Investors in the deep-discount retail sector -- read dollar stores -- have reason to be a tad disappointed over the past year and a half. The stock price of all three of the major players in this business peaked at about the same time, the beginning of 2004.
Since then the stock of industry leader Dollar General (NYSE: DG) has been relatively flat, while its two runner-up contenders, Family Dollar (NYSE: FDO) and Dollar Tree (Nasdaq: DLTR), are both off about 40% from their peaks. Over the same time period the S&P 500 is up about 9%.
I suggest there are two reasons for this sector sluggishness: a long-term question and a short-term problem. The long-term question is how much growth is left in this industry. At the end of this most recent quarter these three players had 15,710 dollar stores in the U.S. -- meaning a lot, particularly given the diversity of such providers outside of the "dollar store" proper realm. Permit me to point out that that's 15% more stores than McDonald's has in the U.S. Over the past five years, McDonald's has been growing domestic locations at a rate of about 1.5% per year. New store growth among the big three dollar stores was 8% last year, and they all continue to forecast big store growth numbers. Do I see a problem brewing here?
The short-term problem is economic. The lower demographic customer base is feeling the pinch of a sluggish economy and high energy prices. Although the customers continue to buy, their dollars are shifting to lower margin consumable items like paper and cleaning supplies, away from higher margin discretionary purchases like apparel. This is causing a margin squeeze, very apparent from the recent quarter earnings releases of Family Dollar and Dollar Tree.
Dollar General reported first-quarter earnings on Thursday, and the pattern is no different. Total revenue growth of 13% and comparable-store-sales growth of 4.3% were pretty respectable. But EPS of $0.20 was flat with last year, and net earnings in dollars fell by 4.3%. Again the culprit was gross margin, down by 80 basis points on a noticeable shift in category sales. Consumable sales were up 18% while home product sales were down 1%. The stock took a hit of 11%, falling $2.50 to $19.55.
The company gave a cautious view of the balance of 2005, forecasting modest growth for the second quarter. It tentatively stuck with full-year guidance of 12% to 15% EPS growth, but now that will be prior to expensing of stock options, whereas previously the forecast included this item. And their release admits that even with this change, current full-year guidance will be "more difficult to attain."
Don't get me wrong. I think all three of these dollar store companies are very well-run organizations. In fact, it's hard to pick a dominant player. Dollar General is larger, but beyond that their financials look similar -- each had 11% revenue growth last year, and operating margins tracked between 7% and 9%.
I believe energy costs will start trending down; there's evidence of this already. So the short-term mix issue is likely to improve, unless we're already seeing too many dollar stores competing for a limited pie of lower-income discretionary spending. This leads back to the bigger question of how much growth is there left in the sector, before saturation and cannibalization become the dominant themes.
I liked the prospects for dollar store growth a lot more five years ago, when there were fewer than 10,000 stores nationwide among the three big players. Even considering the recent pullback in share prices, I think investors need to be cautious of these stocks.
For a variety of views on dollar stores, don't hesitate to read:
Fool contributor Timothy M. Otte loves watching reruns of his favorite Clint Eastwood movie, For a Few Dollars More. He welcomes comments on his articles, but doesn't own the stock of any company mentioned in this article.
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