At Wal-Mart's (WMT) latest analyst meeting, the company said that it would accelerate the rollout of its Neighborhood Markets stores that, at 40,000-square-feet, are about a quarter to a third of the size of a typical supercenter. The Neighborhood Markets grocery stores are designed to penetrate urban settings that do not allow for supercenters. The current roll-out rate is approximately 100/year.
Analysts took this news to mean the company would not be growing its Wal-Mart Express concept, which is basically a dollar store. With this, the sell side, at least, breathed a collective sigh of relief for the long-term growth rate of dollar stores.
Still, longer-term, I believe that the Neighborhood Markets will be a negative for the dollar stores. The sell side analysts who don't acknowledge this threat, in my opinion, are compartmentalizing shoppers to different stores or types of stores, rather than looking at the competition among the differing stores. (It's common sense that Chipotle (CMG) customers would never eat at Taco Bell (YUM). David Einhorn's market research study proved just how ridiculous the idea is.)
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The growth of dollar stores is spearheaded by their increased consumables offering, though somewhat less for Dollar Tree (DLTR) than for Dollar General (DG) and Family Dollar (FDO). Having better food and household products pricing than their competitors is key.
As a retailing analyst, I know that consumers have historically reacted to pricing differentials above 5% when choosing among the same sorts of stores. As the differential approaches around 8% however, it can cause some really important market share shifts. Indeed, we have seen Kroger (KR) gain significant market share from other chains such as Safeway (SWY) and Supervalu (SVU), with prices that I believe have averaged about 6-8% below traditional chains. As an aside, it seems very possible that Supervalu may see bankruptcy based on its years of being priced about 8% above most of its competition.
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Pricing has gotten to be even more of an issue since the recession. Moving forward, it is likely that increased taxes and slow or no economic growth over the next four years will intensify the market share shifts tied to relative prices. For those at the bottom half of household income in the US, the historical and future effect of relative prices is even greater.
In late 2010, one good sell-sider pointed out that dollar stores were taking some market share from Wal-Mart because of the higher cost per trip for small items (due to the increased gasoline cost for these trips), even though Wal-Mart and Target (TGT) had lower prices than the dollar stores. It seems very reasonable that any gains made by dollar stores for those reasons are ripe for reversal in the next few years. Significantly, some of the biggest sales gains at the dollar stores have come from higher income consumers ($60,000/year and up) who would have more access to cars than other dollar store customers and can, even in urban settings, travel further for cheaper prices.
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I have not seen a pricing differential study for Wal-Mart vs. the dollar stores in the last year or two, but I am fairly sure that Dollar General's consumable prices are 3-5% above Wal-Mart's, and that Family Dollar's prices are at 5-7% above Wal-Mart's. I judge these differentials to be big enough to make these stores somewhat vulnerable to Wal-Mart in terms of relative prices. Additionally, I can point to Target's history of fairly scrupulously keeping its relative prices on like consumables at only about 3% over Wal-Mart's. Another factor to be considered in the long-term growth of the dollar stores is sales to baby boomers, many of whom will retire without sufficient nest eggs. In these instances, the availability of a pharmacy at Neighborhood Markets will be a big factor shifting market share to Wal-Mart.
Therefore, I have run two sets of saturation numbers for the dollar stores. The first set takes a 40,000 square foot neighborhood market and assumes that it is equal to four dollar stores on the basis of higher income customers and aging baby boomers not doing much consumer discretionary spending at dollar stores, and with consumables prices being very important.
The next set is a worst case scenario, figuring that the Wal-Mart Neighborhood Market displaces six dollar stores, which may be a stretch, but seems entirely reasonable given Wal-Mart's relative strength.
I am also including the growth of Aldi, the privately-owned, discount retailer headquartered in Germany, where the square footage is closer to that of a dollar store. Aldi stores tend to be found at strip malls and neighborhoods where one would find dollar stores. Because Aldi's prices for its all-private-label food are maybe 4% below Wal-Mart's prices, I will assume that a 1 square foot increase in an Aldi store displaces 1.5 square feet of a dollar store.
What I found is a very significant limitation on the potential growth of dollar stores, assuming that relative pricing vs. Wal-Mart at these stores does not come down. I have seen three sell-side studies of dollar store saturation at 33,000, 42,000, and 47,000 stores (compared to the approximately 22,000 stores that now exist). I used the 33,000 number. Assuming that dollar store square footage grows at a 6.5% growth rate, and using a displacement of four dollar stores by one Neighborhood Market, I found that the saturation level is reached two years earlier, in calendar 2015, instead of 2017 where it would have reached saturation without an increase in dollar stores.
In the 'worst case' scenario, if a Neighborhood Market were to displace six dollar stores, the saturation point would come almost another year earlier. Note that the pace of 100 new Neighborhood Markets per year by Wal-Mart is only equal, on a square footage basis, to adding 23 supercenters per year, i.e., the retailer could easily accelerate the build out, which I think is likely with supercenter concept having reached its own saturation point, at least in the US. Any marked increase in the rollout will make things worse for the dollar stores.
An important corollary to saturation is that margins will very likely start to fall when the saturation level is approached.
To indicate the potential valuation implications, I looked at Dollar General. Using the sell-side's median $61/share target price, a three-year cut in the duration of earnings growth from a sooner store saturation reduces the implied valuation by 18%. Using the present $50 price, a three-year cut in growth rate duration reduces the deserved price by 10%.
I have only looked at one factor in sales change for the dollar stores. Indeed, the 20-25% price premium of the drug stores' front-end merchandise may well be a big positive factor that is not yet discounted in the growth rate of revenue (although the lack of a pharmacy at the dollar stores makes the Neighborhood Market relatively better situated).
There should be no surfacing of this potential problem in the dollar stores' EPS results over the next one to two years -- or possibly even three years. But investors should keep this threat and its magnitude in mind, because things such as this tend to pop up and hurt results and stock valuation unexpectedly.