle?
This is explained with a combination of other issues, primarily margins (above), sales (above), and the Niche/Competition discussions (below). I.e., the nature of what they’ve set out to do --- to sell at prices that are low enough to beat everyone but the biggest competitors --- means that their margins are continually under pressure. The only way they can generate an excellent ROE with low margins is to have a very high sales volume.
With respect to our summary of Fred’s Niche (above), the concern is that the niche is too narrowly defined to support a sufficiently attractive growth rate. I.e., is there “room” between the even-more-local stores that might be even more convenient and perhaps generate even more local support in small-to-medium sized towns --- bounded on the other side by the inexorable growth of the really big stores like Walmart, plus the more classic “dollar” stores?
We have no data to give a definitive answer either way here; it’s a concern that should be explicitly considered, however.
Fred’s swims in very dangerous, competitive waters (per above). Related to this is the M* comment about Fred’s having lower margins than other ~similar (?) store chains, which could suggest that they’re not competing very successfully.
Avi’s review of the 10-K turned up this comment: “Many of the largest retail merchandising companies in the nation have stores in areas in which the Company operates.”
Ultimately, Fred’s niche is either defendable (at a reasonable level of profitability) --- and expandable --- or this chain wouldn’t represent a good purchase for a long-term investor.
Our best estimate is that it is defendable and expandable, but these are crucial factors to get right in an overall assessment.
While not 100% one supplier, here
is something that might need to be considered when we think about risk: Under
2004, all of the Company's
prescription drugs were
ordered by its pharmacies
individually and shipped
direct from the Company's primary pharmaceutical wholesaler AmerisourceBergen Corporation
margin impact on the Company's business until an alternative wholesaler arrangement could be implemented."
Brian suggests that this isn’t a
major risk; there could certainly be some short-term upheaval, but as we know
from studying companies such as
Fred’s tends to sell relative necessities, non-discretionary low-margined goods to folks, and when the economy is good (at least in a given region), those customers are more likely to purchase higher-margined goods from Fred’s and just generally buy more stuff there in general. I.e., increased sales and increased margins in relative good times. The risk we’re talking about here is whether going forward we could see little “discretionary” spending at Fred’s stores. This ultimately boils down to an assessment of the overall economy, particularly as it impacts small-to-medium sized towns in the southeast and midwest.
M* notes that pharmacy accounts for about a third of sales, and that “third-party payers like managed-care firms are demanding lower prices from drugstores for their customers”. Despite Brian’s comment about pharma-supplier companies being competitive (which is true), there is nevertheless the risk of Fred’s already low margins being further squeezed in this area of their business.
Avi notes that lower prices could be a mixed-blessing for Fred's. With 54% of its stores not having a pharmacy, Fred's could capitalize on the prices squeezing some smaller pharmacies out of business. Fred's historically has acquired customer lists and pharmacists that way. Adding pharmacies to their stores seems to also increase traffic in general.
An obvious question that occurs is why pre-tax profits and earnings fell off so sharply in FY 2004. A summary of the multiple factors that caused that
o Higher energy prices, which took money out of customers pockets and apparently also impacted store profitability
o Related to this, customers focused on lower-margined (perhaps just absolutely cheaper) purchases
o Unfavorable weather conditions --- hurricanes and ice storms, to include forced store closings in a high volume period (though you have to wonder where people were shopping instead or if those were just permanently lost sales??)
o Some one-time issues, such as Sarbanes-Oxley costs, executive transition, etc.