Fred’s At Fair Value To $15

Fred’s Inc. (FRED) reported solid second-quarter sales of $447 million, up 5 percent year-over-year, with comp-store sales growth of 4.9 percent. The company’s sales growth indicates that Fred’s continues to benefit from customers trading down to lower cost alternatives as well as the management’s strategic efforts.

We increased our second-quarter EPS by $0.01 to $0.10, which is at the high end of the management’s EPS guidance of $0.07-$0.10. For fiscal 2008, our estimate goes from $0.70 to $0.72 and our 2009 EPS estimate goes from $0.78 to $0.80.

Nevertheless, the company’s positive factors are offset by negative factors such as high food and energy prices and difficulties in its core business. Fred’s stores target lower income customers, and those customers tend to be affected to a greater degree by higher energy and food costs. Fred’s results will most likely be negatively impacted by further pricing pressures.

Moreover, Wal-Mart (WMT) is putting pressure on the rest of the retail sector by regularly cutting prices on groceries, electronics, and home-related products.

With its stock trading at 20.3x our fiscal 2008 EPS estimate and 18.2x our 2009 EPS estimate, Fred’s has limited upside, in our view. All told, we maintain our Hold rating. Fred’s P/E ratio is in-line with its peers. We think the stock looks fairly valued at current levels. Our target price is $15, or about 19x our fiscal 2009 EPS estimate.

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