2 True Growth Stories In An Unexpected Sector

Adam Fischbaum's picture

Friday, February 24, 2017 - 11:30am

by Adam Fischbaum

Ever since I was a kid, I loved discount stores. I remember the old TG&Y five and dime store in my neighborhood. I'd trade in enough Coke (NYSE: KO) bottles at the A&P next door to cobble together twenty five cents to buy a bag of green plastic army men which were bargain-priced at a quarter.

The five and dimes evolved into dollar stores. That's inflation I guess. But as far as stocks go, the dollar store sector has always been one of my favorite sub-sectors in the retail group. The main investment attraction is the steady, resilient growth these businesses have always shown in different economic environments.

Historically, dollar stores catered to lower-income consumers by offering basic, generic or store-brand products that were tailored to that particular group in packaging size and price point. However, interesting things happen during economic downturns. The dollar store segment typically grows.

While their core demographic tends to get hurt and spend less during the downturn, middle income consumers who are feeling the pinch tend to change their spending habits in search of value. When the economy improves, the middle income shoppers usually stay due to the value they found at the dollar stores while the lower income consumers spend a little more. I'm currently seeing this phenomenon with my two favorite names in the sector: Dollar Tree (Nasdaq: DLTR) and Dollar General (NYSE: DG).

Dollar Tree is the real growth story here. After completing its acquisition of dollar store pioneer Family Dollar, the company's growth trajectory declined noticeably due to the mechanics of the merger. Earnings per share (EPS) slipped from $2.89 in 2015 to $1.26 for 2016, a 56% haircut. But the offset was an 80% jump in annual revenue from $8.6 billion in 2015 to a record-shattering $15.5 billion in 2016.

Going forward, Dollar Tree's growth story remains solidly intact. 2017 revenues are expected to top $20.7 billion, with 2018 expectations climbing to nearly $22 billion. If management executes, this would deliver compound annual revenue growth of 20%. The EPS picture is equally strong, with 2017 estimates calling for $3.79 followed by an impressive $4.50 for 2018 for a CAGR of 109%.

But if Dollar Tree is the speedy hare, its rival Dollar General is the tortoise. And that's not necessarily a bad thing. While slightly larger in market cap at $21.4 billion versus Dollar Tree's $18.8 billion, Dollar General's footprint trails Dollar Tree slightly, with 12,483 stores compared to Dollar tree's 13,600 locations. But aside from the similarity in size and the fact that their names both begin with the word "dollar", DG is a somewhat different beast.

The most significant difference is Dollar General's grocery business. Most stores feature what can be described as a small grocery store within the store that sells brand name and private label packaged items as well as a limited variety of refrigerated and frozen foods. Food items have become a major focus for the chain, so much so that they have partnered with vendors such as B&G Foods (NYSE: BGS) to create package sizes exclusively for Dollar General in keeping with the company's smaller size and price point philosophy.

This internal merchandising strategy goes hand in hand with the company's organic growth strategy through building the stores and strengthening the brand identity. The result has been compound average annual revenue growth of 9.4% over the past five years, which is strong in any retail sector. The result has been average annual EPS growth of 17% for the same period.

Going forward, revenue growth is expected to slow slightly over the next two years to an average annual rate of around 6.8%. EPS growth should average a 9% clip for the same period. While this does appear to be a deceleration, it seems that management is being cautious with the forecast, leaving room for an upside surprise.

That being said, the stock's metrics tilt towards the value side with shares trading at a forward P/E of around 17 and a nearly 20% discount to the 52-week high. The company also pays a cash dividend of $1 which equates to a 1.3% yield. The company's balance sheet is solid, with a long-term debt-to-capital ratio of just 13.8%

Risks To Consider: On a macro level, the biggest risk to both companies is a severe economic downturn. Both focus on a core audience who are at the lower end of the economic spectrum. These folks are historically pinched and a recession will cause further damage to their pocketbooks and spending habits. The best defense in this scenario, as mentioned earlier, is picking up new customers from more upwardly mobile demographics who are in search of value

On an individual basis, Dollar General's earnings and revenue deceleration naturally generates concern. The company's commitment to a cash dividend does alleviate that somewhat. Due to a growth by acquisition strategy, Dollar General's long term debt to capitalization is a bit high at nearly 40%. This discourages the declaration of a dividend in the near term as the company's nearly $1 billion in operational cashflow will be spoken for.

Action To Take: Both of these stocks tell true growth stories in a traditionally slow-growing, defensive sub-sector. Combined, both are on a two-year average EPS growth glide path of nearly 65%. Currently, both stocks trade an average 20% discount to their 52-week highs. A return to those highs is achievable if the companies delivering on EPS and revenue targets. If both deliver consistently the following year, I see additional upside of 15-20%.

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Adam Fischbaum does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.