by Jeff Reeves | August 6, 2012 1:30 pm
The rise in discount retail stocks is pretty well known by now, with these smaller picks showing up Wal-Mart (NYSE:WMT) stores for a few years running. But the million-dollar question for these low-price retailer shops is whether the gains will continue.
My two cents: The discounters remain a decent buy right now.
These stocks are some of the last trains to pull in to the earnings station, and their results will be closely watched by investors. Dollar Tree (NASDAQ:DLTR) is set to report August 16, Dollar General (NYSE:DG) — a member of InvestorPlace‘s Real America Index — reports August 27 and Family Dollar (NYSE:FDO) doesn’t report until late September.
I’ll get to the growth potential of these stocks in a moment. But first, let’s be clear about the risks:
If you’ll recall, the entire sector of discount retail lost momentum in June after Family Dollar earnings. FDO stock is off about 5% since then, vs. a 5% gain for the broader S&P 500 index. DLTR stock is off almost 5%, too, and DG is down almost 4%.
FDO’s third-quarter earnings rose 12% due to increased diversity including food products and a fancy remodeling of many locations, but there was some disappointment — same-store sales showed just 5% growth, at the low end of the retailer’s projected 5% to 7% forecast. Also, a lower-than-expected tax rate contributed to earnings.
There were also disconcerting signs that the so-called “paycheck cycle” is deepening, where consumers make their purchases once every two weeks on payday and then sales are sparse in between. This makes sales more unpredictable, and doesn’t bode well for consumer spending in general.
Broadly speaking, there is also the risk of buying a top. These stocks are a crowded trade after running up dramatically in the last few years. Though forward P/E ratios aren’t staggeringly large, they are still a bit high. Dollar Tree is the richest at almost 18, while DG and FDO are both above 15. That’s not overbought — especially considering peers with similar numbers — but it’s not exactly a sign of a bargain.
These are real risks. But here’s the bottom line: Discounters are some of the best investments for folks looking for retail exposure in their portfolio. If consumer spending weakens, these picks will be hurt less than many specialty retailers like Abercrombie & Fitch (NYSE:ANF) or department stores like Macy’s (NYSE:M).
And what’s more, I think Family Dollar is actually the least impressive of the trio. So we shouldn’t overburden DLTR and DG with the specific stumbles of this key competitor even if they are similar. Yes, FDO stock has indeed doubled since 2007 and dramatically outperformed the market. But Dollar Tree and Dollar General are up twice that amount.
And, more importantly in the short term, big box discounter Wal-Mart has actually outperformed FDO stock in the last year. Family Dollar earnings and sales are growing at a nice clip, but they certainly aren’t the best in the sector.
Click to Enlarge Take a look at the past performance and projected sales and earnings for these three discounters and you’ll see that top-line growth has been much slower at FDO than at its peers in the discount space. And while earnings have grown at an impressive clip, they simply don’t keep pace with Dollar General and Dollar Tree.
Twist my arm and I’d have to pick DLTR as my favorite among this group. Its revenue growth is more consistent. And while Dollar General has more scale — an over $17 billion market cap and about 9,960 locations vs. a market cap of around $11 billion with just 4,350 or so stores — that may be a disadvantage when it comes to growth. After all, DG can only shoehorn so many stores into strip malls and eventually will reach a critical mass.
I think the recent pullback amid the market’s strength these last few weeks could provide a decent entry point if you’re looking for some retail exposure but are reluctant to bet on a secular recovery in consumer spending. Discounters like Dollar Tree and Dollar General (and to a lesser extent, Family Dollar) should do well even in this weak spending environment. The fundamentals prove that.
Do you have a stock that’s on your mind? Drop me a line at email@example.com and I’ll take a look at it.
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at firstname.lastname@example.org or follow him on Twitter via @JeffReevesIP. As of this writing, he did not hold a position in any of the aforementioned securities.
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