Dollar Stores Are Still Good for a Few Dollars

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

Discount retailers gained great strength after the 2008 crisis, when many customers traded down from regular retail channels. Dollar stores acquired a particular popularity, mainly because they offered groceries and other products at a price 20% below the supermarket average in easy-to-navigate, small-format stores that were conveniently located.

As the economy recovers, however, this business model does not seem to be losing its clientele. Dollar stores still offer compelling growth prospects for years to come. Within the segment, three companies, Dollar General (NYSE: DG), Family Dollar (NYSE: FDO) and Dollar Tree (NASDAQ: DLTR), stand out for their scale and profitability.

Wal-Mart, the wide-moat retail behemoth, has been taking an incursion in the industry and worrying many. These three companies don’t seem widely affected by this fact, however, and look pretty well positioned to mitigate its effects. Moreover, the advance of Internet shopping doesn't seem to hit this industry much. Its targeted client base, which earns under $30,000 to $40,000 per household per year, appears to be less inclined to shop online. So, let’s take a look at them and see if they deserve your trust and your money.

The discount Goliath

Dollar General leads the segment, with a market capitalization of almost $17 billion and over 10,000 shops across the U.S. Among the three companies analyzed in this article, Dollar General is expected to deliver the greatest store base expansion, at a rate of 500 to 600 new locations per year (a massive figure for the consumer defensive sector). Some of the main growth catalysts over the next few years are the firm’s private labels, cost-cutting initiatives and an ever-improving sourcing model.

After the announcement of weak first quarter results a few days ago, however, the company's stock price plummeted. According to SeekingAlpha, “...the continued pressure on the U.S. consumer which helped Dollar General in the recession and the years following is now turning against the company. Many US consumers are simply cash strapped and have little to spend at its stores.” Nevertheless, the company still has a 25%+ upside this year, while a market overreaction has taken the stock price to a convenient point for investors.

Currently trading at about 16 times consensus earnings versus the 23 times industry average, and expected to deliver an average annual earnings-per-share growth rate of about 16% that surpasses the industry mean by about 25%, I’d recommend buying and holding on to this stock. Its history of double-digit earnings-per-share growth over the past few years backs these projections. The same can be said about its comparable-store sales, which continued to increase even through the last quarter and are expected to continue in this uptrend for another few quarters yet. Moreover, the roll-out of tobacco, beer and wine for sale in stores should drive growth even further in the years to come.

Dollars do grow on trees

Dollar Tree is second in scale within my list, with a market cap of $11 billion, and has been one of the best-performing companies in the sector this year. It offers one of the best returns on invested capital in the segment at over 28%, plenty of room for expansion and an expected average annual earnings-per-share growth rate of 17% (Zacks estimate) for the next five years. The company trades around industry average valuations at 17.6 times its earnings, so I'd recommend buying this stock for the long-term.

Dollar Tree offers a $1 fixed price point, making its retail model different than other dollar stores. This has served to resist Wal-Mart´s advance; despite having to stand the highest Wal-Mart overlap within this coverage universe, it has still retrieved the best margins, returns and growth rates while holding very little debt (see table below).

<table> <tbody> <tr> <td> </td> <td> <p><strong>Dollar Tree</strong></p> </td> <td> <p><strong>Industry Avg.</strong></p> </td> </tr> <tr> <td> <p><strong>Rev Growth (3 Yr Avg)</strong></p> </td> <td> <p><span>12.2</span></p> </td> <td> <p><span>3.9</span></p> </td> </tr> <tr> <td> <p><strong>Net Income Growth (3 Yr Avg)</strong></p> </td> <td> <p><span>24.6</span></p> </td> <td> <p><span>7.7</span></p> </td> </tr> <tr> <td> <p><strong>Operating Margin % TTM</strong></p> </td> <td> <p><span>12.6</span></p> </td> <td> <p><span>5.8</span></p> </td> </tr> <tr> <td> <p><strong>Net Margin % TTM</strong></p> </td> <td> <p><span>8.5</span></p> </td> <td> <p><span>3.4</span></p> </td> </tr> <tr> <td> <p><strong>ROA TTM</strong></p> </td> <td> <p><span>24.2</span></p> </td> <td> <p><span>8.0</span></p> </td> </tr> <tr> <td> <p><strong>ROE TTM</strong></p> </td> <td> <p><span>39.5</span></p> </td> <td> <p><span>20.8</span></p> </td> </tr> <tr> <td> <p><strong>Debt/Equity</strong></p> </td> <td> <p><span>0.1</span></p> </td> <td> <p><span>0.7</span></p> </td> </tr> </tbody> </table>

Source: Morningstar

Going forward, a management with an outstanding track record (which is, for this writer, the firm´s strongest feature) should continue to deliver great results. With a limited store base and plenty of room for expansion, the future looks promising. Moreover, the productivity of new stores has been coming in higher than that of existing locations.

International markets provide plenty of expansion opportunities as well, especially in Canada and Latin America. Strong first quarter results prove that the firm’s growth initiatives and cost efficiencies are, and should continue to be, quite fruitful.

Still looking good

Family Dollar is the smallest of these firms in terms of market cap, at roughly $7.3 billion. Expected to deliver an average annual earnings-per-share growth rate in line with the industry average at 12% to 13%, the company trades at 16.7 times consensus estimates, a 28% discount to its peers’ averages. I’d recommend buying and holding on to this stock. Just like its competitors, its business seems quite far from capped, and comps are expected to continue to rise for a few more years still.

Going forward, several initiatives including the roll-out of tobacco, an aggressive remodeling campaign and a distribution agreement with McLane coupled with plenty of room available for store base expansion should drive revenue to new heights. Furthermore, a wide gap between Family Dollar and Dollar General in terms of earnings per share provides plenty of space for evolution while a new management with critical experience in the sector should help the firm narrow it. The launch of wine and beer sales is another foreseeable initiative in the near future that could contribute to the company´s sales.

The company will also yield about 1.69% in the form of dividends in addition to continued share repurchases, returning value to investors while offering above-average margins and returns. The company also has healthy debt-to-cash levels (see table below), so stockholders should rest easy.  
 
<table> <tbody> <tr> <td> </td> <td> <p><strong>Family Dollar</strong></p> </td> <td> <p><strong>Industry Avg.</strong></p> </td> </tr> <tr> <td> <p><strong>Operating Margin % TTM</strong></p> </td> <td> <p><span>6.8</span></p> </td> <td> <p><span>5.8</span></p> </td> </tr> <tr> <td> <p><strong>Net Margin % TTM</strong></p> </td> <td> <p><span>4.2</span></p> </td> <td> <p><span>3.4</span></p> </td> </tr> <tr> <td> <p><strong>ROA TTM</strong></p> </td> <td> <p><span>13.4</span></p> </td> <td> <p><span>8.0</span></p> </td> </tr> <tr> <td> <p><strong>ROE TTM</strong></p> </td> <td> <p><span>35.7</span></p> </td> <td> <p><span>20.8</span></p> </td> </tr> <tr> <td> <p><strong>Debt/Equity</strong></p> </td> <td> <p><span>0.4</span></p> </td> <td> <p><span>0.7</span></p> </td> </tr> </tbody> </table>

Source: Morningstar

Bottom line

Although the economy is recuperating slowly, dollar stores do not seem to be losing the customers they won during the recession. Their target demographics continue to be cash-strapped or have become accustomed to the dollar store concept, finding it more comfortable and cheaper than other existing retail channels. With plenty of expansion opportunities ahead in the U.S. and international markets, I'd recommend that you consider adding these three stocks to your portfolio. Although my number one pick would be DollarTree, all three comprise very promising investments.

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Damian Illia has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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