Why This Retailer is Poised to Run

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

Family Dollar (NYSE: FDO) is the first of the dollar stores to report results this earnings season and if this is what to expect then investors in the sector can look forward to better things to come. In this article I want to explore a few themes and see if future performance is likely to be as good. I'll also look at who might be affected by the changing trends in retail.

America You Are Not Alone

North Americans can be forgiven for thinking the trend towards discount stores is a recent phenomenon, but actually the Germans were there first. Germany experienced a period of austerity during the reunification phase between West and East Germany. This period of belt tightening led to extraordinary growth of privately held retailer Aldi, and its rival Lidl.  It didn’t stop there. Indeed, these two discount stores are now gaining share in the UK as it goes through its own period of austerity. Recent market research figures in the UK have Aldi’s sales growing at 25.6% and Lidl’s at 12.6%, and together they have 6% of the market.

My point is this. The UK consumer is now shopping at discount stores. The German consumer continues to do so even as its economy grows relatively strongly. In other words, while austerity may have started the movement towards discount stores once consumers get used to them they tend to stick with them and this works across cultural boundaries.

The Third Woman         

Analysts like to talk of a two tier shopping environment where the mid-market shopper is trading down and buying more at the low end and then the high end shopper is spending more of her cash at the high end. Allow me to introduce the third woman.

The third woman has realized that she can buy certain items at a cheaper price at a discount store and she has realized that she can take those savings and buy higher priced and higher quality items in high end or specialized stores. She has also realized she can buy high quality goods at cheaper prices in other stores.

Incidentally, it is because of the third woman argument that I like Nordstrom (NYSE: JWN) and TJX Companies (NYSE: TJX). Nordstom offers higher quality clothing and it is doing all the right things in retail. It is expanding its on line offerings and increasing the roll out of its lower priced Rack stores in order to appeal to more price sensitive shoppers. Moreover the flagship store in New York is appealing to tourists. I don’t think age of austerity is bad for retailers, just for those who don’t adjust.

Similarly, TJX Companies offers off-price clothing and home ware to the consumer and it’s an excellent way for her to buy the same quality but more of it. Foot traffic is up at TJX and its rival Ross Stores and I think we are at the start of a long term favorable trend here. The company is attractively priced and generates large amounts of underlying cash flow.

But I digress. Back to Family Dollar!

 

Family Dollar in Graphs

The numbers were pretty good and are a continuation of the benefits coming from the trends discussed above.

The first thing to highlight is that same store sales are increasing well…

 

…but gross margins appear to be declining. This is partly because there has been an increase in lower margin consumables sales over the years. For example in the latest results…

 …and it’s this last point that should cause concerns for other parts of retail. The traditional grocers like Safeway and Kroger (NYSE: KR) are being challenged. Kroger has excellent management who has fought hard to retain market share and keep revenues going, but frankly I think it is competing against some very tough forces now. Gross margins are declining and Kroger finds itself pressured from the dollar stores and from big box retailers like Wal-Mart. In this sort of environment and with foot traffic increasing at discount stores; does Kroger deserve a PE of 22x? Moreover, companies like Family Dollar are expanding rapidly.

Here is how selling floor space has been expanded over the years at Family Dollar… 

 …In addition Dollar Tree and Dollar General are also aggressively expanding store roll outs. All of this means real challenges for the food industry. Take for example a business like Treehouse Foods which as a private label manufacturer is supposed to be a ‘trading down’ play. However, so many of its customers have faced issues with declining sales via traditional grocers that it has had to realign itself to try and sell more into the ‘alternate’ channels. In other words, the big box retailers and dollar stores.  Treehouse doesn’t think this trend is going to stop anytime soon and I would agree.

Where Next For the Dollar Stores?

My view is more of the same. As the experience of Germany demonstrates consumer expectations are very hard to change when they get used to buying items at lower prices. The question is whether the market is over saturated or not? So far, gross margins are still holding up well and consumables margins actually look set to expand as commodity input costs fall. I think there is more to come here and the discount retailer story still has plenty of room to run.

 


SaintGermain has a position in TJX Companies. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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