Credit: Shutterstock photoIn many parts of small-town America, big shopping trips for basic necessities can take over an afternoon. Maybe there's a drive of a half-hour or more to Wal-Mart ( WMT ), then the epic journey across an airfield-sized parking lot and through a massive store to a long checkout line. But if you need just a few items for dinner that night, there's probably a Dollar General ( DG ), Dollar Tree ( DLTR ) or Family Dollar on the way there -- much to Wal-Mart's dismay.
The situation is no accident. It was the result of carefully engineered and years-long strategies among dollar store chains to preempt Wal-Mart and siphon market share from the biggest of the big boxes. In response, in 2011, the ever-competitive crew from Arkansas launched Walmart Express, aimed at neighborhood shoppers and consumers making those quick, so-called "fill-in" trips.
Even though Dollar General operates nearly 12,000 stores in the U.S. -- about the same as Wal-Mart and its Sam's Club subsidiary run worldwide, it was still a David vs. Goliath contest. Dollar General revenue crept above $20 billion for the fiscal year ended in January. Wal-Mart's fiscal 2016 take: more than $482 billion.
But a funny thing happened. Wal-Mart's plan didn't go well. Analysts said the Express stores risked swiping market share from Wal-Mart's larger locations. And the things at which Wal-Mart excels in a big-box format -- from supplying its stores to displaying the products -- didn't work in a small-box context. Thus, in January, Wal-Mart announced it would close its Express stores.
"The fact that they completely exited Express really shows you that these dollar stores have just built a much better retailing mousetrap," BB&T Capital Markets analyst Anthony Chukumba told IBD.
A Long Way From Last Grocer
The exit also underscored the dollar stores' advantages over their big-box rivals.
Among those is the fact that smaller stores mean greater adaptability when real estate is limited. Dollar General has toyed with an even smaller store format, Chukumba noted, helping the company squeeze more stores into crowded urban areas or meet the needs of smaller rural markets. Other companies in the Retail-Discount group, like bigger-box closeout chain Big Lots ( BIG ), don't have that option.
Another advantage: The industry model keeps labor costs low. "You need somebody there on truck day -- someone reliable to unload the truck -- and a good store manager," Chukumba said. "And that's pretty much it."
Smaller stores also allow the dollar-store companies to cluster more outlets together, meaning the trucks that deliver products to stores can hit more of them in less space.
"There are a lot of stores that you can pack into areas if you're a dollar store vs. a big-box store like Costco ( COST )," Morningstar analyst Ken Perkins told IBD. "You can't have those Costco stores located as close together."
Another benefit: The average purchase at a dollar store is between $10 and $11, and the prohibitive costs of shipping cheap items protects the stores from the threat of e-commerce. BB&T estimates that Dollar General's pricing, on average, is "consistently within" 3%-4% of Wal-Mart's.
In reporting fourth-quarter results, Dollar General said its food-related and tobacco categories saw the most significant sales growth, indicating the chain could continue to nibble away at Wal-Mart, which gets more than half its sales from groceries.
The rise of the dollar stores runs contrary to projections from roughly a decade ago that Walmart would be the last grocer standing amid the struggles of chains like Kroger (KR), Safeway and Albertson's, Edward Jones analyst Brian Yarbrough told IBD. Over that period, dollar stores strived to improve their reputation as ill-lit, last resorts in run-down parts of town.
Today, Yarbrough says, the stores are nice: "They're bright, they're well-lit, they're in the racetrack format," he says, referring to a layout which moves shoppers more quickly through the stores to checkout.
"I think that dollar stores have invested a lot of money and done a better job, and then I think too you just see people looking for convenience," he said.
Bigger Than Paycheck To Paycheck
The broader issue for dollars stores is the state of the American consumer. Are shoppers going to the dollar stores more for convenience or for necessity?
Despite falling gas prices, which were expected to bolster consumer spending, both Chukumba and Yarbrough contend that health care and rent costs have risen. Wage growth, meanwhile, has been lukewarm. Many of the customers who gravitated to the dollar stores during the recession appear to have stayed, even as the economy has improved.
Perkins, in commentary from October, said that "increasing income inequality in the U.S. could drive an even larger number of lower-income consumers into discount stores; the U.S. went through two recessions and economic recoveries between 2000 and 2014, yet the U.S. poverty rate steadily increased from 11.3% (31.6 million people) to 14.8% (46.7 million people)."
However, analysts that spoke with IBD also say dollar stores' makeover attempts have cultivated an audience based on more positive factors.
"A lot of customers who may have traded down to these dollar stores during the Great Recession ... had a much better experience in the stores than they thought they were going to," Chukumba said. He added: "It speaks to me more about consumers focused on value than it does poverty."
Still, the discount stores' many low-income consumers live paycheck to paycheck. The economic recovery has been more fragile for them than other income brackets. Dollar-store growth prospects could become just as fragile if government assistance gets leaner, Morningstar notes.
Consolidation has helped. Dollar Tree's acquisition of Family Dollar gives it broader access to lower-income consumers.
Core Dollar Tree stores cater to households with annual incomes of more than $50,000, JPMorgan analyst Matthew Boss wrote in a research note in March. Family Dollar stores target household incomes of $30,000 to $40,000. The combination, Boss wrote, creates a multi-price-point retailer with a broader customer reach and a network of 13,000+ stores, "which we believe positions the company in a sweet spot to benefit from size/scale opportunities over time."
Consumers Ain't Slowing Down
As a group, dollar store stocks have outpaced the general market. IBD's Retail-Discount industry group rose 34% off its January low. The group ranked No. 20 on Friday among the 197 industry groups tracked by IBD. That was up from 74 some two months ago. Dollar General, Big Lots, Five Below (FIVE) and newcomer Ollie's Bargain Outlet (OLLI) have all ramrodded the advance.
And Yarbrough remains upbeat about the U.S. consumer overall. People are spending more on bigger purchases such as cars, vacations and home renovations, he said, indicating solid confidence.
"I've probably listened to 20-plus calls over the last two months," Yarbrough said, "and not on one of them did I hear a company say 'We're really worried about the consumer, the consumer's really slowed down,' or anything like that."
The dollar stores could also turn their attention more toward higher-quality products and fresh produce, Perkins said. But fresh produce is a lower-margin business, and it would likely require a separate supply chain for the produce alone. Fresh produce also bruises the more people touch it, and the companies would need to take measures to ensure quick turnaround and decent presentation.
But more fresh produce would drive more foot traffic and give more people an excuse to avoid the stores' bigger-box rivals.
"My parents live on a lake ... and they're in a town with a thousand people," Yarbrough said. "And guess what's in town? A small local grocery store and a Dollar General and a Family Dollar. And the nearest Wal-Mart's probably 35 miles away."
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
