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Much has been made of the bifurcating customer, a growing phenomenon in which high-end and low-end stores have both been growing profits as customers diverge into economic haves and have-nots. Nowhere is this pattern more apparent than in grocery retailing. Over the last five years, two of the best grocery retailers have been Whole Foods Market (Nasdaq: WFM ) and Dollar Tree (Nasdaq: DLTR ) , posting nearly equal revenue growth while others have fallen by the wayside. As customers flock to specialty venues, traditional stores like Safeway (NYSE: SWY ) will need to find an edge, and even leaders in the specialty space won’t be safe forever as competition heats up.
This chart exemplifies the phenomenon. Safeway and SUPERVALU (NYSE: SVU ) have stalled over the years, with essentially flat annual revenue growth, while Whole Foods, often derided as “Whole Paycheck,” has performed wonderfully even in the face of a deep recession. And while low-cost leaders like Costco (Nasdaq: COST ) and Wal-Mart (NYSE: WMT ) have done reasonably well, the recession has driven customers even further down the price spectrum into the arms of stores like Dollar Tree.
It’s no wonder then that Whole Foods and Dollar Tree have some degree of pricing power, however counterintuitive it may be for the latter company. Once again, the two companies share nearly the same figures. For Whole Foods, a high margin makes sense, because the store sells a lot of premium items. A high margin at Dollar Tree may seem odd, but is also logical. The store is basically a reverse Costco. A life-size bottle of Mrs. Butterworth’s may be cheaper per ounce at Costco, but its total selling price is considerably higher than the pocket-size version at Dollar Tree. Thus, customers at Dollar Tree may end up spending more over the long run, but they pay that premium for the peace of mind that comes with being better able to manage short-term spending. This feature is extremely important to those living paycheck-to-paycheck or even relying on food stamps.
Ultimately, though, free cash flow is what investors really care about. The runaway success of Whole Foods and Dollar Tree over the last few years has led to a lot of expansion, which has naturally led to more sales and more profits, but at the cost of more capital expenditures. Meanwhile, mid-range competitors have wisely held off on expansion, and thus retained more of the profits they do eke out.
This chart could use some clarification, though. It looks like SUPERVALU, despite reporting billions in losses over the last few years, has somehow earned massive amounts of cash. Some of that free cash flow growth did come from asset sales, as the company attempted to lighten its business and become more efficient, but the bulk of it came from goodwill and intangible asset writedowns.
These types of assets are an earnings manipulator’s dream, for two reasons. First, they’re on the cash flow statement, which fewer investors pay attention to. And second, their value is essentially based on management’s estimates. By writing them down a lot, current cash flow gets a major boost, and future expenses are artificially reduced. This is why this technique is featured prominently in Howard Schilit’s book Financial Shenanigans. Now I’m not saying SUPERVALU is manipulating its cash flows, but I would take this inflated number with a grain of salt.
The Foolish bottom line
Whole Foods and Dollar Tree operate on different ends of the value spectrum, and yet both have had strikingly similar results as customer groups diverge into increasingly separated categories. A shrewd options investor might see an investment in both companies as a kind of straddle on the American economy, benefiting as customers veer off further toward either end of the spectrum. Add them to My Watchlist to stay updated.