Rich Future for Dollar Stores

How many retailers can you say are not seriously threatened by an economic downturn, the Internet, Wal-Mart ( WMT) or less-than-stellar store locations?

All this is largely true of the so-called dollar-store retailers, those mushrooming retailers such as Dollar Tree ( DLTR), Fred's ( FRED) and Dollar General ( DG) that comprise the second-fastest growing retailing sector behind supercenters, with sales growth of about 5.5% a year. And the growth story looks far from over.

"We anticipate that this channel will be a strong growth channel compared to others," said Sandy Skrovan, vice president of retail-research firm Retail Forward. Skrovan believes the group is well-positioned to keep growing into untapped markets: Retail Forward estimates the U.S. market can support another 15,000 dollar stores. "The big players continue to roll out stores -- Family Dollar ( FDO) and Dollar General are rolling out a store a day."

While the stocks have had an impressive run over the past few years, a recent pullback among the major participants in late 2003 may present a good opportunity to pick up these stocks on the cheap.

"The gains these stocks have seen are really just the beginning," said James Altucher, a partner at hedge fund Subway Capital and contributor to Street Insight, TheStreet.com's sibling publication.

So let's take a closer look at the group, exploring why the demographics and competitive landscape are playing to its favor.

Demographics

The perception is that dollar stores are primarily the province of lower-income families in urban or rural areas, but research shows the group has been making great inroads into all swaths of U.S. consumers. According to Retail Forward, the percentage of shoppers making a purchase at a dollar store over a 12-month period totaled 54% in 2002 -- up from 43% in 1997. Meanwhile, the percentage of frequent dollar-store shoppers -- customers who patronized the stores at least twice a month -- jumped to 28% from 17% in that time period.

According to ACNielsen Homescan research, dollar stores saw the highest percentage growth rates in household penetration among households with annual income greater than $70,000. In 2002, 45% of households with income above $70,000 shopped in dollar stores, up from 37% in 2000.

Those demographic trends bode well. Daniel Barry, retail analyst at Merrill Lynch, forecasts that the four leading dollar stores -- Dollar Tree, 99 Cents Only ( NDN), Family Dollar and Dollar General -- will post average annual growth of 18% over the next five years, according to Business Week Online.

Unique Niche

Given the enormous growth opportunity, one would expect a bevy of new entrants. Last summer, Wal-Mart sent shudders through the industry when it launched a few dollar stores called "Hey Buck" within some Maryland-area superstores. The fear was that Wal-Mart, the 800-pound gorilla of retailing, would swoop in and crush the field through economies of scale.

The low-cost retailing giant, however, hasn't gone any further with the concept and some analysts says the return on investment on launching thousands of dollar stores wouldn't be worth the time and effort for Wal-Mart.

In the meantime, dollar stores continue to gobble up market share from big-box rivals. "Not everybody wants to shop in a 200,000-square-foot big box for everything," Retail Forward's Skrovan said.

Other unique characteristics of dollar stores provide reassurance that their growth story isn't imperiled. First, while Blaylock Partners analyst Mark Mandel thinks an improving economy will help efficiently run dollar-store franchises such as Dollar Tree, the economic downturn of the early 2000s hasn't exactly crimped the group's performance.

Second, while the Internet is reshaping certain areas of retailing -- books, travel, video rentals -- Skrovan, Altucher and others say that dollar stores won't face significant competition from online rivals. "The economics of dollar stores are so tight" they preclude the additional costs of being online, Skrovan said.

Third, while dollar stores are popping up all over the landscape -- not coincidentally replacing shuttered book stores, travel stores and video stores in many instances -- the old mantra of "location, location, location" doesn't necessarily apply as much to dollar stores; bargain-hunting consumers, the cherry-pickers discussed in a recent study on Wharton's Web site, don't mind going to the next strip mall or shopping center over to get the best deals on detergent, tissue products and other items offered at dollar stores -- not to mention the occasional "treasures" the group stocks. "Because of the no-frills, low-priced nature of dollar stores, they don't have to look for prime real estate,' said Skrovan.

Which Is the Pick of the Litter?

Not all dollar store companies are alike, mind you -- in fact, they aren't all technically dollar stores. Dollar General and Family Dollar, for instance, sell many items for more than a dollar -- a recent Prudential Financial report said less than one-third of their merchandise is actually sold for a dollar. Dollar Tree sticks to the dollar price tag, while 99 Cents Only stores -- well, the name says it all.

The price points aren't the only difference. While all of the companies have posted strong growth and growth prospects, 99 Cents Only's price-to-earnings multiple of 30 is higher than peers. Dollar Tree, Dollar General and Family Dollar all sport P/Es in the low- to mid-20s.

If investors had to pick just one, which is the best bet? Investors should do their own research, digging into the companies to determine which stock looks poised to rise the most. Altucher and Blaylock's Mandel, however, are in agreement about their favorite.

"Dollar Tree is our favorite stock in the space," said Mandel. "It's the most favorably priced." Blaylock has a price target on Dollar Tree of $46 a share, which represents a price-to-earnings multiple of 25 times their estimate for 2004 earnings of $1.80. The stock currently hovers around $32 a share, so that price target assumes a 44% gain.

Dollar Tree, which has more than 2,500 stores nationwide, has posted impressive growth -- 23% average annual sales growth over the past three years. Plus, the company's profit margins handily outpace its peers.

As originally published, this story contained an error. Please see Corrections and Clarifications.

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