Is the Sun Setting on Discount Stores?

by Will Ashworth | August 24, 2012 11:13 am

You heard it here first: The sun is setting on the discount store.

Big Lots (NYSE:BIG[1]) and Fred’s (NASDAQ:FRED[2]) announced disappointing results Thursday, including respective Q2 same-store sales declines of 1.9% and 1%.

OK, so my opening sentence was dripping with sarcasm, but those numbers do make you think some of the bloom has come off the rose.

The question is whether these results — as well as Dollar Tree‘s (NASDAQ:DLTR[3]) recent earnings flop[4] — are an aberration or the first red flags signalling a future fall in the industry. Read on, and I’ll examine the issue more closely.

Thursday’s news had all the discounters shedding value — Family Dollar (NYSE:FDO[5]) was off 2%, Dollar General (NYSE:DG[6]) lost 1.6% and DLTR shed a percent — although the significant losses were restricted to Big Lots, which lost more than 21% and Fred’s an equally depressing 10%.

In my opinion, same-store sales growth is one of the most overused and overrated key productivity indicators in retail. It’s far better for a company to see sales dip by 1% in a given quarter at full price than it is to gain 5% year-over-year through the use of promotional pricing. While it’s not as big a deal in the discount business, where prices are already relatively low, it’s something to be aware of.

Like any business, the object of the game is to deliver profits to the shareholders. Both companies did that in the second quarter — although in both cases, they weren’t pretty.

Big Lots saw its second-quarter operating profit drop by 34.3% to $39.3 million, while Fred’s operating profit in Q2 dropped 59.3% to $3.4 million. Yet Big Lots took the bigger hit, which begs the question “Why?”

Reading through its conference call transcript, it’s apparent that Big Lots’ business in the second half of the year is going to get worse, not better. In the third quarter, it expects a loss from continuing operations of at least 20 cents per diluted share compared to a gain of 6 cents in 2011. For full-year 2012, it expects consolidated adjusted income from operations ranging from $2.80 per diluted share on the low end to $2.95 on the high. Either way, earnings are expected to be lower for 2012 in its entirety.

Big Lots generates 30% of its business from consumables and 70% from discretionary spending, whereas Wal-Mart‘s (NYSE:WMT[7]) consumables represent 55% of its overall revenue, leaving it less vulnerable to the whims of the consumer. To remedy its merchandising problems, Big Lots is moving John Martin back into his former position as executive vice president of merchandising and marketing. From what I can tell, its weakness in 2012 is a blip on the radar rather than a permanent situation.

Fred’s also appears to be passing through a lull in its business. In 2012, it expects earnings to grow between 10% and 20%, on top of 13% growth in 2011. In the three years prior to 2011, its earnings averaged an annual growth rate of 40.8%. Fred’s is opening 20 new stores and pharmacies in the final two quarters of the year, and though it faces intense retail competition, the fact that it continues to expand suggests there’s lots of life left in the discount store industry.

In my estimation, there doesn’t appear to be anything devastating facing the discount industry — including Thursday’s earnings reports — that would indicate the industry is ready for a big fall. And investors looking for a bargain ought to take a closer look at Big Lots, because it’s now officially oversold.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.

  1. BIG:
  2. FRED:
  3. DLTR:
  4. recent earnings flop:
  5. FDO:
  6. DG:
  7. WMT:

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