Will Retailers Win or Lose over the Fiscal Cliff?

Masam is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The Investment Case

The discount retailer, Dollar General (NYSE: DG) is recommended as a buy given that some key growth catalysts are on the horizon:

1) The potential to expand its store base for many more years by moving into new markets and filling in existing ones;

2) The ability to sell basic items at good values in highly convenient locations, which is driving same-store sales;

3) The opportunity to improve efficiency and partner better with major vendors; and

4) The ability to generate significant amounts of free cash flow used to buy back stock.

The Business Drivers

DG is the largest small-box discounter, with over 10,000 stores in 40 states, and its scale gives it clout with both domestic and international vendors. It has demonstrated the ability to open more than 600 new stores a year even as its returns improve steadily. The offering and store shopping experience have been refined over the past 5-10 years to offer consumables, home items, and basic apparel not only to low-income consumers (the largest population segment in the U.S.) but also to a growing group of middle and upper income consumers.

I am extremely bullish on the new management team that has joined the company during the past five years. The team has successfully upgraded the quality of merchandise, begun partnering with top consumer goods companies, improved store and supply chain productivity, and managed expense growth. Yet, I still see potential for more improvement.

Some Competitor Analysis

DG is currently fighting against two sets of competitors:

1)      The other dollar stores, e.g. Family Dollar (NYSE: FDO) and Dollar Tree (NASDAQ: DLTR).

2)      Large retailers like Wal-Mart (NYSE: WMT) and Target  (NYSE: TGT).

Dollar Stores

It is important to note that the dollar stores are often successful in recessionary times given their steep discounts, which are ideal for the economically battered customers.

Family Dollar operates about 7,500 stores in 45 states. The company is expected to report its first quarter earnings on Jan. 3, 2013. Analysts are expecting EPS of 75 cents, which means a 10% year-over-year rise. Revenue is expected to be $2.38 billion, 10.8% higher than the previous year’s results. The special thing about this stock is that it is the only dollar store stock that offers a dividend; the stock currently offers a yield of 1.32%.

Dollar Tree is another interesting stock in the ‘Dollar store Universe.’ The stock has been receiving some attention after one of the company’s directors, Conrad Hall, purchased 5,000 shares on Nov. 16, 2012. The company reported a rise of 40 bps in the third quarter’s operating margin. This signifies that the company is well on its way to streamline its costs. Also, the company stated in its earnings call that it expects a 70 bps expansion in its operating margins in the fourth quarter.

<img src="/media/images/user_15211/capture1_2_large.PNG" />


The graph shows that DG has been generating relatively stable margins over the last 4-5 quarters.

Big Retailers

Investing in Wal-Mart seems to be a low risk/low reward game to me. It is an obvious choice for the risk-averse investors. The ROE is above 20% and the earnings are expected to increase by 9% in the next year. Wal-Mart disappointed its investors after it gave disappointing guidance in its third quarterly earnings release. However, investors are forgetting the point that Wal-Mart has been able to turn around its US business by fixing the mistakes it made in merchandising and pricing. It is hammering its low price message again.

Target has a dividend yield of 2.43% (higher than Wal-Mart’s 2.33%). Target has become a much attractive buy compared to Wal-Mart. Greater use of REDCard and store remodeling has driven domestic top-line results. A wide variety of food products and 5 percent discounts for its cardholders helped the company to surpass analysts’ estimates in its third quarterly earnings release.


Upside/Downside Scenarios

The market’s greatest concerns are:

1) The risk that the current high operating margins are the peak;

2) The financial pressures facing low and middle income consumers will intensify and dampen DG’s revenue growth; and

3) The ~16% of shares still owned by private equity (PE) will be sold, putting pressure on the stock.

I see DG’s retail concept (limited assortment in a small store) as relatively new and previously under-managed, so the true profitability potential is untested, while the perception of the stores’ value and convenience should insulate it from any pullback in consumption. Also, DG went public again in 2009 and has performed well even as PE has been selling constantly.

In an upside scenario, the stock could reach $58 (16.5x adjusted FY13 EPS of $3.50), which assumes a better economy leads to more purchases of high-margin discretionary items and DG continues to broaden its customer base. In a downside scenario, the stock could drop to $40 (13x adjusted FY13 EPS of $3.09), which assumes sales weaken either because the economy improves, causing DG to lose market share, or because the economy weakens and total consumer spending declines.

Valuation Analysis

DG trades at a forward multiple of 13.3x, which is pretty cheap compared to its three-year forward P/E historical average of 15.2x. The price target of $52 represents a multiple of 15.5x and a FY13 EPS of $3.33, which assumes the market dismisses some of its concerns regarding the long-term margin potential and the sustainability of strong sales.

AnalystX has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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