Wal-Mart vs Dollar Stores: Who Wins?

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

Wal-Mart (NYSE: WMT) is the king of retailers in the U.S. Nobody wants to compete with everyday low prices. However, dollar stores such as Family Dollar (NYSE: FDO) and Dollar Tree (NASDAQ: DLTR) have carved out a niche at the lowest end of the low-end consumer spectrum, which has allowed the stores to remain successful despite facing intense competition from Wal-Mart.

However, Wal-Mart is not content to allow these cheapo stores steal customers. Instead, the company is rolling out its Neighborhood Market concept to directly compete with Family Dollar and Dollar Tree. This is not welcome news to owners of dollar stores; the entry of Wal-Mart into any market indicates that prices are about to drop. But it might not be the end of the world for Family Dollar and Dollar Tree.

Strong Growth Prospects

Both Family Dollar and Dollar Tree have substantial runways for growth before they start to cannibalize sales at existing stores. Over the last ten years, Family Dollar has grown EBITDA per share at a rate of nearly 13% per year. Dollar Tree has grown its EBITDA per share at over 16% per year over the last ten years. This is a testament to the stores' ability to compete in their niche.

In addition to their high growth rates, both companies performed well during the most recent recession and could benefit from another downturn in the U.S. economy. What's more, the federal government will inevitably have to enact fiscal austerity at some point in the future, potentially pushing tens of millions of U.S. citizens into the dollar store target market.

However, in the short-term, measures like the restoration of the payroll tax and possible cuts to entitlement programs have a disproportionate effect on the dollar stores' existing customer base, which acts as a hindrance to sales growth and margin expansion.

Defeating Leviathan

Wal-Mart's Neighborhood Market format was actually launched in 1998, but it has only recently received increased attention from management in light of the continuing economic difficulties in the U.S. and abroad. Although only a quarter of the size of its superstores, Neighborhood Market stores are 40,000 square feet -- much larger than the typical Family Dollar and Dollar Tree formats.

In theory, Wal-Mart can make a massive push into the dollar store markets and overtake the niche by shear pricing power. However, it may not be so easy in practice. The existing dollar stores have built large networks of distribution warehouses -- sometimes as big as 900,000 square feet -- that allow them to offer low prices due to efficiencies of scale. This will be difficult for even Wal-Mart to replicate any time in the next half-decade.

Wal-Mart is also making large investments in e-commerce with the hope of competing with Amazon (NASDAQ: AMZN). But e-commerce is outside Wal-Mart's circle of competence -- does anybody really think that Wal-Mart can push Amazon aside and breeze into the online market? The same setup exists in the dollar store niche: Family Dollar and Dollar Tree have been at it for years and have a stronghold in the market; it is unlikely that Wal-Mart can come in and shove them aside.

So, while the battle for the dollar store niche may become ugly in the next few years, Family Dollar and Dollar Tree are likely to ultimately win out over Wal-Mart.

Ted Cooper III has no position in any stocks mentioned. The Motley Fool recommends Amazon.com. The Motley Fool owns shares of Amazon.com. 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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