Discount Store Stocks to Watch

With inflation running rampant on both sides of the U.S.-Canada border, prices of goods have been skyrocketing. This has had a huge impact on consumer finances, which are yet to fully recover from the impact of COVID-19.

Federal governments both in the U.S. and Canada have moved to raise interest rates in the hopes of taming mulishly high inflation. However, higher goods prices have forced many consumers to cut spending and look for cheaper places to shop for grocery items and a range of other goods.

This has created a strong tailwind for discount stores and low-cost retailers that are somewhat immune to the inflationary pressures visible across sectors of the economy. As more consumers look for ways to make their shopping dollars go far, the following businesses are well positioned to benefit in the shorter term, until at least the access inflation in the economy begins to be mopped up.

U.S. discount retailer, Dollar General (DG) sells branded and private-label products across a wide variety of categories through over 17,000 stores across 46 states. The firm’s main focus is value, reflected in the fact that more than 80% of its items are sold at US$5 apiece or less.

The firm's core clientele is economically modest, typically with annual household incomes of US$40,000 or less. “Such shoppers demand value across a broad spectrum of products, but Dollar General has done well to concentrate its assortment behind a limited number of items in a wide range of categories,” says a Morningstar equity report.

The focus on lower-cost items also serves as a bulwark against digital competition. “While online-only rivals benefit from avoiding store operating expenditures, small-ticket items carry little margin to absorb shipping costs,” points out Morningstar equity analyst, Zain Akbari, adding that “the average Dollar General basket includes about five items at a total transaction size of roughly US$12.”

Despite intensifying competition, Dollar General's advantageously located store network and low-priced items should allow it to deliver economic returns, contends Akbari, who recently lifted the stock’s fair value to US$203 from US$190.

Dollar Tree (DLTR) operates discount stores in the U.S. and Canada, and sells branded and private-label goods, generally at a US$1.25 price. Nearly 50% of Dollar Tree stores' 2020 sales came from consumables (including food, health and beauty, and household paper and cleaning products), just over 45% from variety items (including toys and housewares), and 5% from seasonal goods.

Dollar Tree has a long history of strong performance, enabled by its differentiated value proposition. “We contend that the namesake stores feature a more favorable competitive positioning,” says a Morningstar equity report. “The differentiated concept has the vast majority of items priced at US$1.25 (which the company raised from US$1 in late 2021), simplifying the company's value proposition (though the firm has added a small section of somewhat higher-priced items).”

The firm changes elements of the assortment rapidly creating a treasure hunt experience, driving store traffic. “This approach helps to insulate the segment from digital rivals, as the customer's thirst for value and the modest, fixed price point for most items encourages shoppers to visit frequently,” says Akbari.

The low cost and impulse-friendly nature of Dollar Tree’s offerings mostly attract low- to middle-income consumers to its locations. “While this cohort is receptive to digital retail's charms, we believe that the dollar store segment is better protected than most, as the low price point and limited basket size (US$8 average transaction) leave little room for online retailers to absorb shipping costs economically,” argues Akbari, who recently raised the stock’s fair value to US$111 from US$106.

A value-oriented retailer, Five Below (FIVE) operates 1,020 stores across 38 U.S. states, catering to teen and preteen consumers. Stores feature a wide variety of merchandise, the vast majority of which is priced below US$6. The firm’s products fall in several categories including leisure (sporting goods, toys, and electronics; 47% of 2020 sales), fashion and home (beauty products and accessories, 36% of 2020 sales), and party and snack (seasonal goods, candy, and beverages; 17% of 2020 sales).

Five Below frequently refreshes its wide range of trend-focused items which incentivizes shoppers to return and helps keep the attention of the preteen and teenaged customers. “This approach helps insulate the firm from digital rivals, as the customer's thirst for value and the modest price points (items priced at or below $5) promotes traffic while improving Five Below’s ability to capitalize on both routine shopping trips and more impulse-oriented visits,” says a Morningstar equity report.

The retailer has generated consistent returns by leveraging a differentiated concept and prudent expansion strategy. “The firm should be able to expand profitably, as its nimble supply and distribution network are well-suited to meeting the ever-changing demands of its customers (preteens, teenagers, and their money-wielding parents),” says Akbari.

The company offers a variety of items in a tailored store environment while giving parents a measure of cost-certainty. Such a concept remains “attractive to shoppers under a range of economic scenarios,” asserts Akbari, who pegs the stock’s fair value at US$151.