A Different Kind of Dollar Store

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

Low-end retailers like Family Dollar Stores (NYSE: FDO)(NYSE: FDO)(NYSE: FDO) are taking too many risks to be good investments. I recently argued that at least two of them have entered bubble territory because of over expansion.

Yet that doesn't necessarily mean I’m totally bearish on all discount retailers; there’s one I’m actually long on because it doesn’t take on the same risks as the others. Although I must point out that it too has some serious problems. On the bright side, it isn't expanding mindlessly, unlike Family Dollar and Dollar General (NYSE: DG)(NYSE: DG)(NYSE: DG). And it generates positive free cash flow.

Big business with smaller risks

The company is Big Lots (NYSE: BIG)(NYSE: BIG)(NYSE: BIG); that’s right, the goofy outfit that used to run those really cheesy commercials that featured D-list celebrity Jerry van Dyke. Big Lots business model is to sell overstocked merchandise, stuff other retailers cannot sell, for a profit. Sounds funny, but don’t laugh.

Big Lots is big business, and it actually makes money, which sets it apart from a dollar store operator. It reported revenue of $5.41 billion on last year, and that number has been increasing steadily for quite some time. That's right, $5 billion on what some would consider junk. 

Big Lots operates 1,400 stores in 48 states and it recently expanded into Canada by buying out a similar outfit called Liquidation World. That’s a lot smaller than the big two, but it also indicates fewer risks. Unlike Family Dollar and Dollar General, Big Lots expands slowly and methodically. It waited a year to start rebranding Liquidation World.

When it does expand, Big Lots carefully chooses its locations. It tries to set up shop in established shopping centers with proven traffic, to increase eyes and limit construction costs. It seems traditional dollar stores can and will pop up wherever there's room.

What Big Lots has that others don't

Big Lots has one major advantage against the dollar stores and that's free cash. In its last earnings report, Big Lots reported free cash flow of $42.9 million. Recently, Family Dollar reported free cash flow of less than $1 million (around $290,000) and Dollar General is cash flow negative.

These figures are ugly because Family Dollar operates 7,600 stores and Dollar General operates 11,000 with new locations opening every day. It indicates a Big Lots unit makes more money than a traditional dollar store. That means it does a far better job of squeezing out profits per square foot than its competitors.

Shrinking cash from operations

There is one big problem with Big Lots though. The amount of cash it's generating from operations has been dropping dramatically. While Family Dollar and Dollar General cannot figure out how to make money, Big Lots is struggling to figure out how to keep making money. 

<img alt="" src="http://g.fool.com/editorial/images/58070/ycharts_chart-2_large.png" />

Big Lots reported $215.73 million in cash from operations in its latest quarter. That represents a drop in cash from operations by nearly 50% since April 2010, when it reported $401.9 million. Those figures indicate that Big Lots has not been able to maximize its profitability.

To be fair, Family Dollar’s cash from operations is also a lot lower than it was in 2010. Family Dollar reported operating cash of $580.45 million in 2010 and only $440.88 million 2013. The interesting  thing is that Family Dollar’s cash from operations has recently started shooting up, as the chart indicates.

<img alt="" src="http://g.fool.com/editorial/images/58070/ycharts_chart-1_large.png" />

Dollar General, on the other hand, has reported steadily increasing cash from operations for the past few years. Its cash from operation figures rose from $655.14 million in April 2010 to $1.068 billion this year.

Risks Everywhere for Little Cash

Those figures indicate that Dollar General and Family Dollar’s expansion strategy might be starting to pay off. They also show that Big Lots’ go-slow philosophy might be costing it. The company may not have the same growth opportunities as the others.

Discount retailers are a very risky business and they seem to be taking risks that may not be worth the rewards. Ultimately, Big Lots’ limited growth strategy might be just as risky as the more traditional dollar store counterparts.  But at least there seems to be a method to its madness. Take a look for yourself, perhaps you'll come up with a different conclusion.

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Daniel Jennings 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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