Why You Should Sell Family Dollar And Dollar Tree To Buy This Dollar Store

| About: Dollar General (DG)

The economic recovery is still erratic as consumers are controlling their expenses. In addition, the load of additional payroll taxes is also drying up consumers' pockets. Consequently, consumers are hunting for bargains, and they are going from one store to another to grab the best deal while shopping for consumables. This is why dollar stores like Dollar General (NYSE:DG), Family Dollar Stores (NYSE:FDO), and Dollar Tree Stores (NASDAQ:DLTR) depend largely on consumables for luring customers to stores.

The popularity and growth of dollar stores is one of the legacies of the "Great Recession." They thrive by catering to bargain hunters and those with a smaller monthly shopping basket as consumers try to stretch their dollars. Let's take a look at how these companies have performed recently and how each of them could do in the future.

Dollar Tree: Size Matters

Dollar Tree, the smallest of the three in terms of store count, has been performing reasonably well over the last few years. However, it seems that cannibalization is taking its toll. Its third-quarter results failed to meet the Street's expectations. Let's take a look at what Dollar Tree's recent quarterly results reveal and how it is positioned versus its peers.

In its third quarter, Dollar Tree posted a revenue gain of 9.5% on a year-over-year basis to $1.88 billion, missing the consensus estimate of $1.91 billion. Revenue was primarily driven by a 7% jump in retail selling square footage and a 3.1% increase in comparable-store sales, or comps, versus last year. The growth in retail square footage was due to the opening of 117 new stores, the expansion or relocation of 19 stores, and the shutdown of six stores during the quarter.

Dollar Tree's gross margin also expanded by 10 basis points and earnings jumped 13.7% to $0.58 per share. This growth was, however, not enough to beat the Street's estimate.

Going forward, Dollar Tree expects low single-digit comps growth and square footage growth of 7% in the fourth quarter. The top line is expected to be in the range of $2.25 billion-$2.31 billion and earnings are expected to be in the range of $1.01-$1.07 per share.

Dollar Tree has been emphasizing the need for margin expansion and revenue growth through the introduction of private-label offerings as they result in higher margins. It has also expanded its frozen and refrigerated food item selection as a result of robust demand for such items from consumers.

Family Dollar Is Struggling

Taking a cue from Dollar Tree, Family Dollar partnered with McLane in order to add an assortment of products in the frozen and refrigerated food categories to make the space more competitive.

However, Family Dollar had flat comps in its recently reported quarter, and perhaps this is an after-effect of too much crowding in the dollar-store space. This came after an earlier projection of 2% growth in comps, so the company is struggling to meet its own expectations on comps. It also failed to meet the consensus estimate on revenue, which grew 5.8% to $2.5 billion versus the comparable quarter a year earlier.

On the earnings front, the company saw growth of 14.7% to $0.86 per share which compares with $0.75 in the prior-year quarter. However, based on store traffic trends, Family Dollar issued weak guidance for the upcoming quarter.

Family Dollar expects earnings in the range of $0.65-$0.75 a share for the first quarter and it also expects comps to decline in the low-single digit range. Based on Family Dollar's weak performance, analysts and commentators are speculating about the takeover of Family Dollar by its biggest rival, Dollar General.

Dollar General: Rapid Expansion Makes It The Best Pick

The merger of Dollar General and Family Dollar would, in fact, create the largest small-box retailer in the U.S. and also strategically position the combined company to offer good competition to Wal-Mart's (NYSE:WMT) move of opening neighborhood stores. The scale of combined operations would also offer stiff competition to drugstores. Edward Kelly, a food and drug retail analyst at Credit Suisse, evaluated a potential merger and found that it would make strategic sense, even at a large premium.

Dollar General is the largest of the three with a store count of 11,061 stores spread across 40 states and it still manages to grow its store footprint at a decent pace. In 2014, it plans to open approximately 700 new stores and relocate or remodel approximately 525 stores, resulting in square footage growth of 6% to 7%. This is almost at par with Dollar Tree's projected 7% square footage growth.

Dollar General reported a comps gain of 4.4%, faster comps growth than either Dollar Tree or Family Dollar. On the back of this robust comps gain, new store openings, and remodels, Dollar General's revenue increased by 10.5% to $4.38 billion, with the consumables category being the star performer with 11.9% growth.

The consumables category is important as it constituted about 75% of total revenue for Dollar General in the reported quarter. The consumables market is worth $800 billion in the U.S., and double-digit growth in this segment reflects that Dollar General is moving in the right direction to grab more market share.

Wrapping Up

Dollar General's size could play a vital role going forward as it looks to dominate the dollar store space. The company saw the best same-store sale growth in the prior quarter and its revenue growth was also impressive. Furthermore, it is planning to open a higher number of stores than the other two in absolute terms, although the square footage growth in percentage terms is expected to remain identical to the others due to the bigger size of Dollar General.

Hence, Dollar General may be the best positioned of these three retailers in the future and investors should consider choosing it over the other two.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.