Discount Retailers: Investing Essentials

Discount retailers are the go-to stores for most Americans today. Here's what investors need to know about the industry.

Aug 8, 2014 at 12:03PM

In the past several decades, discount retailers have become the go-to shopping destinations for most Americans, displacing department stores and even (to some extent) grocery stores. By and large, people are willing to sacrifice a little bit in customer service and convenience to get a lower price.

The Internet has made it easier than ever before to find out which stores have the lowest prices. This is widening the advantage of discounters over traditional retailers, but it is also creating a new set of Internet-only competitors, led by Amazon.com. With that in mind, here are some things you need to know to invest in discount retailers.

What are discount retailers?

Discounters come in all different shapes and sizes, ranging from small dollar stores to giant warehouse clubs and hypermarkets. But they share one basic premise: Discounters try to minimize overhead and labor costs (also known as SG&A, short for "selling, general, and administrative expenses").

By keeping SG&A costs down, discount retailers can use lower markups than traditional retailers while still earning good profit margins. As a result, discounters tend to focus on low prices in their messaging to customers.

How big is the discount retail industry?

Discount Retailers Wal Mart Store Wmt

Wal-Mart dominates the U.S. discount retail segment today.

In North America, discount retail is well on the way to becoming a trillion-dollar business. The sector is dominated (especially in the U.S.) by Wal-Mart. In 2013, Wal-Mart generated 71% of its $473 billion in annual revenue in the U.S., with large contributions coming from Canada and Mexico.

By contrast, the No. 2 and No. 3 U.S. discounters -- Costco and Target -- combined for more than $175 billion in revenue, most of which comes from North America. That's an impressive figure, but still less than half of Wal-Mart's North American revenue.

Other discounters (including smaller big-box chains and dollar stores) are much smaller in terms of revenue, though many are still multibillion-dollar companies.

How does the discount retail industry work?

The discount retail industry has steadily gained wallet share by offering low prices on everyday goods as well as some discretionary items. Like most retailers, discounters buy goods wholesale and then try to mark them up enough to cover their costs and earn an acceptable profit.

But discounters tend to have much lower initial markups (the difference between the wholesale and listed retail price) than traditional retailers. This strategy is generally called "everyday low pricing," or EDLP.

By contrast, traditional retailers usually have higher markups. They then use sales and coupons to achieve a more attractive final price for customers while also creating a sense of urgency (because the coupons/sales usually expire quickly).

Leaving aside the different pricing strategies, the discount retail industry is defined by lower SG&A costs than traditional retailers. As a result, discount retailers are able to offer lower prices (on average) than competitors such as department stores, even including the impact of sales and coupons.

This pricing advantage is the main tool that discounters use to drive customer traffic. The main trade-off is that their stores tend to look spartan and have bare-bones customer service compared to most department stores.

What drives discount retail?

Discount Retailers Costco Store Cost

Unlike most discounters, Costco mainly caters to the upper-middle-class demographic.

Since discounters focus on selling at the lowest price rather than offering the best service or having the swankiest store, they generally cater to a working-class and middle-class clientele. (Costco is a notable exception, and has a wealthier customer base.) As a result, the national employment rate and average household income level are important drivers for the discount retail industry.

When the economy is growing steadily, discounters tend to prosper, because customers on tight budgets get some breathing room to make discretionary purchases. When the economy is in a funk, many customers have to cut back on discretionary spending and become even more price-conscious, squeezing discounters' revenue growth and profit margins.

Dollar stores are the one exception to this phenomenon. They generally have the lowest price points. As a result, dollar stores gained enough market share during and after the Great Recession to make up for the weak overall environment for discount retailers.

The growth of e-commerce is another major driver for how well discounters do. Amazon.com has been adding more than $10 billion a year to its top line since the end of the Great Recession, a figure that rises to more than $20 billion including the value of merchandise sold by third-party merchants. This is a significant drain of wallet share from bricks-and-mortar stores to e-commerce.

Many top discounters were slow to embrace e-commerce and are now racing to catch up with the likes of Amazon. Their ability to build competitive e-commerce businesses -- or to persuade customers to keep visiting physical stores for most purchases -- will determine whether they maintain their relevance over the next decade.

Adam Levine-Weinberg owns shares of Costco Wholesale. The Motley Fool recommends Amazon.com and Costco Wholesale. The Motley Fool owns shares of Amazon.com and Costco Wholesale. 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.

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