Description

Duckwall-ALCO, Inc. (DUCK) is a regional retailer based in Abilene, Kansas. The company operates two distinct chains of full-line discount stores. Duckwall stores average 5,700 sq. ft. and are designed to serve communities of 2,500 people or less. ALCO stores are approximately 20,000 sq. ft. and positioned to serve communities with populations between 5,000 and 16,000. Currently Duckwall-ALCO operates 88 Duckwalls and 175 ALCOs. The majority of sales (91%) originate from the ALCO units. Unless you’ve traveled to O’Neil, Nebraska, Willow Springs, Missouri, or Miller, South Dakota, all this is probably news to you.

Three factors make Duckwall-ALCO a compelling investment:
1) It is a simple story with a compelling valuation. The business model is clean, the balance sheet solid, and management is intent on building shareholder value.
2) DUCK is in the early stages of a chain-wide (ALCO stores) remodeling program which is having significant impact on same store sales growth and company earnings.
3) DUCK’s market position has defensible competitive advantages.

The Business:
DUCK has 4.171 million shares traded on NASDAQ for a market cap of $58,394 million. Total debt is $26,344 (including net present value of capital lease obligations, but excluding operating leases), and EV is $84,738. This happens to be lower than net working capital of $90,382. All told there are 263 stores with TTM sales of $416.9 million and TTM EBIT of $10.9 million. Earnings for the same period came in at $5.3 million or $1.25 per share. The TTM ratios are as follows:

TTM
EV/EBIT 7.7
EV/EBITDA 4.9
P/E 11.2

The accounting is straight forward but understates true earnings because of the incremental returns available from capex spending. (More on that later.) Note that these results were achieved in the current week economic environment and may represent trough margins. Management has reduced shares outstanding by 18% since 1999. In the same period, non-lease debt has also been reduced from $37.5 million to $20.4. The company has a modest growth strategy focused on closing stores in competitive markets while expanding into non-competitive markets. This should result in a net increase of 2 - 4 stores per year.

The Catalyst:
Beginning in fiscal 2002 (fiscal year ends at January 31st) the company set forth a plan to remodel 32 ALCO stores per year. The remodeled stores have achieved significant increases in same stores sales compared to other stores. While management won’t break out specific numbers, they have repeatedly trumpeted the success of the remodeling program and made reference to double digit increases in same store sales. This is evident in the acceleration of company wide sales during fiscal 2002. 32 remodels were completed by Q4 2002 and 7 more in Q1 2003. This program is very cost effective, averaging $100,000 per store or $3.2 million per year.

Of that $3.2 million about $2 million is categorized as “Purchase of Property and Equipment” on the cash flow statement. The rest flows through the income statement as SG&A. Also, DUCK spends about $1.325 million to open each new store. While it is not clear how much of this is expensed and how much is capitalized, it is clear that there is a significant investment quotient to the company’s capex spending (which has roughly equaled depreciation).

The combination of increased sales from the remodeling program and significant margin leverage should lead to a healthy increase in earnings as this remodeling effort continues in fiscal 2003 and beyond. (At a rate of 32 per year this is a five year project.) I believe that operating income can increase from $10.4 million in fiscal 2002 to $14.7 million in this fiscal year. Net earnings can rise from $4.7 million to $8.0 million as margins expand from 1.2% to a very reasonable 1.9%. These increases would result in earnings per (diluted) share of 1.90 in fiscal 2003 and 2.04 in fiscal 2004. The ratios based on these 2003 figures are:

Fiscal 2003 (ending Jan. 31st, 2003)
EV/EBIT 5.8
EV/EBITDA 4.0
P/E 7.4

The Moat:
DUCK’s competitive advantage lies in its strategy to focus on ultra-small demographic markets.

To say that DUCK’s target market, small rural towns with populations of 10,000 or less, is under the radar of all the formidable retailers is an understatement. The category killers’ target demographic is often ten to twenty times the size of the towns DUCK serves. Even Wal-Mart’s small format “Neighborhood Market” concept is designed to play to a much larger audience.

There are however two retail chains that compete head to head with DUCK. Fred’s is a formidable competitor but is concentrating its efforts east of the Mississippi and to a slight larger demographic. Shopko has a division of stores called Pamida, which operate in the same regional space as DUCK. This division, which was acquired in 1999, has not lived up to Shopko’s expectations and is currently suffering negative same store comps. Shopko has put future expansion on hold.

With one competitor on the ropes and another concentrating on a different region, DUCK’s management feels that it can target 50 potential sites for new stores. At a rate of 4 per year, the company can continue its modest expansion for at least another ten years.

What’s to stop Fred’s, Pamida or any other retailer from eventually expanding into DUCK’s markets? MAD (mutually assured destruction) is a cold war era acronym used to describe the deterrent nature of nuclear weapons. (He won’t fire at me because he knows I’ll fire back at him and then.....well, we’ll both be dead.) Fortunately, the same “mutual understanding” applies to retailers in the markets that DUCK serves. In towns of 2500 – 5000 people there is room for only one such retailer, period. The players know that competing store to store in these markets will result in two losers, and so they are happy to leave established markets alone and look for opportunity elsewhere.

Currently 84% of DUCK’s stores are in completely non-competitive markets. That number is growing as DUCK exits markets where competition exists (at a rate of about 2 stores per year) and builds new stores in non-competitive areas. This should increase the overall profitability of the chain as well as its ongoing competitive advantage.

Ultimately, should a Wal-Mart or Fred’s need to acquire another $400 million of incremental revenue, it would be far more rational to acquire DUCK then to drive it out of business.

Catalyst

Successful implementation of remodeling program should result in continued same stores sales improvement and substantial increase in earnings per share in the next twelve months.