Thursday, January 3, 2013

Where Next For the Discount and Off-Price Stores?

Everyone loves the dollar stores as an investment theme. If there is a sector of the retail market that has better represented the anemic (but trending) recovery then I haven’t found yet. This recession has been particularly hard on blue-collar America and the recovery only seems to have benefited certain segments of the population. The result is to create an environment where consumers have gotten used to trading down and increasing their categories of shopping within discount operators like the dollar stores. So where are we now with the likes of Dollar General (NYSE: DG)?

Buying Value at the Dollar Stores?

I last discussed the sector in an article linked here. The key thing to look at in that article is the adjusted free cash flow figure.  Even with this assumption the stocks didn’t look like good value at the time.

I merely assumed the reported depreciation represented the maintenance capital expenditures, and this produced a free cash flow over enterprise value figure. None of which looked particularly cheap. This sort of thing is usually a good approximation, but it should only be used if you are confident that the expansionary CapEx will generate the same amount of return on assets as previous investment. This has appeared to be a ‘no-brainer’ type argument this year, but Dollar General’s recent Q3 2012 report and guidance are giving pause for thought.

Here are the key comparable same store sales metrics for DG and the mid-point of guidance for Q4.

It’s not only that the guidance is weaker, but the commentary around the results has spooked investors.

My Three Concerns with Dollar General

Dollar General described an environment in which rivals are aggressing on price competition. As a consequence, its management expressed a ‘cautious’ approach to its prospects amidst a sales environment of extreme fluctuations in weekly sales. My interpretation of this is that Dollar General feels this is mainly a factor of the macro environment and few can challenge its knowledge of the ‘pay check cycle’ in the US. However, I have two concerns/questions.

  • Might this not be a result of customers becoming extremely price sensitive and holding out for discounts at retailers?
  • The dollar stores have all been aggressively expanding stores, and the traditional grocers/retailers are also starting to fight back on offering value
  • With a gradually improving economy, is this the time to be aggressively expanding new stores while same store sales are slowing?

In a sense, I'm building a classic argument of an industry undergoing strong growth and then being subject to increased competitive pressure and margin pressure as the competition reacts and capacity expands.

Expansion Plans Continuing While Market Is Getting Tougher

Indeed, the expansion plans are continuing. By the end of 2012, 625 new stores are expected to have been opened with another 635 planned for next year, and DG described its new store pipeline as being ‘full.’  The amount of square footage devoted to sales is expected to increase by 7% and in line with recent history.

So expansion plans continue, but DG is having to respond to competition and will reduce pricing in certain categories while engaging in increases in incremental advertising.  The argument cited was that this was in long term interests and intended to encourage customer loyalty. Frankly I find this to be a puzzling argument.

By definition, discount store purchasers are shopping for price. They aren’t shoppers particularly interested in brand loyalty or being faithful to an outlet as some kind of affirmation of lifestyle. They just want to buy some cheap macaroni and cheese, and reducing the price of it is not going to engender any loyalty to the store doing it beyond the time when someone else offers it cheaper.

The pricing reductions smack of a forced move to deal with a changing marketplace. Indeed, Dollar Tree (NASDAQ: DLTR) recently reported that its same store sales only increased 1.6% from 4.8% last year.  Although, Family Dollar (NYSE: FDO) recently reported a far more respectable 4.7% same store sales increase. No matter, both stocks have been beaten up in sympathy with what DG reported.

Where Next for the Sector?

I like to include Ross Stores (NASDAQ: ROST) and TJX Companies (NYSE: TJX) in this mix of companies, and they are particularly relevant because DG reported disappointing results in apparel. Indeed, DG was forced to issue markdowns in order to try to clear inventory. Is that a warning sign for Ross and TJX?

I confess I’m a bit concerned (I hold TJX), but my hunch is that DG is starting to realize that clothing retail is not an easy affair and is far less commoditized than, say, grocery or even home d├ęcor. TJX reported November sales that were better than its internal expectations. It was the same story at Ross Stores, although the key period for both will be over Christmas.  Moreover, these two companies don’t really compete with the dollar stores in terms of clothing.

As for the dollar stores, they are still attractive businesses, but growth expectations have to be reduced and I think it’s time for investors to consider the points I raised earlier. Investors are going to look for some re-acceleration in same store sales growth, and when it happens the stocks may well have gotten a bit lower. They are attractive (the discount store story isn’t over yet), but the stocks still do not look cheap enough.

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