Discount retail stores seem to have a number of tailwinds working in their favor. The economy in the United States is still gradually recovering from the depths of the Great Recession, which means that millions of households are still pinching pennies. But the continued weakness of deep-discounters core lower-income demographic is turning from a clear advantage into a double-edged sword. Despite an aggressive push to open new stores, earnings out of this group remain weak, and their outlooks for 2015 are shaky at best.
Here is why investors should avoid deep-discount retailers as investment opportunities next year.
Earnings reports not as outstanding as they look
Discount retailer Five Below (NASDAQ:FIVE) , a store that offers all of its products for $5 or less, reported third-quarter earnings that look great on the surface. Revenue soared 24% and earnings jumped 20%, year over year. But shares of the company collapsed 12% on the day of its earnings release in early December. The reason for this discrepancy is that the discount retailer industry is displaying a disturbing pattern, in which revenue growth is simply being achieved thanks to large numbers of store openings. Comparable-store sales, which measure sales at stores open at least one year, looks far less impressive. For example, Five Below's same-store sales grew just 1.5%. A similar dynamic played out for fellow discount chain Dollar General (NYSE:DG) when it reported its third-quarter earnings. Total sales increased 7%, but same-store sales increased just 2%, year over year. Same-store sales missed estimates, which called for 3% growth.
Going forward, investors have further reason for concern, since forecasts for upcoming quarters are weak. Five Below expects 4% comparable-store sales, and it took down its earnings estimates by one penny per share. Dollar General recently cut its forecast as well, in which same-store sales are now expected to increase below management's previous forecast of 3%-3.5% growth.
Rising costs create a big challenge
Part of the problem for these discount retailers is that their costs are going up and it isn't as easy to pass that long to customers. Five Below's gross margin contracted by 70 basis points. This was due to the fact that its cost of goods jumped 25%, which exceeded its revenue growth. For its part, Dollar General's gross profit as a percentage of net sales fell 18 basis points.
For most businesses, this normally would not be a major issue. They would simply pass on these rising costs to consumers. But deep-discount retailers don't enjoy the luxury of pricing power. Their entire reputations are built on the fact that they offer rock-bottom prices. Consumers who shop at these stores are lower-income, which means they cannot absorb pricing increases. Keep in mind that Five Below's marketing strategy is to brand itself as a store where all products are priced at $5 or less. If Five Below were to raise prices, it would significantly alienate its core customer.
Valuations don't allow much wiggle room
When Five Below reported its earnings, the stock fell 12%. That was a clear indication that even though its earnings looked good on the surface, these stocks are too aggressively valued. The market isn't giving Five Below and Dollar General any wiggle room, because both companies trade for lofty valuation multiples. For example, Dollar General trades for 35 times fiscal 2016 earnings estimates, which is a very high number for a company that recently reduced its forecast for next year.
Dollar General is cheaper than Five Below, but at 17 times forward EPS estimates, it's far from a bargain. Dollar General faces the added hurdle in an uncertain, and expensive, acquisition attempt of industry peer Family Dollar. Dollar General reiterated its commitment to the deal in the company's earnings report, but has not received merger approval yet. Dollar General has offered $9.1 billion for Family Dollar, which exceeds 30 times Family Dollar's earnings on a valuation basis.
The bottom line is that the deep discount stores don't have much margin for error. Several stocks in the sector are aggressively valued, particularly so since these companies are warning investors to be so enthusiastic about future quarters. They are still priced for outperformance, meaning it's possible they could sell off once again after reporting earnings next quarter.
Investing in Five Below and Dollar General in 2015
The deep-discount retailers are in a tough spot. Their extremely cost-conscious consumers have not seen a recovery on par with the recovery for the broader economy. This is keeping a lid on their spending power. In addition, discount retail is being hit with rising costs, and since their core demographic is low-income consumers, they have little choice but to absorb the costs themselves, rather than pass on rising expenses to customers through higher prices.
These headwinds are combining, and Five Below and Dollar General are getting squeezed. With little evidence that these trends will reverse in the coming year, investors may want to avoid these two stocks in 2015.
Bob Ciura has no position in any stocks mentioned. The Motley Fool recommends Five Below. The Motley Fool is short Five Below. 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.