3 Discount Retailers to Keep in Mind

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

As American consumer spending remains tight, the discount retailer industry keeps growing strong. Of course, this opens pretty good opportunities for investors. Here, I will take a look at Dollar Tree (NASDAQ: DLTR) and Dollar General (NYSE: DG), two big players in this market, and Kroger (NYSE: KR), a leading grocery chain that has been beating analyst estimates. 

Going for groceries

Kroger is the largest U.S. grocery chain, operating over 2,400 stores across the country. Recently acquiring Harris Teeter for $2.5 billion, the company received another 212 stores, which should strengthen its position in the southeast part of the country. Kroger trades at $38, or 13 times its earnings, which is a 35% discount to the industry average, and has gained almost 50% so far this year.

Kroger’s dominant position in the U.S. market has enabled the company to sustain revenue growth and increase its market share, despite persistent competition from non-traditional food retailers. Unlike other traditional grocery retailers, the company managed to consistently produce returns above its cost of capital.

The company’s management has maintained a shareholder-friendly stance, as much of its free cash returns to them via share buybacks and dividends, which was reinstated in 2006 and currently pays 1.6%.

On the down side, investors should take into account that Kroger’s debt-to-capitalization ratio has been growing (it is currently at 63.4%), which could hamper its financial flexibility, and food inflation (likely to recur in 2014) should have a negative impact on the company’s gross margin rates. Plus, as the U.S. economic downturn has affected consumer habits, consumers may trade Kroger stock for low-price leaders if the company fails to stay vigilant on its market share.

Discount for trees

Dollar Tree is a discount store operator that offers merchandise at the fixed price of just $1. Its shares have already gained over 30% this year. Trading at $53, or 19 times its earnings, which is just $3 below its all-time high, Dollar Tree is still an attractive buy.

Counting over 4,700 stores between the U.S. and Canada, Dollar Tree has a proven track record and remains highly profitable. Its growth estimate of 18.3% for the next five years exceeds the company’s competitors. More importantly, its net profit margin grew steadily over the last five years, up to 8.45% for 2013.

The recession’s effect on U.S. consumer habits meant good news for discount stores. Yet, what makes Dollar Tree worth the money is that, lately, is has been outperforming its peers. The company’s Q1 sales grew 8.3%, almost quadrupling the growth rate of comparable stores.

My biggest concern is that, with current store expansion at 7% per annum, the company might be expanding too rapidly which could lead to market saturation. However, altogether, Dollar Tree holds good short and long-term prospects and is a stock worth considering for your portfolio.

Generally okay

Counting over 10,000 stores, Dollar General is the leading discount retailer in the U.S. With a year-to-date return of 22%, Dollar General trades at a reasonable valuation of $53, or 18 times its earnings, which is a 3% discount to the industry average. Like its competitors, the company is undertaking heavy store expansion, and this year plans for 365 new stores and the relocation of over 500 others. Dollar General is expected to grasp a dominant position in the growing discount store market in the near future, as analysts forecast an increase in market share.

Despite failing to meet Q1 revenue estimates, Dollar General has been performing solidly for the last five years (including an outstanding performance from 2008-2009, where it increased profits by 200%). Yet, it should be noted that during the last two years, Dollar General’s gross margin has been decreasing, indicating reduced efficiency, which is an important indicator for an established company.

The increasing competition from Wal-Mart, which is continuously offering a broader range of low cost items and will soon be rolling out a small store format, certainly stands as a formidable threat to discount retailers, particularly to one already being challenged by its industry competitors. The crucial point for the company is whether or not will it be capable of retaining the large percentage of consumers it gained during the 2008 recession. Taking everything into account, I wouldn’t rush to buy this stock.

Bottom line

Although these three firms have been performing soundly, my bet here is on Dollar Tree. Besides a strong track record, it has robust growth prospects and should outperform its peers.  In his 2011 breakthrough hit, soul singer, Aloe Blacc, chanted that a dollar was all he needed. Maybe a dollar is all you need, too.

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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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