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In this weak macro-economic environment, discount retailers are expected to perform well. The core customer base for these discount retailers is made up of low income households. Owing to the high rate of unemployment and moderate levels of food inflation, low income and middle income families will continue to search for bargains and this will lead to a push in sales at discount retailers. In this article, I will perform fundamentals based valuation analysis on 5 discount retailers and determine if it makes sense to open a position at current levels. The companies selected for analysis are Dollar Tree (DLTR), Dollar General (DG), Family Dollar (FDO), Big Lots (BIG) and Fred's (FRED). The table that follows presents the basic information of these companies.

Company Basics

DLTR

DG

FDO

BIG

FRED

Market Cap (Billion)

10.99

16.74

7.27

1.9

0.577

Debt to Equity Ratio

15%

55%

35%

17%

1%

Stock Performance 5 Yr

299%

125%

193%

-3%

22%

Stock Performance 1 Yr

-12%

-2%

-14%

-13%

6%

Dividend Yield

0.0%

0.0%

1.6%

0.0%

1.5%

DG is the largest company on this list with a market capitalization of approximately $17 billion while FRED is by far the smallest company with a market capitalization of $577 million. However, FRED along with FDO are the only two dividend payers on the list with both yielding approximately 1.5%. DG has the highest debt-to-equity ratio followed FDO. FRED has minimal debt. Over the past year, excluding FRED, every stock on the list has declined in value while the broader markets rallied. DLTR did have a huge run up in the previous 5-year period generating returns of approximately 300%.

Growth Rates:

Next, I evaluated the historical growth rates of revenue, income, EPS, book value and the projected growth rates. These are summarized in the table shown below:

Growth Rates

DLTR

DG

FDO

BIG

FRED

Revenue

10 Year

10%

9%

7%

3%

4%

5 Year

12%

11%

6%

3%

2%

1 Year

12%

8%

9%

4%

4%

Income

10 Year

13%

12%

6%

8%

-1%

5 Year

25%

-

12%

2%

22%

1 Year

27%

24%

9%

-14%

-9%

EPS

10 Year

18%

12%

10%

16%

0%

5 Year

31%

-

17%

14%

25%

1 Year

33%

28%

15%

-2%

-7%

Book Value

10 Year

-4%

0%

-4%

-7%

-1%

5 Year

-4%

1%

-5%

-10%

-2%

1 Year

-5%

-3%

-5%

-13%

-3%

Growth Projections

Next Year

16%

16%

12%

11%

18%

Next 5 Year

18%

15%

12%

10%

11%

Historical growth rate analysis reveals that DLTR is the standout winner in the group with consistently high growth rates in revenue and income during the past decade. The only complaint is on the book value front wherein the book value declined at an annual rate of 4%. Ironically, none of the firms selected grew its book value over the past decade. BIG and FRED are the laggards in the group with anemic growth rates. In fact, EPS declined last year for both BIG and FRED. Going forward, DLTR is again expected to lead the way with a long-term growth rate of 18%. FDO, BIG and FRED are all expected to grow at similar rates.

Margins

After analyzing the growth rates, the next step was the evaluation of gross and operating margins of the 5 firms. The results are presented in the table below.

Margins

Averages

DLTR

DG

FDO

BIG

FRED

Gross Margins

10 Year

35%

30%

34%

40%

28%

5 Year

35%

31%

35%

40%

28%

Last Year

36%

32%

35%

39%

29%

TTM

36%

32%

34%

39%

29%

Operating Margins

10 Year

10%

7%

7%

5%

2%

5 Year

11%

9%

7%

6%

2%

Last Year

12%

10%

7%

6%

2%

TTM

13%

10%

7%

5%

2%

DLTR continues to dominate when it comes to margins. It reported operating margins, which were 300 bps better than the second-best company in group . FRED and BIG are again laggards. Although DG generated string gross margins, its operating margins are significantly below that of DLTR and DG. However, all companies have predominantly maintained their margins over the past decade, which is a positive.

Profitability:

To evaluate the profitability of the five companies, ROIC and ROA were selected as the desired metrics. Again, DLTR is the clear leader based on these metrics. BIG and FDO have also historically generated strong returns on invested capital. FRED's ROIC of 7% is poor in my opinion. A similar trend can be seen when it comes to the historical return on assets generated by the five firms.

Operations

Averages

DLTR

DG

FDO

BIG

FRED

ROIC

10 Year

19%

8%

18%

13%

7%

5 Year

25%

5%

20%

21%

6%

Last Year

35%

12%

23%

19%

7%

TTM

34%

11%

24%

19%

7%

ROA

10 Year

14%

7%

11%

8%

5%

5 Year

18%

6%

12%

12%

4%

Last Year

24%

10%

13%

10%

5%

TTM

24%

9%

13%

10%

5%

Valuation:

Having developed a good idea about the fundamentals of the five companies, the next step was to perform relative valuation. The multiples used in the analysis were based on historical analysis of individual companies and industry multiples. The table below presents the valuation analysis results.

Valuation

DLTR

DG

FDO

BIG

FRED

Next Yr Est

$3.27

$3.71

$4.22

$3.31

$0.99

EPS Growth Rate

18%

15%

12%

10%

11%

Future EPS (5 Yr)

$5.89

$6.13

$6.47

$4.61

$1.43

Expected P/E

15

14

13

11

11

Price 5 Yrs Out

$88.40

$85.85

$84.11

$50.67

$15.69

Unlevered Beta

0.95

0.95

0.95

0.95

0.95

D/E Ratio

2%

17%

10%

9%

0%

Current Tax Rate

35%

35%

35%

35%

35%

Levered Beta

0.97

1.05

1.01

1.01

0.95

Risk Free Rate

2.2%

2.2%

2.2%

2.2%

2.2%

Risk Premium

6.00%

6.00%

6.00%

6.00%

6.00%

Size Premium

0.62%

0.62%

0.74%

1.54%

2.35%

Cost of Equity

8.6%

9.1%

8.9%

9.7%

10.2%

Fair Value

$58.63

$55.55

$54.80

$31.86

$9.65

Current Price

$49.12

$51.18

$63.23

$32.86

$15.71

% Overvalued

-19%

-9%

13%

3%

39%

As shown in the table above, DLTR and DG are undervalued while FDO and FRED are overvalued at current levels. BIG is fairly valued in my opinion. DLTR is by far the best company on the list and thankfully also looks an attractive investment at current prices. I would look to initiate a position in DLTR and DG and sell any existing positions in FDO and FRED. In fact, based on the weak fundamentals compared with its peers, I would initiate a short position in FRED.

(Kindly use this article for information purposes only. Please consult your investment advisor before making any investment decision.)

Source: Discount Retailers: 2 To Buy, 1 To Hold And 2 To Sell