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The economic weakness has led to a change in spending pattern for low-end consumers. Recent same-store sales reports from various general merchandise retailers indicate a shift away from large supercenters like Wal-Mart (NYSE:WMT) and Target (NYSE:TGT) to discount stores like Dollar Tree (NASDAQ:DLTR) and Family Dollar Stores (NYSE:FDO). Dollar Tree for example reported same-store sales growth of 7.1%, 4.7% and 4.8% during the 1st three quarters of the year, respectively. The last quarter increase of 4.8% was aided by a 1.4% higher ticket price and 3.4% increase in customers. I am not fond of the use of higher ticket price to boost sales as I do not see it as a sustainable model in this sluggish growth economy. Therefore, the 3.4% increase in customers is promising. Contrast that to the 4.3% comparable-store sales growth at Target during the last month which was almost completely a result of the 4% increase in ticket prices. Sooner rather than later, the price hikes will result in an acceleration of low-end and medium-end customers moving to the discount retailers.

I consider the discount store industry as an attractive business to be invested in during these hard times. Analysts expect the industry to grow at an annual rate of 14% for the next five years. In this article, I will evaluate five companies from this industry and develop my fair value estimates for the individual companies. The companies selected for analysis are:

1) 99 Cents Only Stores (NYSE:NDN)

2) Fred’s Inc (NASDAQ:FRED)

3) Dollar Tree, Inc

4) Big Lots (NYSE:BIG)

5) Family Dollar Stores

As some of you might notice, I have not included Dollar General (NYSE:DG), the biggest firm in the industry. The company seems to be doing well, but has substantial debt on its balance sheet. As such, it does not meet the guidelines I use for investment purposes.

As part of my analysis, I paid close attention to the historical growth rates in revenue, net income, and book value. To measure efficiency in operations, I examined the cash conversion cycle, and gross and operating margins. Next, I looked at the return on invested capital to evaluate how well the companies were using their financial resources to generate returns. Finally, employing a very subjective analysis, I ranked the companies based on the individual criteria. The growth rates, operational characteristics, and my rankings for these parameters are presented below.

Historical Revenue Growth Rates:

10 Year

5 Year

1 Year

Ranking

NDN

9%

7%

5%

5

FRED

7%

3%

3%

4

DLTR

11%

12%

12%

1

BIG

4%

2%

5%

3

FDO

7%

6%

9%

2

Historical Income Growth Rates:

10 Year

5 Year

1 Year

Ranking

NDN

4%

46%

23%

4

FRED

4%

3%

25%

2

DLTR

12%

18%

24%

1

BIG

-

-

12%

5

FDO

6%

15%

8%

3

Historical Book Value Growth Rates:

10 Year

5 Year

1 Year

Ranking

NDN

8%

6%

11%

1

FRED

6%

5%

8%

2

DLTR

11%

10%

8%

3

BIG

4%

5%

0%

4

FDO

3%

2%

-16%

5

Future Earnings Growth Projections:

Next Yr

Next 5 Yrs

Past 5 Yrs

Ranking

NDN

9%

13%

37%

4

FRED

15%

13%

6%

3

DLTR

18%

19%

30%

1

BIG

17%

12%

12%

5

FDO

15%

15%

20%

2

Cash Conversion Cycle:

10 Year

5 Year

TTM

Ranking

NDN

57

58

69

5

FRED

71

73

71

4

DLTR

64

54

57

2

BIG

79

65

65

3

FDO

41

33

27

1

Gross and Operating Margins:

Gross Margin %

Operating Margin %

Current

5 Year Avg

Current

5 Year Avg

Ranking

NDN

40.6

39.76

8.3

3.26

2

FRED

28.7

28

2.7

1.88

5

DLTR

35.8

34.78

11.5

8.8

1

BIG

40

40.12

6.6

5.64

4

FDO

35.5

34.72

7.5

6.38

3

Return on Invested Capital:

10 Year

5 Year

TTM

Ranking

NDN

8%

7%

11%

4

FRED

8%

8%

8%

5

DLTR

17%

17%

27%

1

BIG

10%

13%

20%

3

FDO

18%

19%

23%

2

Using the rankings above, I summarized the scores to come up with an overall ranking. The table that follows presents the summary rankings for the five selected firms.

Company

Symbol

Ranking

Score

Dollar Tree

DLTR

1

1.4

Family Dollar Stores

FDO

2

2.6

Fred's Inc

FRED

3

3.6

99 Cents Only Stores

NDN

4

3.6

Big Lots

BIG

5

3.9

As shown above, it is not even close. Of the five discount firms analyzed, Dollar Tree is the best discount retailer in my opinion and would be my preferred investment choice, assuming it is available at a discount (pun intended). Family Dollar Stores is the clear number 2. The rest are cluttered together and are best avoided unless available at deeply discounted prices.

The next step was to determine the fair value for these companies. This was done using relative valuation. It should be noted that the P/E estimates were developed using historical analysis of the earnings multiple from the last 10 years. The analysis and results are shown in the table that follows:

NDN

FRED

DLTR

BIG

FDO

Current EPS

$1.09

$0.83

$3.75

$2.72

$3.12

EPS Growth Rate

9%

9%

13%

8%

11%

Future EPS (5 Yr)

$1.66

$1.28

$7.00

$4.07

$5.14

Expected P/E

16.4

16.4

18

13

17

Price 5 Yrs Out

$27.19

$21.04

$126.02

$52.92

$87.38

Unlevered Beta

0.86

0.86

0.86

0.86

0.86

D/E Ratio

0

2%

17%

38%

49%

Current Tax Rate

37%

36%

37%

38%

37%

Levered Beta

0.86

0.87

0.95

1.06

1.13

Risk Free Rate

2%

2%

2%

2%

2%

Risk Premium

6.50%

6.50%

6.50%

6.50%

6.50%

Size Premium

1.63%

2.35%

0.62%

1.54%

0.74%

Cost of Equity

9.2%

10.0%

8.8%

10.4%

10.1%

Fair Value

$17.49

$13.06

$82.63

$32.20

$54.12

Current Price

$21.89

$13.63

$82.82

$36.62

$57.92

% Overvalued

20%

4%

0%

12%

7%

As shown above, unfortunately, the industry as a whole seems to be slightly overvalued. I would not be interested in buying any of companies at these levels. 99 Cents Stores stands out as a grossly overvalued firm. I would look to sell any existing positions at these levels. For someone with a higher risk appetite than me, the stock could make a good short candidate. As for me, I plan on initiating a position in either Dollar Tree or Family Dollar if and when the stocks start trading at a 15-20% discount. Alas, it might be a long wait.

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

Source: Analyzing 5 Discount Retail Stores