The Merchandise is Cheap, But Are the Stocks?

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

Discount retailers can be pretty fun to shop at. After all, spending less money on life's necessities means we have more money to plow into the stock market. And that's a good thing. Recently, I went to Dollar Tree (NASDAQ: DLTR) and bought a potato peeler for a dollar, at Target a peeler was at least seven bucks.

Understandably, the merchandise might not be as high quality as stores that don't offer rock bottom prices. But in many instances it gets the job done just as well as more expensive items. As an investor, examining the discount merchandise phenomenon begs the question: Are the stocks as good of a value as the merchandise?

A southern discounter, and his name is Fred

Fred's (NASDAQ: FRED) operates 691 stores, primarily in the southwestern states. Not wanting to be crushed by the likes of Wal-Mart, the company primarily focuses on small and medium sized towns. Going forward, the company will be aggressively trying to expand its pharmacy segment.  

2012 was not a great year for Fred's. While year-over-year sales were up 4%, net income decreased by 11%. The five year growth rate for EPS was 24.9%, but the same figure for sales is only 1.89%. If sales don't start increasing, EPS growth will start to stall out.

Additionally, even for a discount retailer, Fred's has low margins. Combine that with the lowest ROE of any company I'll be discussing in this article and you'll find that Fred's is not a company you should be owning.

Commander of the discount army

Dollar General (NYSE: DG) is a bit more impressive than Fred's. In 2012, it recorded its 23rd straight year of consecutive same store sales growth. Dollar General also focuses on small towns, with approximately 70% of its stores located in communities with less than 20,000 people. 

Thanks to a 2010 acquisition, the company established a foothold in the Canadian dollar store market. Not everything costs just a dollar at its stores though. Almost everything is under $10 and about one-fourth of items are $1 or less. 

Dollar General has performed well over these past five years. Sales and net income grew at compound annual growth rates of 11.8% and 47.2% respectively. 

When the company reported its results for the first quarter, the outlook it gave for the rest of the year was rosy. It expects sales to increase 10%-11% year over year and same store sales to increase 4-5%. 

The company plans to open 635 new stores this year, increasing its store count by 6.4%. Dollar General has opened over 600 stores in each of the past three years and is not slowing down. As long as sales keep rising and debt doesn't balloon out of control, that growth should be good for shareholders.

Everything's $1 or less

When I shop at a dollar store, I go to Dollar Tree where everything is one dollar or less. Not that I wouldn't patronize other dollar stores if I could, but Dollar Tree is the only one I've ever come across.

The company managed to grow at impressive rates as well over these past five years. Net income grew at a 5 year annual rate of 25.2%. Sales grew at a rate of nearly 11.75%, nearly in line with Dollar General. 

I was impressed that Dollar Tree expanded net profit margins by 3.7% between 2009 and 2013. Its net profit margin for the most recent year was 8.4%. I'm impressed a company selling everything for a dollar or less can have such good margins.

Dollar Tree has also been buying back its own shares at an impressive rate. Between January 2010 and January 2013, the company reduced its outstanding shares by 14.5%.

Dollar Tree has made some moves that suggest the company is in it for the long haul. The Chesapeake planning commission unanimously approved the company's proposal to turn a 70 acre plot adjacent to its headquarters into a commercial and residential hub for employees. The company's plan stipulates that the project will be completed in phases over the next 35 years. 

 Final Foolish thoughts

Discount merchandisers are wise to normally stay out of large cities, they'll just end up getting crushed by Wal-Mart. However, they do seem to have carved out a niche in lower population markets with a desire for inexpensive merchandise. 

None of these stocks appear to be screaming bargains, hardly any stocks are right now. Fred's is one stock that I would most certainly maintain a safe distance from.

Its tough to make a decision between Dollar General and Dollar Tree. None of them seem like they'll offer incredible returns in the next few years, but a dollar cost averaging program in each will very likely outperform a savings account.

Dollar General has been growing its stores, and sales at an impressive rate. However, I personally like Dollar Tree more, it has superior margins, and its trailing twelve month return on equity was nearly 40%.

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Ryan Palmer 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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