Fred’s Slips to Underperform (DG) (FRED) (WAG)

Zacks

Following second quarter 2011 earnings, Fred’s, Inc. (FRED) has been downgraded to Underperform from Neutral.

Fred posted adjusted earnings of 13 cents per share in second-quarter 2011, which lagged the Zacks Consensus Estimate of 14 cents per share following management’s expectations of a tough retail conditions to continue across the markets in 2011.

Although Fred’s experienced increased customer traffic and comparable pharmacy script counts in the quarter, the challenging economic conditions coupled with low consumer confidence due to the debt crisis adversely affected the customers throughout the quarter.

Fred’s had been continuing its capital improvement programs in infrastructure, distribution center upgrades and further development of the information technology capabilities, throughout 2010. Technology upgrades have been made in the areas of merchandising allocations systems, human resources and payroll systems, in-store systems, and pharmacy systems.

The Core 5 program is currently working as an ongoing catalyst for comparable store sales growth and gross margin improvement. The company has also planned to continue to reinvest in the stores targeting 200 additional remodels and upgraded stores in 2011.

However, Fred’s believes that going ahead, the federal debt crisis will outweigh the benefits of the company’s strategic initiatives, improvements of the Core 5 Program and the cost-reduction programs.

The company is also subjected to various federal regulations promulgated by the Center for Medicare and Medicaid Services under the Medicare Prescription Drug, Improvement and Modernization Act of 2003, as it is a provider of Medicare prescription drug plan benefits.

Further, there are various legislative and regulatory initiatives pertaining to such healthcare related issues as reimbursement policies, payment practices, therapeutic substitution programs, and other healthcare cost containment issues, which are frequently introduced at both the state and federal level. The recently enacted Patient Protection and Affordable Care Act of 2010 will also impact the pharmacy business in future.

Additionally, Fred's has a long-term supply contract from a single supplier, AmerisourceBergen Corporation (“Bergen”), for its pharmaceutical operations. During 2010, all of the company’s prescription drugs were ordered by its pharmacies individually and shipped directly from Bergen. However, this could have a material adverse effect on the company’s operations and its gross margins due to any significant disruption in the relationship with this supplier.

Besides, the company is significantly dependent on the government’s finance as a large portion of its sales are funded by the federal and state governments and private insurance plans. Moreover, as the health care industry is working toward cost-containment, it will impose lower reimbursements and utilization restrictions.

Accordingly, reimbursements may be limited or reduced, which will negatively impact the revenues and cash flows. A worsening economy and recent healthcare legislation will add to the company’s woes.

Fred's Inc. runs Discount General Merchandise stores in a number of states in the southeastern United States. Fred's stores generally serve low, middle and fixed income families located in small to medium -sized towns. Fred’s faces intense competition from national, regional and local retailing establishments, including department stores, discount stores, discount clothing, grocery and convenience stores and drug stores. Consequently, the company is under severe stress to maintain profitability.

Fred’s faces stiff competition from Dollar General Corporation (DG) and Walgreen Co. (WAG). It currently holds a Zacks #5 Rank, which implies a short-term Strong Sell rating. On a long-term basis, we maintain an Underperform rating on the stock.

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