Tuesday, August 7, 2012

Are the Discount Store Stocks Still Good Value?

As Jamie Dimon just found out at JPMorgan, managing risk is a whole lot harder than it appears. What makes it difficult is that it is easy to be seduced into thinking we are managing risk if we accept the consensual view. Unfortunately, the ‘consensual view’ of managing risk is -- by definition -- one that many people hold and the price of carrying it tends to go up. If that position then fails, its holders will be left carrying the can. I think a similar situation could be developing here with some of the discount retailers in the US.

To be clear, I’m not saying they are unattractive businesses. Nor, am I saying that they don’t have good prospects or that I think they will do not well. What I am saying is that, every investment comes with a risk and, a price for that risk. Simply put, on a risk reward basis, stocks like Dollar General (NYSE: DG), Dollar Tree (NASDAQ: DLTR) and Family Dollar (NYSE: FDO) look fully priced to me and before considering an investment, investors should understand the underlying assumptions being made by the market with these stocks.

Investors like to lump these stocks together with off-price retailers like TJX Companies (NYSE: TJX) and Ross Stores (NASDAQ: ROST) but, I think there is a clear difference here. With the off-price retailers, shoppers are essentially buying the same product for less, whilst with the dollar stores they are often buying a cheaper substitute or even a private label brand. In other words, I think that shoppers at TJX and Ross Stores outlets will be more ‘sticky’ in an economic upswing. It is one thing to buy the same product cheaper, it is anything thing to buy a cheaper product!

Dollar Stores No Longer at a Discount

A quick look at the fundamentals suggests that these stocks are not cheap.

However, what investors are really paying for is an extension of the kind of performance that these companies have generated over the last five years. I think it is dangerous to assume this because market conditions might not stay the same. Essentially, the dollar stores are key beneficiaries of a recessionary and slow-growth environment. They represent a far cheaper option to do some basic shopping. The last five years have been very tough on the poorer segments of the US population and we can see how this benefits the dollar stores if we look at sales per store.

These numbers are very impressive and, naturally, they have encouraged aggressive expansion in store roll outs. In contrast to much of corporate America, dollar stores have been quick to spend and grow their businesses.

All of which has led to strongly increased revenues for the sector. In fact, Dollar Tree and Dollar General have both increased revenues by around 11.7% per annum. Family Dollar has grown at a slower pace but the aggressive expansion plans for 2012 suggest it is playing catch up. The company intends to open or expand 600 stores in the year. Compare this to Dollar Tree’s plans to do similar, with 390 stores. Furthermore, Dollar General is investing $650 million in capital expenditure on new stores.

So we have a scenario of a favorable economic environment leading to strong sales growth and expansion and analysts have not been slow in penciling optimistic assumptions. For example, look at Dollar General. Analysts have revenue forecasts of $16.04 billion and $17.49 billion for the next two years. Now assuming that they expand stores to 10,500 and 11,000 at year end, this assumes sales per store numbers of $1.53 million and $1.59 million, respectively versus $1.49 million in 2011. This seems aggressive to me.

Evaluating the Dollar Stores

I’m not trying to rewrite the book on evaluation techniques in this article, nor do I want to argue that there isn’t growth ahead for these companies. My point is that there is not only downside risk in an economy, there is also upside risk!

Simply put, if employment gains carry on at a clip of around 100-250k a month, at some point, consumers will start to revert to shopping where they used to before. Or at least, they will go more often to more upmarket retailers like Walmart or Costco. This could have an effect on the key sales per store metric for these stocks.

I use the word ‘key’ to describe the sales per store metric, because most of the growth assumptions are based around this number expanding. In one sense, it is likely to over the next couple of years because the new stores take a while to reach maturity. However, at some point, I think this number will start to slow its growth and investors should be focused on it. Why is it so important?

The answer is that even if we adjust for the expansionary capital expenditures in these companies, the stocks still look expensive. To demonstrate this, let’s use the depreciation figure as a proxy for maintenance capital expenditures and see what kind of adjusted free cash flow yield these stocks are currently on.

The way to think of the last column is as a proxy for the evaluation of the stock if they just stopped investing in new stores. Future growth would then solely rely on sweating the existing assets and generating sales per store growth.  Naturally, if there was any kind of slowdown or reduction in this metric, then it would leave these companies challenged from an evaluation perspective. In other words, I think that current evaluations do not support the stock price -- it is all about growth.

Essentially, an investment in the dollar stores is a ‘bet’ on a continued recessionary type environment. If they have benefited from a reduction in employment and tougher conditions for the mass market consumer, then it logically follows that they should relatively suffer when employment and income growth makes a comeback. I’m not against holding such stocks in a portfolio -- on the contrary they add diversification -- but every stock has its price. And right now, I think these stocks have been bid up too high as the market chases the story.

I’m searching for a discount at the dollar stores but I can’t find in their stock prices.