Do Dollar Chains Present Better Value Than Big Box Discounters?

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

The prevailing story about discount stores has been that dollar store formats have outpaced big box discounters. They have seen phenomenal earnings growth, and they have positioned themselves as the new low cost leaders, usurping Wal-Mart (NYSE: WMT).

As interesting or compelling as this story is, investors should focus on relative value. The most important question is if a stock is trading at a discount to its peers or to some other measure of value. Growth stories fade over time and peer group performance differences tend to average out. As investors, we should demand attractive prices, even in the face of growth stories.

Family Dollar Disappoints

Family Dollar (NYSE: FDO) has disappointed expectations for rapid growth by posting a lower-than-expected quarterly profit. During the fiscal first-quarter, which ended on Nov. 24, 2012, its gross profit margin was down to about 34% from over 35% a year earlier. Analysts are forecasting yearly earnings on average of about $4 a share, and Family Dollar recently supported these estimates by adjusting its earnings forecast to of almost $4 per share, below its previous estimate of nearly $4.50 per share. All of this sent its shares tumbling 12%.

The apparent cause of its current condition is a change in its sales strategy to focus more on high-turnover items such as cigarettes, other tobacco products, gift cards, magazines and soft drinks. Although this strategy initially attracted more customers, it also hurt profitability, as the aforementioned items tend to carry a lower profit margin. In addition, larger price cuts in the store also hurt margins, while this year's payroll tax increase has limited their customers' discretionary spending. During a conference call with analysts Chief Executive Officer Howard Levine stated, "Clearly, (our customers) do not have as much today for discretionary purchases as they did."

Although organic sales growth at stores open for at least a year rose almost 7%, the increase during December was only 2%. Also, its current forecast for the second quarter is for earnings of about $1 per share, with a same-store sales growth of 4% to 5%. The sole category that has met growth expectations is consumables (its largest category), which comprises food and beauty products. The sales of this category rose nearly 19% in the first quarter.

Family Dollar is making changes to increase growth, but it is unlikely to maintain its past growth trajectory. The company is tweaking its advertising campaign, simplifying its store operations and reselecting its assortment of merchandise, all in a push to boost revenues and earnings. A continuing trend of lower than expected discretionary sales, plus additional markdowns on such items and strong consumables sales growth add up to what Chief Financial Officer Mary Winston called "gross margin pressures similar to, or slightly more than what we saw in the first quarter."

Wal-Mart’s Global Bribery Scandal

Wal-Mart is currently the focus of media attention based on investigations into bribery outside the U.S. Investigations and legal defense will cost hundreds of millions of dollars, and could cost more in fines. This scandal could further damage the company’s reputation and slow international growth.

The investigation into Wal-Mart’s violations of the U.S. anti-bribery law is not confined to Mexico alone, but has now expanded to China, India, and Brazil. These regions are critical for Wal-Mart because they are among the company’s biggest and fastest growing markets. More than half of Wal-Mart’s 10,524 stores are outside the United States. It has 534 stores in Brazil, 2,230 stores in Mexico, and 384 stores in China. Since bribery was thought to be a catalyst for launching new locations, taking away bribery would slow growth.

Internal investigations are also expensive. Amazingly, the cost of the current investigation in nine months was $99 million. Wal-Mart’s compliance program has cost about $35 million since spring 2011. Where does this money go? It pays for 300 lawyers and accountants from outside the company who work on the compliance program.

Changes to corporate procedures have been made as a result of the investigation. In the past, segment-level general counsels reported directly to the CEO. Now, the legal departments of each segment report to the general counsel of all of Wal-Mart. The company’s protocol for conducting investigations has also changed. Foreign subsidiaries are to inform the global ethics office in Bentonville before beginning any inquiry into the wrongdoing.

Comparing Valuations

Investors shouldn’t buy Wal-Mart stock unless it trades at price multiples that are substantially lower than its peer firms. At present, this is not the case:

<table> <tbody> <tr> <td> <p><strong><span>Ticker</span></strong></p> </td> <td> <p><strong><span>Company</span></strong></p> </td> <td> <p><strong><span>P/E</span></strong></p> </td> <td> <p><strong><span>P/S</span></strong></p> </td> <td> <p><strong><span>P/B</span></strong></p> </td> <td> <p><strong><span>P/</span><span>FCF</span></strong></p> </td> </tr> <tr> <td> <p><span>BIG</span></p> </td> <td> <p><span>Big Lots</span></p> </td> <td> <p><span>10.57</span></p> </td> <td> <p><span>0.3</span></p> </td> <td> <p><span>2.52</span></p> </td> <td> <p><span>12.08</span></p> </td> </tr> <tr> <td> <p><span>TGT</span></p> </td> <td> <p><span>Target</span></p> </td> <td> <p><span>13.37</span></p> </td> <td> <p><span>0.55</span></p> </td> <td> <p><span>2.41</span></p> </td> <td> <p><span>19.48</span></p> </td> </tr> <tr> <td> <p><span>WMT</span></p> </td> <td> <p><span>Wal-Mart</span></p> </td> <td> <p><span>14.07</span></p> </td> <td> <p><span>0.49</span></p> </td> <td> <p><span>3.11</span></p> </td> <td> <p><span>25.19</span></p> </td> </tr> <tr> <td> <p><span>DLTR</span></p> </td> <td> <p><span>Dollar Tree</span></p> </td> <td> <p><span>15.32</span></p> </td> <td> <p><span>1.22</span></p> </td> <td> <p><span>5.63</span></p> </td> <td> <p><span>22.15</span></p> </td> </tr> <tr> <td> <p><span>DG</span></p> </td> <td> <p><span>Dollar General</span></p> </td> <td> <p><span>15.83</span></p> </td> <td> <p><span>0.89</span></p> </td> <td> <p><span>3.01</span></p> </td> <td> <p><span>26.83</span></p> </td> </tr> <tr> <td> <p><span>FDO</span></p> </td> <td> <p><span>Family Dollar</span></p> </td> <td> <p><span>15.89</span></p> </td> <td> <p><span>0.69</span></p> </td> <td> <p><span>5.08</span></p> </td> <td> <p><span>NA</span></p> </td> </tr> </tbody> </table>

Wal-Mart trades at a higher price-to-earnings multiple and higher price-to-free cash flows multiple than Target (NYSE: TGT) or Big Lots (NYSE: BIG). These stocks are arguably cheaper than Wal-Mart based on valuation, and they are not the feature of landmark international scandals (at least not at the moment). They are better alternatives to Wal-Mart.

Target was recently added to the Dividend Channel "S.A.F.E. 25" list, signifying a stock with above-average ”DividendRank” statistics including a strong 2.4% yield, as well as a superb track record of at least two decades of dividend growth, according to the most recent DividendBank report.

Zacks recently upgraded its recommendation on Big Lots to "Neutral." The rating agency cited "better-than-expected third-quarter 2012 bottom-line results and an upbeat outlook, with a price target of $30.00."

The company posted a third-quarter 2012 adjusted loss of 10 cents per share compared with adjusted earnings of 6 cents in the comparable prior-year period. However, the reported loss per share compared favorably with the Zacks Consensus Estimate of a loss of 24 cents, and fared better than the company’s projected loss of 20 cents – 30 cents per share.

Dollar Tree, Dollar General, and Family Dollar all trade at P/E ratios that exceed the 14.20 average of the Standard and Poor’s 500 index. Investors should not be impressed, but should instead wait for lower valuations among these stores.

BillEdson11 has no position in any stocks mentioned. The Motley Fool owns shares of Big Lots. 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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