Out-Discounting The Discounter

Why dollar stores that sell at cut-rate prices are giving Wal-Mart pause

When Wal-Mart Stores Inc. (WMT ) comes to town, other stores -- from grocers to hobby shops -- quake. But while mighty Wal-Mart may look invincible, one retailing sector has learned to feast on the crumbs that the giant discounter leaves behind. Dollar stores, those bare-bones, strip-mall chains that sell staples and knickknacks at cut-rate prices, are now the fastest-growing retailers in America. They've become an alternative for a growing legion of shoppers who find Wal-Mart a bit too pricey or a bit too hard to get to. Led by Dollar General (DG ), Family Dollar (FDO ), and Dollar Tree, the sector has added more than 4,000 new stores in the past three years, an increase of 34%.

So far, they're just a speck on the Wal-Mart landscape; combined sales for the group totaled $16 billion last year, compared with $178 billion at Wal-Mart's nameplate U.S. discount stores. But that doesn't mean they've escaped notice. As the dollar stores are expanding and attracting a bigger pool of customers with more name-brand products, Wal-Mart and a handful of other retailers are testing their own dollar-store sections to head off the competition. "They are a major threat, so much so that Wal-Mart will eventually have to buy one of these chains or start one," predicts Harvard University professor John R. Stilgoe, who has studied Wal-Mart's and the dollar stores' growth. Says Sharon Weber, a Wal-Mart spokeswoman: "There is room in the retail environment for all types of competitors."

The two largest chains, Dollar General and Family Dollar, account for the biggest share of store openings in the category. Dollar General, based in Goodlettsville, Tenn., will add an estimated 625 stores this year for a total of about 7,325, giving it the most units of any U.S. retailer. Family Dollar, of Matthews, N.C., will add nearly 485, bringing its total to about 5,693. Wal-Mart, by comparison, will open up to 240 "Supercenter" combination discount and grocery stores, and up to 45 of its discount stores. Still, thanks to its giant-size format, Wal-Mart will add more than four times the square footage of the dollar stores.

URBAN OPPORTUNITIES. Wal-Mart's sheer heft has created opportunity for dollar stores. The discounter usually opens its mammoth stores on the outskirts of towns. Dollar chains can put their much smaller stores right in downtown neighborhoods, closer to where people live. Parking is usually a snap, and shoppers can be in and out in less time than it would take to hike across a jumbo Wal-Mart lot. And as their name implies, the dollar stores offer low prices, sometimes even beating Wal-Mart. "Wal-Mart competes on price and assortment," says David A. Perdue, Dollar General's chief executive. "We compete on price and convenience."

How does a strip-mall chain beat the world's most efficient retailer on price? It's not by matching Wal-Mart's world-class technology or legendary clout with suppliers. Instead, by offering even less in the way of frills than Wal-Mart, the dollar stores have ultra-low overheads. They gravitate toward second-tier strip centers, cutting real estate costs to the bone, says Glenn J. Rufrano, CEO of New Plan Excel Realty Trust Inc. (NXL ), which owns shopping centers with dollar-store tenants. And dollar stores, which started out as liquidators, are quick to pick up cut-rate leases when other retailers go out of business.

The chains also save on marketing -- basically, by not doing any. Family Dollar, for instance, prints one advertising circular a year. They approach labor the same way: Dollar General and Family Dollar employ about four people per store. And all the chains rely on closeout and stock-overrun merchandise for a portion of sales.

This penny-pinching approach means that dollar stores appeal to a different demographic than Wal-Mart. Shoppers with family incomes under $30,000 account for 51% of dollar-store sales, according to market researcher ACNielsen Corp. Analysts estimate that the typical Wal-Mart shopper has an income closer to $40,000 and edging up as supercenters attract wealthier grocery shoppers. Dollar General and Family Dollar mostly sell items that are $10 or less. Dollar General prices most goods in round numbers -- $1, $2, or $3 -- to reinforce the message, while Dollar Tree Stores Inc. (DLTR ) prices everything at a buck.

These days, the dollar-store formula is starting to pull in higher-income shoppers. Families earning $70,000 and above were the fastest-growing group at the chains in 2003, ACNielsen research shows. Partly that's because the chains are adding more brand-name consumer products -- the same products shoppers would find at Wal-Mart. Patty Brock, who shops her local Dollar General in Sun Prairie, Wis., about once a month, says she finds many items there that she used to get at Wal-Mart, like Crest toothpaste, Gillette shaving cream, and Zest soap, at similar prices. Those familiar names help bring in new customers. "It's legitimizing the dollar-store channel," says Jeffrey A. Rein, president of Walgreen Co., the nation's largest drug- store chain.

For a lot of suppliers, anything that offers some relief from their dependence on Wal-Mart has got to be a welcome change. Procter & Gamble Co. (PG ) has installed a team of workers at Dollar General's headquarters, just like it has at Wal-Mart. Its products now account for 11% of Dollar General's sales. P&G even produces special, smaller sizes for the chains so they can hit their low price points. For Family Dollar, P&G produces 18-ounce bottles of Dawn dish soap to sell at $1.

Now big-name retailers are experimenting with their own versions of dollar stores. Wal-Mart is testing "Pennies-n-Cents" sections in 20 Supercenters. Target Corp. (TGT ), meanwhile, is trying out "The 1 Spot" in 125 of its discount stores. Kroger Co. (KR ), the nation's largest supermarket chain, Exxon Mobil Corp. (XOM ), which operates convenience stores at some gas stations, and Walgreen are also experimenting with dollar sections.

Of course, the fast-growing dollar stores will run into some of the same challenges Wal-Mart faces as they approach saturation in the best markets. Forced to move beyond their rural roots to more urban markets, they face higher real estate and labor costs. On April 20, 99 Cents Only reported a 35% decline in quarterly earnings per share, in part because of expansion costs. Still, with 15,000 dollar stores nationally, consulting firm Retail Forward Inc. estimates there's room to double that count. A market that juicy just might prove irresistible to the likes of Wal-Mart.

By Robert Berner in Sun Prairie, Wis., and Brian Grow in Atlanta

    Before it's here, it's on the Bloomberg Terminal.