Description

Fred’s (“Fred”)

Fred’s Inc. runs a series of dollar store/pharmacies in the rural southeast. The Company had been (from a margin standpoint) underperforming chain and had brought in new management in the form of CEO, Mike Bloom, who spent his career at Family Dollar and CVS. The Company/Management struck gold by getting cast off RAD/WBA stores at a big discount from their now blocked merger. That deal was going to take FRED from a shaky $50mm or so of EBITDA to $200mm plus of EBITDA. Now that deal is off the table, we are left with the turnaround that management was brought in to fix in the first place. Based on comparable margins, there is every reason to believe that Fred’s approximately $2.1 billion in sales (only (0.15x EV/Sales) should generate close to $100mm in EBITDA. At 6x, the stock would trade around $8-$13 a share. The is risk with Amazon’s potential entry into the drug space which has hammered the stock another 20% over the last week or so.

The crux of the bull argument is that Fred massively underperforms Walgreens/Boots (“WBA”) and others in the space when it comes to EBITDA margins, the Company’s SG&A as a percentage of sales is 450% above Walgreens and Dollar Tree (one could argue that Fred’s is a hybrid pharmacy and dollar store). Unlike most retail turnarounds, comparable sales have stabilized, it’s the margins that need to improve. The Company is also underpenetrated on the pharmacy side which is a management priority. The Company spent most of 2017 getting ready for a deal that did not happen and stalled a bit, though sales declines seem to have stopped and drug sales have increased.

There is no reason that Fred cannot produce low/mid end of industry EBITDA margins of 2.5-5.0%. This compares with the roughly 7% at CVS/WBA and 11% at DG/DLTR. There are two big areas of low hanging fruit:

1) Rationalizing the DC base of 1.45 million square ft. (850,000 square ft. in Tenn. and 600,000 square ft. in Ga) --- warehousing costs go into selling, general and administrative expenses). The Georgia facility was built for a time when they were going to expand rapidly in the area, which didn’t happen. It is unclear what the savings would be but it isn’t hard to believe it could cost at least $5-10mm to operate.

2)     Reducing the cost to “fill” (dispensing costs, including overhead and labor, to fill a prescription) aided by leveraging lower paid pharmaceutical technicians, who typically earn an average of $30,000 per year versus much higher paid pharmacists ($110,000 is the average salary of a pharmacist who works in a grocery store). Fred’s has 350 full service pharmacies. If you replace 350 people at $80,000 a year differential that alone save $28mm a year. You probably only get a fraction of that number, but when combined with the DC, it is not hard to see how there is $20-30mm of low hanging fruit.

These margins would yield approximately $53- $105 of EBITDA, which is what the Fred’s was doing regularly until 2014.  Using middling EBITDA multiples of 5-7x for a middling business and taking net debt of $108mm (including the $25mm termination fee from Rite Aid) gets a range of value from $4.06 (just under where the stock currently trades) to $16.46. I believe a 4% EBITDA margin and a $8.19-$12.60 share price is a pretty realistic outcome over the next 1-3 years. There is some sales low hanging fruit in the form of alcohol sales which had traditionally been shunned and a renewed emphasis on pharmacy to drive sales, margins and traffic. Early signs are encouraging. The Company wisely ended monthly comps, but unfortunately did not wait until the business was in better shape which would have been better timing and given investors more visibility during a period of maximum uncertainty.

Other Considerations

The Company has a large NOL that is worth about $1 a share in present value terms (using a 10% discount rate) and pays a 4.55% dividend yield while you wait. There is an activist on the board in the form of Alden Capital which is the firm run by distressed debt legend, Randy Smith. They (unfortunately for them) doubled their position at $20 after the Rite Aid deal was announced and have a cost basis in the mid to high teens. The management says they have been helpful and seem to buy into the return to industry level margin scenario that I have outlined. I was recently on a conference call with the CFO and he sounded realistic about what they were trying to do. His body language was positive on the sales front without being specific.  He also thought that their rural store base offered some protection from Amazon if and when they enter the space, but how many retail CEOs have said that and been proven wrong?

Fred’s is tiny in a field of giants and there was high (50%) short interest when the stock was in the $20s during the Rite Aid deal. Those shorts have stuck around betting that Fred’s will never return to decent margins and eventually file/liquidate. Obviously, they are potential buyers should management prove them wrong. The Company is also looking to give guidance again once the business turns as well as loosen buy back windows so insiders can buy more freely. The notable lack of insider buying at these levels is a concern. Kroger has always been mentioned as a potential buyer and Rite Aid could further operationally leverage and financially deleverage themselves with a stock for stock deal. I am not counting on a sale to drive returns, but Alden with 24% of the float will want to exit at some point and a sale would be the cleanest way.

Catalyst

A return to the low end of industry margins which improves both the multiple and FCF characteristics as well as leverage ratios. Amazon defers entry or does not have as big an impact as the 20% decline in the stock signals/fears. Sale of the Company.