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  1. Home
  2. / Investing
  3. / Consumer Discretionary

Step Away From the Dollar Stores

Here are three big reason why you want to be on the sidelines.
By BRIAN SOZZI Aug 26, 2016 | 10:00 AM EDT
Stocks quotes in this article: DG, DLTR, WMT

The thesis around one of the easiest trades in the business got badly bruised on Thursday.

Dollar stores such as Dollar Tree (DLTR) and Dollar General (DG) were hammered in response to their tepid fiscal second-quarter earnings and outlooks. All signs pointed to the following rare occurrence happening.

  • Big-time deflation in consumable goods like milk, which has the effect of pulling down sales for companies that are expected to deliver huge sales gains. For some reason, Wall Street and the home gamers never seem to factor in inflation and deflation in their modeling and often get surprised when their large swings in either direction.
  • Walmart (WMT) has been the price aggressor in the retail business year to date and has managed to rip off more than seven-straight quarters of traffic gains. These gains are coming at the expense of dollar stores.
  • Food stamp reductions that began in April are a sales killer for dollar stores.
  • Both of the main dollar stores continue down the road of mind-boggling new store opening/remodeling plans, which is creating inefficiencies in a business model that can't afford to have any.

The million-dollar question today is whether to begin building positions in these once-high flyers. After all, they remain solid long-term growers, have good moats around their business and serve a critical function in society. I spent the night reviewing both quarters and earnings calls and came away less than enthused, for now, on the companies. Here are several key factors that should leave you on the sidelines.

Pricing War

I am in the process of doing a longer piece on this, but my general sense was that the discounters have entered a pre-holiday-season price war. Judging by the comments on pricing from Dollar General and Dollar Tree (and my knowledge of the situation at Walmart), each company has begun lowering prices on key food and household products in an effort to drive traffic. For example, Dollar General has dropped the price on 450 of its top-performing products across many of its stores. I think these new initiatives will come at the expense of margins for the balance of the year and that Wall Street is still underestimating the impact. Shout out to Walmart -- you finally have the dollar stores playing catch-up.

Cannibalization Intensifies

Dollar stores thrive on efficiencies in terms of store design (it's no frills, few employees on hand) and transportation. One way to create those efficiencies is to open stores right around the block from each other, which both dollar stores have done. But I think both of the companies are starting to run into a key problem from their pursuit of efficiencies by opening hundreds of stores over the past five years: cannibalization. In other words, the companies are no longer growing the market for their services, rather just shifting sales in the community among stores. This is a structural issue and one that Wall Street is probably not too keen on factoring into its forward outlook. But what it's likely to cause is slower sales growth and possibly lower returns on investment.

Food Stamp Cut

Let me provide some background on this because clearly investors were caught off guard. The thinking on the food stamp cuts that began in April was that increasingly, poor people would live at the dollar stores each week. That hasn't played out.

Starting this year, unemployed food stamp applicants between 18 and 49 years old who are not disabled or raising minor children, will only qualify for the food stamp program for three months during a three-year period. So, those consumers who no longer qualify for the food stamp program lost their benefits April 1. The change impacted roughly 500,000 to 1 million people. As a result of this, dollar stores are seeing fewer visits to their stores -- if someone doesn't have any money, then they can't buy essentials. Moreover, when those affected visit the stores with whatever money they have, they are buying fewer items and skipping the higher-margin discretionary departments such as apparel. So, the dollar stores are being forced to drop their prices.

I think this will remain a headwind for the sector this year. Perhaps next year its impact will die down as the labor market picks up (or so we hope) and these folks returning to paying jobs. But for now it's a structural impediment for the dollar stores.

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TAGS: Investing | U.S. Equity | Consumer Discretionary | Consumer Staples | Stocks

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