Thanks to a fragile economy and an increasingly cautious U.S. consumer, deep discount retailers have performed relatively well over the past several years. Even so, the next few years could prove to be even more fruitful for the discount, or dollar store, retailers. The perceived notion is that this future success is merely predicated on the economically sensitive consumer continuing to shop at these stores, yet the story goes much deeper than that.
Simply a Growth Story
The vast majority of investment returns comes from growth. As a value investor, I would much rather pay a premium to book for a long-term growth story than buy below book for assets that are unable to deliver profits and cash flow. Deep discount retailers such as Dollar Tree (DLTR), Family Dollar (FDO) and Dollar General (DG) are very likely going to create enormous value for shareholders as a result of future growth.
And the growth story is not only because low-income consumers will continue to shop at dollar stores, which is a given, but because these retailers are going to experience even more growth as middle-income shoppers start making more trips. To understand why is to understand the evolution of the dollar store. Once perceived as a four-wall structure with overflowing bins and shelves of unnecessary merchandise, dollar stores are transforming into major sellers of consumer staples from laundry detergent to socks. According to Dollar General CEO Rick Dreiling, over 20% of his customers are households of $70,000 or more a year.
Huge Value Component
This evolution is what will propel these businesses to greater growth in the years ahead. A pack of four AA batteries can be found at Dollar Tree for $1.00. At my local grocer, the same batteries are selling for nearly $5. Even Wal-Mart (WMT) couldn't come close to matching the price. And consumers are finding that they can get those kinds of savings on other staples such as soap, paper towels and toothpaste. Your friends will never know where you bought the item, but you will know that you saved 25% to 75%, and that is a real value proposition.
The small size of these retailers is also no accident. Would you rather have to find parking in a huge Wal-Mart parking lot and then navigate 40,000 square feet for laundry detergent or would you rather pull up to a 10,000 square foot Dollar General, walk about 10 yards and then check out?
The main question is how such stores can continue to offer savings despite rising fuel and commodity costs. The answer is found in the business model. Dollar General is the largest retailer in the U.S. with over 9,500 locations. Over the next year, the company will open 625 new stores and add 6,000 jobs, very welcome news in this economy. But look closer: The math suggests that each store will need approximately 10 employees. A quick back-of-the-envelope calculation reveals that each Dollar General store generates $1.2 million to $1.5 million in annual sales for a store staffed by less than a dozen employees.
No surprise then that Berkshire Hathaway (BRK.A/BRK.B) recently disclosed a small stake in Dollar General. We will know in about three months if that position was increased or not. Several months ago, Bill Ackman of Pershing Square disclosed a bigger stake in Family Dollar. Of the three main players, Dollar Tree has a net cash position on the balance sheet. But really, both Family Dollar and Dollar General have conservative balance sheets. All trade at attractive P/E multiples relative to the retail industry average; when you factor in the potential growth, the value proposition is even better. Here's a valuable fact: Dollar General has had 21 years -- that's years, not quarters -- of same-store sales growth.
Going forward, the landscape has never looked better for dollar stores. Whether the economy is strong or weak, these businesses are getting an entirely new demographic of shoppers that will propel growth for years to come.