Is Wal-Mart Taking Aim at the Dollar Stores?

If you had a dollar for every time an analyst speculated over what would happen if Wal-Mart   decided to target a certain market, then you would have enough money to buy a Family Dollar store outright instead of fretting over encroaching competition. The dollar stores do look like they could see Wal-Mart muscling in, so investors looking for another way to play the value segment of retail might consider Ross Stores or TJX Companies  instead.

Wal-Mart targets the dollar stores, or does it?
By now, most investors will be aware of Wal-Mart's recent announcement in which the company states that it intends to double its planned small-store expansion to 270-300 stores, from an initial target of 120-150. Essentially, this is seen as Wal-Mart taking direct aim at the dollar stores, especially given Wal-Mart's undoubted purchasing power and reach.

 

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Family Dollar Has Much To Do In 2014

Family Dollar Stores $FDO shares have been sliding recently, with the stock down 6.5% in the last three months. Moreover, the latest news wasn't good. Recent results saw the company lower full-year earnings estimates, and the departure of president and COO Michael Bloom isn't exactly what investors needed to hear right now.

In addition, Family Dollar continues to underperform its rivals Dollar General  $DG  and Dollar Tree Stores  $DLTR , while end-market conditions for the dollar stores remain challenging, as lower-income groups in the US are not proportionately benefiting in the recovery. Can Family Dollar turn things around? And is it now the value play in the sector?

Family Dollar disappoints
Key points from the first-quarter earnings report:

• Comparable same store decrease of 2.8% vs. guidance for a low-single digit decline

• Earnings per share of $0.68 vs. guidance for $0.65-$0.75

While the results were not particularly bad, there were some significant downgrades in its full-year guidance to August 2014.

Full Year 2014 Guidance	At Q4 2013	At Q1 2014
Net Sales	mid-single digit increase	low-to-mid single digit increase
Comparable-Same-Store Sales	low-single-digit increase	low-single-digit decline
Net Store Openings	445	445
Gross Margin	expansion	flat
Capital Expenditures	$550 million to $600 million	$450 million to $500 million
Share Repurchases	$100 million	$250 million
Earnings Per Share	$3.80-$4.15	$3.25-$3.55

Source: Company Presentations

Guidance for net sales, comparable-same-store sales, and gross margin was lowered, but store expansion plans were kept consistent. In addition, don't assume that the lower capital expenditures guidance was an adjustment to the company's weakening performance. Rather, it's more reflective of a change in how its new stores are being financed. In the words of CFO Mary Winston, more 'build-to-suit' financing structures are being used compared to 'fee-development' financing.

This implies reduced capex but increased leasing activity. Eagle-eyed readers will note that share-repurchase plans have gone up by $150 million. All told, Family Dollar's outlook worsened, and it seems to be rewarding investors with share repurchases partly funded by reducing capex. Meanwhile, it's likely to be increasing leasing debt in order to continue to fund a store expansion program.

Whether this is a wise strategy or not will be determined by the success of its readjustment plans for 2014, which involve things like:

• A renewed focus on everyday low pricing

• A pallet-delivery program to increase supply chain efficiency

•  Store layout refreshes

• Adjusting marketing strategy to increase traffic to the stores

• Continuing to invest in the new store program

What went wrong?
To understand the reasons behind the plans, it's best to look at what has been going wrong. In discussing the departure of Bloom, Family Dollar's CEO Howard Levine declared that:

"[W]e weren't happy with our financial results. Ultimately, Mike and I were not aligned on our merchandising strategy and we decided to make a change."

Family Dollar's merchandising strategy has undergone some changes in recent years. For example, in the summer of 2012, the company underwent a significant program of adding 1,000 new items, including tobacco, and making store-layout changes. According to Levine, the changes had positive effects on traffic and spending but also resulted in "significant margin pressure, higher store manager turnover, increased shrink and lower inventory productivity."

Some of these effects can be seen in the following graph:

Source: company presentations.

In response to these issues, the company limited changes in consumable categories and store layouts in 2013. The end result is that the first significant changes in its consumable categories took place in the recent quarter; 18 months after the changes in 2012.

Dollar Tree and Dollar General doing better
Essentially, the dollar stores generate traffic via consumables sales and then hope to increase margins by selling discretionary items. As a consequence, the delay in changing its consumable categories has hurt Family Dollar while the retailer has also struggled to generate growth in its discretionary sales. In fact, Family Dollar's traffic slowed "particularly in November and December[,]" while its non-consumable sales (25% of total sales) only rose 1% in the last quarter.

This is in contrast to rival Dollar Tree, which managed to generate positive comparable sales for every month in the last quarter. On its conference call, Dollar Tree's management stated, "So what you saw beginning in [the second quarter of] this year was a little bit of a shift, with the non-consumables growing a bit faster than the consumables."

Moreover, in contrast to Family Dollar, Dollar Tree grew comparable-same-store sales by 3.1% in the last quarter "driven by increased consumer traffic."

Meanwhile, in its last quarter, Dollar General managed to generate "strong customer traffic growth throughout the quarter[,]" partly thanks to the addition of tobacco. Dollar General also grew its non-consumable sales for the second quarter running and reported positive results in its seasonal and home categories.

The bottom line
Family Dollar's performance in 2013 wasn't great, but there is a case for the stock to be a good value proposition. Dollar stores aren't going away anytime soon, and if the company gets its merchandising and layouts right, then there is no reason why consumers won't come back. It's not rocket science.

However, the commitment to rolling out new stores at the same pace is somewhat concerning, considering that the management has enough on its plate in reenergizing the business. Foolish investors might want to be a little patient before piling in. It's one for the monitor list. 

Ross Stores Looking Good For 2014

After a strong share price move leading into its earnings, off-price retailer Ross Stores  disappointed investors with its quarterly results and guidance. Meanwhile, its main rival TJX cheered the market by beating estimates and raising guidance. It's time to look at Ross Stores and assess whether or not the recent decline is a buying opportunity.  In addition, looking at trends in discretionary spending at Dollar Tree, Dollar General  , and Family Dollar  will help guide Foolish investors towards a clearer picture of conditions at the lower end of retail.

Ross Stores breaks a trend
Some stocks can develop a logic all of their own. The market has gotten used to TJX and Ross beating their respective internal guidance. Subsequently, when they fail to do so it's regarded as a disappointment. While TJX managed to generate 5% same-store sales growth (its guidance was for 2%-3%) in the quarter, Ross's same-store sales came in lower than the mid-point of its guidance for the first time in a long while. Moreover, Ross' fourth-quarter guidance of 1%-2% same-store sales growth was uninspiring.

Source: company presentations

It gets worse. In discussing the business environment on the conference call, Ross' management noted a number of reasons why the company was taking a more cautious approach to the rest of the year.

retailers are planning to open earlier than prior years on Thanksgiving Day... ...6 fewer shopping days in 2013 between Thanksgiving and Christmas... ...retailers have reported disappointing results over the past few quarters... ...will create the most intensely competitive and promotional holiday selling period in recent years.

Moreover, Ross' traffic was flat in the quarter, with an increase in basket size driving sales growth. This could be a concern, because in a shorter selling season, traffic is going to be even more important than usual.

Frankly, Foolish investors should look out for more variability in the outlook statements from the retail sector this Christmas. Companies can only report what they are seeing, and spending trends are likely to change dramatically because of the shortened selling season. 

While Ross is gloomy, what is the rest of the industry saying?

What Dollar General, Dollar Tree, and Family Dollar said
TJX raised its guidance, but it was noticeable that it did not adjust the guidance for its fourth quarter, which indicates some caution. Turning to the dollar stores, they have been battling all year to try to increase their discretionary-product sales. Such products tend to come with higher margins than consumables, and they are a good indication of a return to spending power at the lower end of the market.

Dollar Tree's relative performance with discretionary products has been better than the other dollar stores this year. Indeed, on its third-quarter conference call management stated "So what you saw beginning in Q2 this year was a little bit of a shift, with the non-consumables growing a bit faster than the consumables." However, it's not entirely clear whether this is a macro effect or a response to Dollar Tree rolling out relatively fewer consumable products than it has in previous years.

The picture wasn't any clearer with Dollar General in its third quarter. In response to an analyst's question on "encouraging" discretionary trends, CEO Richard Dreiling replied that he thought the "trade-down customer is getting more comfortable with the quality of the products we're putting out there" and "I think we're doing a much better job on the merchandising selection here." Finally, on its fourth-quarter conference call, Family Dollar argued that there was...

...stabilization in our discretionary businesses and we delivered our best comp performance of the year in these higher-margin categories. We remain cautious on the outlook for our customer, but we do believe that we are turning the corner in several key discretionary businesses.

All three are cautious on the consumer, but frankly, none of them reported deterioration with their discretionary products. It's fair to summarize their statements as mildly positive.

Time to buy Ross Stores?
With that said, is it time to buy into the weakness in Ross Stores with the anticipation that it will beat its cautious guidance?

The dollar stores aren't saying overtly negative things on discretionary spending, and Ross Stores's third-quarter numbers weren't that bad. Its guidance isn't great, but 1%-2% same-store sales growth is what it projected for three of the last four quarters.

Furthermore, on the evidence of the trailing figures collated below, there is a good case for buying in. Note that adjusted free-cash flow is simply trailing operating cash flow minus depreciation. This is a more useful measure of underlying cash-flow generation because all of these companies are in an expansionary phase.

($ in millions)	Dollar Tree	Family Dollar	Dollar Tree	TJX	Ross Stores
Enterprise Value	12,060	7,890	21,600	44,670	15,810
Revenue	7,850	10,391	17,217	27,338	10,114
Operating Cash Flow	731	472	1,242	2,599	1108
Depreciation	187	224	320	544	197
Adjusted Free-Cash Flow	544	248	922	2,055	911
Adj FCF as % Revenue	6.9	2.4	5.4	7.5	9.0
Adj FCF as % Enterprise Value	4.5	3.1	4.3	4.6	5.8
EPS Growth Rate %	10.7	10.2	15.7	13.6	12.3

Source: company presentations, author's analysis

A company that generates 5.8% of its enterprise value (market cap plus debt) in free-cash flow with double-digit growth prospects is usually attractive. Provided that Ross can at least hit its holiday-season guidance, the stock looks like a good value.

TJX Remains a Buy

Investors in off-price retailer The TJX Companies  will be very pleased with the company's latest results. Not only were earnings ahead of estimates, but management also guided investors toward some significant developments that should drive the company's long-term growth. There has always been a lot to like about TJX, and now there is even more.

TJX beats estimates, again
TJX previously guided toward diluted earnings per share in the range of $0.69-$0.72 and comparable-store-sales growth of 2% to 3%, but it delivered $0.75 and 5%, respectively, in its third quarter.

The company has a history of giving conservative guidance, and it arguably did so again this time around. Despite the impressive third-quarter numbers, management reiterated its fourth-quarter forecast of only 1%-2% comparable-store-sales growth, and diluted EPS of $0.77-$0.80. Don't be surprised if it beats projections.

A note of cautionA note of caution came from the outlook provided by a rival off-price retailer Ross Stores. In giving its outlook for the all-important fourth quarter, Ross' management argued that the upcoming holiday season "will be the most intensely competitive and promotional holiday selling period in recent years."

One issue that faces the entire retail industry is the six fewer shopping days between Thanksgiving and Christmas this year. In other words, in-store shopping is likely to be more intense, and retailers will fight hard for foot traffic by offering promotions. This is likely to create some confusing signals from the sector.

However, to be fair, Ross and TJX offered up the same guidance of 1%-2% comparable-store growth in the fourth quarter. The difference was that TJX beat EPS estimates in the third quarter, while Ross was only inline.

It was a similar story with Dollar Tree Stores. The dollar store missed analyst estimates for the second straight quarter, and its management spoke of "weak consumer confidence" and inevitably the short shopping season this year. Furthermore, EPS guidance for the fourth quarter of $1.01-$1.07 was weaker than the analyst consensus of $1.10.

However, Foolish investors should note that Dollar Tree's non-consumable categories (which tend to be more discretionary items) grew at a similar rate to consumable; that's a good sign that consumers do have a bit more discretionary income. It could be that Dollar Tree's management is just being cautious.

TJX's long-term growth prospects
Turning back to TJX, each of its divisions achieved good sales growth in the quarter.

Note that TJX's home goods (10% of total segment profits year-to-date) sales grew much faster than the company average, while according to management Ross' home business "ran at the same rate as the company" in the third quarter. Furthermore, TJX gave some positive updates on its long-term growth plans in three ways.

First, the company's management now believes it can increase its number of stores by 60% to 5,100 stores, with Marmaxx's (73% of segment profits and around 1,966 stores  currently) potential raised to 3,000 locations, some 400 more than it previously estimated.

Second, management declared itself "excited" by its e-commerce plans, and more investment will follow in due course.

Finally, its European segmental margins (6% of year-to-date segment profits) grew to 10.4% versus 9.1% last year, and TJX raised its long-term target to "10%-plus." Considering that Marmaxx has margins better than 15%, it's reasonable to expect that TJX can continue to increase European margins in the future.

Where next for TJX?
It's going to be a tricky season for retailers. The spending environment isn't fantastic, and the shortened selling season will cause great potential for retailers to report mixed signals as the holiday season progresses.

Nevertheless, TJX has consistently demonstrated an ability to appeal to off-price shoppers, irrespective of market conditions. Meanwhile, its long-term growth prospects are getting stronger, and investors should focus on these aspects of its potential rather than the short-term noise created by a shorter selling season.

Family Dollar's Results Weren't That Good!

Investors can be forgiven for thinking that all is well with the outlook for the dollar stores after Family Dollar (NYSE: FDO) rose sharply in post-earnings trading. However, in reality, there were some warning signs for the economy in the report.  Moreover, the underlying story in these earnings is of how well the company is adjusting to weak market conditions. Dollar General (NYSE: DG) and Dollar Tree(NASDAQ: DLTR) were marked up in sympathy, but it would be a mistake to assume that they will report in a similar manner to Family Dollar.

More margin pressure

In common with Dollar General, Family Dollar is seeing margin pressure as its sales mix shifts towards lower-margin consumables and away from higher-margin discretionary items. In fact, the share of consumables rose to 72.5% of total sales, compared to 68.9% last year. In contrast, Dollar Tree managed to benefit from margin expansion by growing its sales mix in the other direction. However, this appears to be an isolated case amongst the mass market retailers.

Family Dollar actually highlighted industry data that suggested that its typical consumer was spending less in the marketplace, but more at its stores. This is not a great sign for the economy. This data also implies that if there is growth to be generated, it will come at the expense of its competition. Family Dollar is likely taking share from the supermarkets within the grocery category. Unfortunately, consumables like tobacco and groceries are not really high-margin items. So even as Family Dollar expands sales in these areas, it will not see gross margin expansion.

These trends are nicely illustrated with a look at the company’s sales and margin trends over the last few years. Note the company’s forecast for the next quarter is for an anemic-looking 2% same store sales growth. This is a bit disappointing, because even though the first quarter was weak for most retailers due to a number of issues (payroll tax increases, tough weather comps, tax refund delays and the sequester), the second quarter was supposed to be a more favorable environment.

On the other hand, the positive news is that gross margins were forecast to be almost flat in the next quarter, much to the liking of the markets.

Why the market likes these results

The real takeaway of these results is how Family Dollar is adjusting to a slower sales environment. Gross margins were predicted to be almost flat in the fourth quarter, and in the conference call, the management discussed the possibility for them to be flat in 2014 as well. There are a number of reasons for a more positive outlook for both gross and operating margins:

• The company has adjusted to the slower sales environment and is now highly focused on reducing things like freight, distribution center, and advertising costs.

• It is starting to lap the unfavorable mix shift movements from last year, so comparisons will get easier.

• Management spoke of some recent improvements in its core discretionary businesses and spoke of the beginnings of stabilization.

The last point is the key, because Dollar Tree has already managed to do this in 2013, while Dollar General was punished by the market in early June when it lowered guidance thanks to weakness in its discretionary sales.  In addition, Family Dollar is somewhat playing catch-up because its discretionary merchandising decisions were below par in 2012. In short, Family Dollar tried to increase sales with discretionary items like clothing, but found it a tough sell to its customers.

Why you shouldn’t get too excited

In putting these points together, it’s hard not to be puzzled as to why the market dragged the other two dollar stores up in sympathy.  Family Dollar didn’t have many good things to say about the economy. In addition, if it really is winning market share, then the other dollar stores could be missing out.

 Also, the dollar stores have tended to report similar trends in same store sales (as shown in the graph below), but they have tended to differ in how they deal with sales mix issues and getting their discretionary sales right.

In conclusion, if these results were all about Family Dollar adjusting to a slower sales environment, then there isn’t a strong reason to think that Dollar Tree and Dollar General are about to shoot the lights out in their next reports. Don’t get too excited.

Dollar General Still isn't Good Value

The latest results from Dollar General (NYSE: DG) were met with a sharp mark-down as they disappointed in terms of both the sales and margin outlook.

In general the dollar stores are attractive for their defensive properties, but many of the headwinds that began in mid 2012 are still around and they are finding growth a lot harder to come by. In summary Dollar General’s results raised more questions than answers and the current valuation still makes it a difficult stock to get too excited about.

Dollar General disappoints

After a disappointing quarter Dollar General declared that its expected sales growth rate and gross margin performance for the full year would be less than it had -only recently- predicted.

There were a few reasons cited and I have pulled out the salient points below

• Payroll taxes, tough weather comps and sales headwinds from tax refund delays hurt the current quarter’s results

• The sales mix contained a larger amount of consumables which tend to be lower margin. Furthermore even within consumables there is a shift to lower margin consumables

• Inventory shrink was larger than expected

• Increasing tobacco sales are naturally reducing margins

The issues hurting consumer’s income were somewhat expected (and Dollar General had previously argued that this would be a weak quarter anyway) but the sales mix concerns were somewhat more surprising. For example, Dollar Tree (NASDAQ: DLTR) had recently given results and notably pointed out that its discretionary sales were growing faster than consumables. This suggests that Dollar General’s issues might not be solely down to tighter customer wallets in the quarter.

Moreover if we look at how Family Dollar (NYSE: FDO) has performed in recent times, we can see that comparable sales growth has been achieved in a climate of falling gross margins. In short, Family Dollar tried to expand its non-consumables sales (mainly home based and apparel) and ran into difficulties as it found it hard to sell higher margin products to its customers.

In summary, Dollar Tree did fine with expanding discretionary sales and therefore gross margins, but Family Dollar has had problems doing this (particularly last year) and now Dollar General is lowering estimates thanks to lower-than-expected discretionary sales.

My feeling is that Dollar General’s difficulties are more a consequence of the difficulty in increasing higher margin sales. It seems that hard pressed consumers feel more inclined to shop for consumables in its stores. As to the weather effects, if they had significant effect on discretionary sales then why wouldn’t the management raise guidance now that spring weather has arrived?

Comparable same stores down across the industry

As ever it is useful to compare how same store sales are faring across the industry. Please note that these numbers are adjusted to the calendar year as these companies have different reporting periods.

It’s clear that same store sales growth started slowing in mid 2012. Family Dollar did achieve some growth but, as discussed above, that was largely a consequence of an expansion in lower margin product sales. The dollar stores are seeing slowing comparable same store sales growth and traditional grocers (Safeway, Kroger etc) are starting to fight back through engaging customers with pricing and promotional activity.

While these issues are affecting the industry there has been no let up in their store expansion strategies. Indeed Dollar General affirmed that its number one investment priority was to open new stores. Indeed it is planning $575 million to $625 million in capital expenditures and hoping to open 635 new stores while relocating/remodeling around 550 stores.  Is this push for growth, by the whole industry, a wise strategy given that same store sales growth is slowing?

Are the dollar stores good value now?

As ever we need to put the growth prospects in the context of valuation. Dollar General’s forecast for comparable same store sales growth of 4-5% isn’t bad in a slow economy and its earnings are forecast to grow double digits over the next few years. On the other hand none of the dollar stores look particularly cheap right now and the expansion plans are impacting the generation of free cash flow.

For companies in a growth phase I like to equate their capital expenditures with depreciation in order to create an adjusted free cash flow number.

In conclusion I think it’s still time to hold fire on the sector right now. It's probably better to follow its customers and hold out for a discount.

Time to Buy Dollar Tree?

Investing in the dollar stores has been one of the most profitable trades since the 2008 financial crisis. With that said, it has been a bumpy ride along the way with all of the leading players having experienced a difficult second half to 2012 and then a nice recovery in 2013. In the light of Dollar Tree’s (NASDAQ: DLTR) latest results I thought I would shed some light on what has been happening in the sector.

The dollar stores in 2012

The general story with the dollar stores can be explained by a couple of charts. The first is the price performance over the last year:

DG data by YCharts

This indicates that the market was very willing to buy their growth stories up until the middle of 2012. So what went wrong?

The answer is that Dollar General (NYSE: DG) and Dollar Tree started experiencing falling same-store sales growth. Meanwhile, Family Dollar (NYSE: FDO) did experience same-store sales growth in 2012, but this was at the expense of margins. I’ve discussed its issues at more length in an article linked here.

In summary, Family Dollar had tried to expand its sales of higher-margin home and apparel goods but ran itself into procurement difficulties. In a sense, it was guided to make such an attempt because it tends to sell a lot of consumables (which tend to be lower margin) and generates significant traffic by doing so. However, the difficulties that it found in trying to expand in these categories speak volumes about the highly competitive nature of its industry.

As for the general growth slowdown, I think it is a normal consequence of a business development. All three firms have chased growth by engaging in significant capital expenditures to fund expansion. It is natural that at some point same-store sales growth will slow because competitors will be attracted to the industry and start to encroach on their market share. This can come from things like dollar stores opening up near each other or from supermarkets like Kroger or Safeway deciding to compete on price through things like loss-leading discounts or promotions in order to drive traffic.

The industry responds

I’ve discussed Family Dollar’s response above. As for Dollar General, it saw significant competition in the last half of the year and its story is one of expanding sales in consumables. In particular, its move into tobacco has caused some margin contraction. The simple fact is that dollar-store customers remain economically hard-pressed. Any strategy to expand into higher-margin categories has been met with resistance. Meanwhile, end markets are getting more competitive.

Turning to Dollar Tree, I think its recent results were quite good and contained a few notable positives.

•  Discretionary-items sales are growing faster than consumables. This should help margin growth in the future.

• Gross margins improved thanks to merchandise leverage and operating margins improved.

•  E-commerce initiatives are driving growth and opportunities to attract store traffic.

• Store openings continue, with 375 new stores and 75 relocations planned planned for 2013.

•  A wide-scale program to increase the number of stores with freezers and coolers should drive incremental traffic.

• The Deals format stores should allow for growth opportunities with higher-priced ticket items without compromising the core appeal or recognition of its Dollar Tree format.

In summary, Dollar Tree has managed to increase margins while carrying on investing in new stores. It’s guiding towards a 7.3% increase in square footage for 2013 and forecasts low-single-digit same-store sales growth.

Where next for the dollar stores?

With all this said, the sector’s strong run doesn’t really leave any of these companies looking cheap. With companies in their growth phase, it is important to realize that they will not be generating high cash flows when they are investing for growth. With that in mind I decided to adjust their free cash flow figures by taking their depreciation rates as a proxy for capital expenditures.

The figures for Dollar General and Dollar Tree are for the last full year but I’ve calculated the numbers for Family Dollar on a trailing basis because its full year runs to August.

We can see the effect of the poor inventory decisions by Family Dollar in the cash flow numbers.

Frankly none of these stocks looks cheap right now.  Even with adjusting for the extra expenditures implied in their store roll-outs, I don’t think that the underlying metrics make them attractive. Despite their attractive growth prospects, the dollar stores still have competitive conditions, and it probably makes sense to wait a bit for a better entry point and some confirmation that same-store sales growth has stabilized.