As the U.S. faces a serious economic downturn, many Americans are seeking out the cheapest possible option when buying necessities. Enter ultra-discounters like Dollar Tree (DLTR), 99 Cents Only (NDN), and Family Dollar Stores (FDO).
All three retail chains have seen their stock prices surge this year, a rare bright spot in a stock market beaten down by the financial crisis and recession worries.
Shares of Family Dollar Stores are up almost 32% so far in 2008, while shares of 99 Cents Only and Dollar Tree have both risen 37%.
Another downscale option, Wal-Mart Stores (WMT), has also prospered as consumer trade down from pricier retail options to discounters. Wal-Mart shares are up almost 14% in 2008.
Luring the Most Cost-Conscious
But a dollar-store customer is "not the same shopper as at Wal-Mart," which appeals to a broader, higher income demographic, says Standard & Poor's equity analyst Jason Asaeda. Family Dollar Stores, for example, describes its typical customer as a woman in her mid-40s, the head of her household, who earns less than $30,000 each year.
By focusing on products priced under at least $10, and in most cases under $1, dollar stores aim at the most value-conscious customers in the U.S.
As economic pain increases, the ranks of dollar store customers seem to be growing. "It's great for consumers who are becoming extremely cost-conscious," Asaeda says.
Not a Lot of Leeway
A rise in commodity costs this year threatened to hurt both discounters' profitability and their typical customers' available cash. Low-income discount shoppers typically spend a larger share of their income on gas, and rising prices at the pump meant less was left over for even basic necessities bought at dollar stores like shampoo and cleaning products.
Plus, higher fuel and commodity costs raised the chain's costs. With set price points like 99 cents, the stores can't easily raise prices.
However, after the recent fall in commodity prices, retailers' costs should begin to ease, both for shipping and for the products on its shelves. "Based on recent conversations with industry experts, we believe inflationary costs in Asia are easing materially over the past 60 days, which should help the stock from a headline perspective over the next few months," JPMorgan (JPM) analyst Charles Grom wrote regarding Dollar Tree Stores in mid-October. "[T]he 50% drop in gasoline prices should benefit the customers of value retailers more than any other retail segment," noted Dan Wewer, an analyst at Raymond James (RJF), in a Nov. 3 report.
Aggressive Expansion Plans
The retail landscape is full of chains that are struggling to bring customers in the door and thus expecting profits to fall in the next year. During the good economy of the past few years, many chains rapidly expanded across the country. They now find themselves with fewer expansion opportunities.
Dollar stores, by contrast, are one the few categories of retail stores expecting earnings growth next year, Asaeda says. That growth is due to rising same-store sales, cost-cutting, and aggressive expansion plans.
Piper Jaffray (PJC) analyst Mitchell Kaiser Sr. notes Dollar Tree, with its current base of 3,500 stores, eventually expects to operate 6,000 to 7,000 stores. "Much of this growth is likely to come within many of the top 50 metropolitan markets where [Dollar Tree] feels it is underpenetrated," Kaiser says. The chain tries to grow its square footage by 7% per year. "The sector is benefitting from investors looking for companies that can generate consistent sales and profit growth during a recession," Wewer says.
Heading for a Fall?
Another worry for investors during a recession is whether companies are strong enough to weather tough times. In other words, do they have enough cash and a low enough level of debt to avoid bankruptcy, which might wipe out stockholders' investments?
After a review of retailer balance sheets issued Nov. 5, Deutsche Bank (DB) analysts said they foresee no liquidity problems at Dollar Tree, 99 Cents Only Stores, and Family Dollar. For example, the report concluded that 99 Cents Only "has essentially no debt on (or off) its balance sheet."
With all these positive factors, value stores are riding high. Maybe too high. Some analysts are warning that discount retailers are getting overvalued and may be heading for a fall.
All Eyes on the Ultra-Discounters
For example, on Nov. 3, Johnson Rice & Company analyst David Mann downgraded 99 Cents Only Stores from a rating of "overweight" to "equal weight" because of worries its stock price was too high. "While we like the company's budding turnaround opportunity, we would look for a more attractive re-entry point," Mann wrote.
The retailer 99 Cents Only reports second-quarter earnings on the evening of Nov. 6. Analysts and investors will be watching the results to see if the ultra-discounters can maintain their momentum. For now, investors may have to pay up if they want to play the bargain-retailing trend.