Following the global financial crisis in 2008-2009, a new culture of frugality has set in among U.S. consumers. This has benefited dollar-store operators like Dollar General (NYSE:DG) and Family Dollar (NYSE:FDO), which have grown their earnings by five year compound annual growth rates, or CAGRs, of 57% and 14%, respectively. In contrast, retail giant Wal-Mart (NYSE:WMT) has seen its net income increase by a more modest annualized 4% over the same period. While the near-term outlook looks bright for dollar stores based on their recent financial results, this could potentially mislead observers as dollar stores don't have long-term sustainable competitive advantages over Wal-Mart.
Leaving no stone unturned
While Wal-Mart has been traditionally associated with the broad product assortments and "everyday low prices" offered by its Supercenters, it announced expansion plans in February 2014 which involved accelerating small-store growth. This will enable Wal-Mart to capture a customer's entire shopping share from quick fill-ins to complete stock-ups.
The dollar stores had appealed to frugal consumers for two key reasons: convenience and price. Dollar stores are typically located closer to consumers than Wal-Mart's Supercenters are and they sold smaller packs of items which allowed consumers to spend less on a per-basket basis (but more on a per-unit basis). This dynamic will change with Wal-Mart's small-store expansion plans.
As of February 2014, Wal-Mart operates 346 Neighborhood Markets and 20 Wal-Mart Express stores. Neighborhood Markets stores will meet consumers' demand for food purchases while Express stores will give customers the convenience of dropping by nearby locations for occasional purchases. Both formats have delivered outstanding results for Wal-Mart, with Neighborhood Market stores growing their fiscal 2014 comparable sales by 4% and Express stores performing well in their initial three-market pilot. Wal-Mart plans to add approximately 270 to 300 small stores in the new fiscal year.
The new small stores opened by Wal-Mart will be more conveniently located near consumers and they will offer more products in different packet sizes, which will thereby negate any perceived advantages of dollar stores.
The outperforming dollar store
As the largest dollar store operator in the U.S. with more than 11,000 stores located across the country, Dollar General has been the key beneficiary of the increased frugality of consumers. In the fourth quarter of 2013, Dollar General achieved its twenty-fourth consecutive year of same-store sales growth and it also delivered record quarterly sales, operating profit, and net income.
As Wal-Mart and other retailers open competing small-store formats, this will greatly diminish Dollar General's convenience-based selling points. Low pricing remains Dollar General's key attraction. Dollar General prices most of the products it sells at $10 or less, with a quarter of them selling for less than a dollar. As a result, Dollar General has plans in place to reduce costs so that it can remain price-competitive. These plans include simplifying store processes to reduce in-store labor; centralized procurement; a reduction in inventory shrinkage rates; and an increase in private-brand penetration.
Despite such strategic plans to reduce costs and remain price-competitive, I don't think that Dollar General can match up to Wal-Mart with respect to purchasing power and subsequently cost savings. Furthermore, Wal-Mart will be able to provide a wider range of products at lower prices, relative to that of Dollar General, at its smaller-store formats.
The underperforming dollar store
While most dollar store operators like Dollar General have reported outstanding results, Family Dollar has comparatively been an underperformer. Family Dollar's recently announced strategic actions, at the time of its second-quarter 2014 results, have set alarm bells ringing in the industry. Firstly, it will close about 370 stores that have been underperforming. Secondly, Family Dollar will reduce its cost structure by trimming corporate overhead and realigning key organizational functions. Thirdly, it has pledged to make investments to lower its prices on close to 1,000 basic items.
It is worth examining these actions in greater detail to draw insights into the challenges that dollar stores face. The decisions to close 370 underperforming stores and slow new store growth from approximately 525 new stores in fiscal 2014 to 350-400 new store openings in fiscal 2015 suggest that supply has caught up with demand with respect to new entrants. On the other hand, Family Dollar's actions to reduce costs and lower prices suggest that competitors such as Wal-Mart provide similar or even better customer-value propositions in comparison with Family Dollar.
Foolish final thoughts
It is easy to get carried away with the recent financial performances of dollar-store operators like Dollar General. However, the dollar store bubble looks like it could burst at any time. Wal-Mart remains the king of retail and it should cement this position in the foreseeable future with its small-store expansion plans.
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Mark Lin has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.