Friday, November 19, 2010

Equity Buy Recommendation Write-Up of Fred's by AIM Student, Mike Muratore

Fred’s, Inc. (Nasdaq: FRED) Buy Recommendation by Michael Muratore* (Consumer Services Analyst for AIM Equity Fund)

Fred’s sells general merchandise through retail discount stores and pharmacies in the southeastern United States. FRED’s stores offer pharmaceutical products (33.5% of sales), household goods (23.4%), food and tobacco products (16.2%), apparel and linens (7.9%), and health and beauty aids (7.6%), to primarily low, middle, and fixed-income families. Approximately 83% of Fred’s stores are located in markets with populations of 15,000 or fewer people. Full-service pharmacies are located in about 50% of the company’s stores. The company also sells general merchandise to franchised Fred’s stores (2% of sales). As of April 3, 2010, Fred’s operated 669 general merchandise stores, including 24 franchised stores. Founded in 1947, Fred’s is headquartered in Memphis, TN.


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Recommendation

Fred’s operates stores that cater to the basic needs of small-town Americans in the Southeast region of the U.S. The firm has carved a unique niche in the region, providing discount prices on a wide range of products, giving lower and middle-class families a chance to stretch their dollar in today’s challenging economy. Fred’s revenues have been consistent, growing at an average of 3.1% since 2006, despite the economic downturn.


While discount stores are a low operating margin business, FRED has seen solid growth in margins since their low of 0.92% in 2008 to 2.15% in 2010. Management’s forecasted revenue growth is 3-5% in 2010, and conservative growth rates for the next 4 years are about 2% per year. Their latest same stores sales growth of 2.50% in Q2 is significantly better than the peer average of 1.66%. Lastly, Fred’s has a consistent history of paying a dividend to shareholders, with a 5 year dividend growth rate of 13.4%. Their current dividend yield is 1.30%. Because of these reasons and a favorable valuation, it is recommended that FRED be added to the AIM Equity Fund with a target price of $15.70, which offers a potential upside of 27%.


Investment Thesis

Distinctive Niche. FRED’s offers a wide variety of merchandise with a more attractive price-to-value relationship than other drug stores or smaller discount/variety stores - and is more shopper-convenient than a larger discount store like Wal-Mart. Stores are typically located in small to medium sized towns in the southeastern United States, where there are fewer store options for consumers to purchase their basic needs. A good way to think about Fred’s product mix is a combination of Walgreen’s, Big Lots, and Target. Stores have over 12,000 frequently purchased items and maintain low price points and competitive prices. Fred’s stores are usually located in convenient shopping and residential areas, with 43% being freestanding, allowing for easy customer access. Stores are manageable sizes and have centric store layouts that allow for fast customer checkouts.


Core Five Program. Lately, management has focused on what they refer to as the Core Five Program, a strategy to upgrade and remodel stores in order to highlight departments in which Fred’s has a clear and marketable advantage over their small-box competitors. Core Five is designed to build upon Fred’s current strength and competitive differentiation by emphasizing the departments that are strong store trip drivers. These departments are Pharmacy, Celebration and Party, Pets, Paper and Chemical, and Needs for the Home. This year, management increased capital expenditures in the Core Five departments by $8M and added an additional $3M to the advertising for these departments. Management sees each of the Core Five areas eventually achieving 10% same store sales increases, with a 3.5% increase expected in 2010. Lastly, Fred’s has measured that stores with the new layout have 20% better sales per square foot than those with the old layout. As part of the Core Five initiative, Fred’s has already remodeled 190 stores and eventually will remodel 300 more stores in the next 2 years.


Favorable Macroeconomic Environment for Discount Stores. With unemployment rates hovering just under 10%, along with 9-month lows in consumer confidence and consumer sentiment, consumers are still being cautious with their spending. Regionally, the Southeast has relatively high unemployment rates (MS - 8.8%, TN - 9.6%, GA - 10.3%). Fred’s low prices give shoppers an opportunity to save money through Fred’s “Everyday Low Prices” strategy, while buying the essentials. As part of this strategy, Fred’s maintains low opening price points and competitive prices on key products across all departments. Management prides themselves on offering customers a good price-to-value relationship. Fred’s also offers discounted private label items that are cheaper alternatives to national name brand products.


Valuation

To find the intrinsic value of FRED, a DCF model and Price/Book analysis were conducted giving a 75% weight to the DCF and a 25% weight to the Price/Book. Revenue growth rates were projected out taking into account management projections and historical growth rates which averaged close to 3% annually. Fred’s top-line revenue growth rates have been very stable over the past 5 years. FRED is currently trading at a 0.98x Price/Book multiple and the 5 year Price/Book multiple average is 1.29x. This is a discount to their peer average, which is 2.37x on a TTM basis, and a 2.18x 5-year average. The sensitivity analysis accounted for variations in WACC of 9.16% and the terminal growth rate of 3% and yielded a range of values from $13.42 - $17.82. An intrinsic value of $15.50 was obtained using the DCF and Price/Book Multiples analyses. Along with Fred’s 1.30% dividend, a price target of $15.70 was obtained, providing a 27% upside.


Risks

Seasonality. An inherent risk to FRED’s business is seasonality. Fred’s is heavily dependent on sales that occur during the Christmas season (27% of total revenues occur in Q4). An inventory imbalance could definitely result if Christmas sales fall below management’s expectations. Additionally, if fourth quarter results were below expectations, profitability and operating results would suffer if unexpected markdowns were needed.


Change in Third Party Reimbursements, Including Government Programs. A large portion of Fred’s net sales comes from federal and state governments and private insurance plans, particularly in the pharmacy area (about 33% of net sales). With the current attitude towards healthcare focusing on cost-containment, both governments and insurers may seek to impose lower reimbursements and utilization restrictions. Basically, private insurance bases their reimbursement rates off the government rate, and if there is a drop in reimbursement rates, Fred’s revenues would be adversely affected.


Management

Bruce Efird has been CEO since February of 2009. Prior to joining the FRED’S, Mr. Efird was Executive Vice-President-Merchandising at Meijer, Inc. He began his retail career with Food Lion, Inc. in 1984. Mr. Efird brings spent his entire career in the retail industry, with specific experience in the consumable areas of the business.

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* Mike Muratore is a student in the AIM Class of 2011 and is the consumer services analyst. He is a finance and economics major - he graduates in May 2011. Mike can be contacted at: michael.muratore@marquette.edu.

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