Downturn Fears: Should You Own Wal-Mart Or Dollar General?

| About: Walmart Inc. (WMT)
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Summary

Discount retail stores perform well during low times.

Consider Wal-Mart for its strong cash flow, dividend and neighborhood stores.

Avoid Dollar General amid increasing competition.

The market has been in a bearish mode for some time now. Volatility has been favoring the downside for the past few weeks. The bearish trend is justified on some level given the lofty valuation of the technology sector, but it's not fair to blame it on technology alone. Oil prices have been hurting the energy sector while materials are being affected by fears related to a global economic slowdown. However, retail can be a good place to be in during an economic downturn. Discount retailers are a good place to start.

We're going to discuss Wal-Mart (NYSE:WMT) and Dollar General (NYSE:DG) because Wal-Mart has more affordable pricing as compared to Target (NYSE:TGT) and other counterparts, and Dollar General dominates the low-income household market. Both these companies will perform relatively well during economic slowdowns. But which of them should be given preference? Let's explore.

Wal-Mart Stores, Inc.

It's the largest hyper retailer in the U.S. that offers products ranging from grocery to health care. The company has more that eleven thousand stores operating in around 27 countries. The company generates most of its revenue from grocery followed by health and beauty products. 56% of the company's sales came from grocery, while 11% came from health and wellness during the fiscal year ended 2015.

Wal-Mart's scale, and resulting cost leadership, allows it to dominate the market. No other retailer, currently, matches the scale of Wal-Mart in terms of revenue. Low pricing will help the company sustain its financial performance during a downturn. Further, consumers tend to shop at discount stores in slow times, which results in a relatively better top-line for discount retailers. In 2008, the bottom-line of Wal-Mart grew while S&P 500's earnings declined by an astonishing 77%.

Wal-Mart is aggressively investing in e-commerce, which will have a positive impact on the company's top-line in the long run. The company is generating $12 billion a year from online sales. During Q2 fiscal 2016, online sales were up (pdf) 16% on a year-over-year basis. Wal-Mart has a cost-edge over Amazon (NASDAQ:AMZN) in its online retail model. Wal-Mart is using its huge network of brick-and-mortar stores for the pick up service. Customers can order online and pickup from a nearby store. This lessens Wal-Mart's need for building online fulfillment centers. Amazon has to invest aggressively in fulfillment centers. Further, Wal-Mart can also save delivery costs from the pickup strategy.

Neighborhood stores are also a positive move from Wal-Mart. The company is planning to add 270-300 stores every year. These stores complement the e-commerce business model, as consumers don't fancy online purchases of inexpensive, daily use products. According (pdf) to Nielsen, "consumable categories are not likely reach the same level of online prominence as non-consumable categories due to the hands-on buying nature and perishability of the products." Further, Wal-Mart can easily use its neighborhood stores as online fulfillment centers, enabling swift delivery experience for its customers. All in all, Wal-Mart is in a position to give Amazon a run for its money in e-commerce going forward.

The company is also investing in its workforce. Wal-Mart is increasing wages of its workforce. This strategic decisions will help Wal-Mart in improving the shopping experience, reducing employee turnover and improving efficiency across sales floors. All these factors will improve the top-line of the company going forward.

Regarding valuation, WMT trades at a discount as compared to its peers. Forward PE stands at 13.75 as compared to 14.75 for Target. Further, S&P 500 is trading ahead of Wal-Mart. Implied growth calculator indicates that Wal-Mart is a bargain on its current price. See the snapshot below:

Source: Prudena

Based on an 8% required rate of return, the graph indicates that Wal-Mart's residual earnings should decline by 1.12% in perpetuity to reach its current valuation. To the contrary, analysts are expecting 4.6% p.a. earnings growth for Wal-Mart during the next five years. There's no way Wal-Mart can show a perpetual decline of 1.2% in earnings, assuming going concern. In fact, a downturn in the economy will encourage people to shop at discount stores, think Costco's (NASDAQ:COST) customers. Moreover, not only is Wal-Mart a bargain, it also supports a decent dividend. The forward annual dividend yield of the company is 3.02%; S&P 500 supports a yield of 2.2%. Further, Wal-Mart has been consistently growing its dividend payout for the past decade.

Given the fear induced selloff, thanks to the global economic outlook and a recent earnings miss, Wal-Mart seems to be a bargain.

Dollar General

Dollar General is a small-format discount store that recently lost its leading position in the industry, thanks to the merger of Dollar Tree (NASDAQ:DLTR) and Family Dollar (NYSE:FDO). The company is primarily involved in the provision of consumables, which make up around 76% of the company's total revenue. In the U.S., the company has a more concentrated presence than Wal-Mart, as it operates more than 12,000 stores in 43 states. Wal-Mart is trying to bring in competition through its neighborhood stores.

Small-format stores are in the spotlight as they can live in harmony with e-commerce. Dollar General is likely to buck the trend given its second largest market presence. Further, the company is benefiting from the sales of cigarettes amid CVS' (NYSE:CVS) decision to ban them in its stores.

Dollar General is going to benefit from the macro factors. Fuel prices have been low for some time now. As DG serves low-income households, lower oil prices are increasing the average transaction per consumer. The company noted in its recent earnings release that same-store growth is fueled by increased traffic and average spend. Unemployment rate is also low, which is contributing to the sales growth of dollar stores. Wage growth is another positive; 2.5% growth is expected during 2015. Strengthening dollar is not impacting the sales of Dollar General, as the company generates all of its sales from the U.S.

E-commerce is surely benefiting small-box retailers while hurting super center sales. The problem for Dollar General is that big players like Wal-Mart and Target are diverting their efforts towards a small-box format. As mentioned above, WMT is planning on opening 300 stores each year. Target is also planning to open 50 express stores in 2015. As switching costs are near zero for consumers, and Wal-Mart and Target have a higher brand value as compared to dollar stores, an increase in competition doesn't bode well for Dollar General.

Other risks for Dollar General include cut in the government's assistance plans like the Supplemental Nutrition Assistance Program. Low-income households generally receive government assistance in some form. Changes to government policies can materially affect the financial performance of Dollar General. Niche players like Five Below (NASDAQ:FIVE) are also a threat to the company. Five Below targets teenagers. As teenagers have low buying power, they generally shop at dollar stores for electronics accessories and other stuff. Five Below is getting popular with teenagers and, consequently, putting pressure on the traffic of Dollar General's stores.

One other thing, the only competitive advantage Dollar General's stores have over e-commerce is delivery time. Pickup points from Wal-Mart and Target will allow users to buy online and pickup instantly from a neighborhood store. This can seriously hurt the top-line of dollar stores once the concentration of Wal-Mart's neighborhood stores increase.

From a valuation perspective, Dollar General seems fairly priced. It supports a forward PE of around 16, translating into a moderate PEG of around 1.2. The company has to achieve perpetual growth of around 2% in earnings, see the chart below, to achieve its current price.

Source: Prudena

The chart depicts that Dollar General has to grow its residual earnings by 1.93% in perpetuity to reach its current valuation. With 13% p.a. earnings growth touted by analysts during the next five years, 1.93% is plausible. But we believe analysts are projecting rather generously. Given the upcoming competition from Wal-Mart and Target, along with the current competition from Dollar Tree, Dollar General isn't going to achieve a 13% p.a. earnings growth. Moreover, comparing the implied growth of Dollar General to Wal-Mart's implied growth, it's apparent that Wal-Mart is a better bet than Dollar General

Takeaways

Dollar General can grow its sales given the unique nature of its business model. The company is mostly witnessing growth through the opening of more locations. Eventually, the growth will halt as cannibalization comes into play. Wal-Mart, Target, Amazon and Dollar Tree will put pressure on the top-line growth of Dollar General as switching costs are zero. Brand recognition will be key for sales growth, and we believe Wal-Mart will outperform Dollar General in a heartbeat in a given neighborhood. Yes, Wal-Mart is lagging in terms of small-box footprint but it has the resources to materially hurt the sales of Dollar General's stores. In the past, hyper retailers were focused on supermarkets but the shift in strategy is getting clearer, which is the biggest threat to Dollar General. Given the stock is fairly priced, we think investors should not take the risk of confronting the competition. All in all, we favor Wal-Mart over Dollar General in discount retail.

Disclosure: I/we 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.

Additional disclosure: "This publication is for informational purpose only and reflects the opinion of Focus Equity’s analysts. The opinion doesn't constitute a professional investment advice. Focus Equity is a team of analysts that strives to provide investment ideas to the U.S equity investors."