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Dollar stores are no bargain for investors

The business of selling cheap merchandise to poor people is getting more and more expensive.

Dollar General Corp.'s $9-billion (U.S.) cash bid for Family Dollar Stores Inc. trumps Dollar Tree Inc.'s $8.5-billion offer, made three weeks ago. It values Family Dollar at nearly 10 times its earnings before interest, taxes, depreciation and amortization (EBITDA) – a sweet price indeed for a retailer that is struggling to maintain growth.

Some investors appear to be counting on yet another salvo in this bidding war and boosted Family Dollar's stock price above the $78.50 a share that Dollar General is offering. Consider it one more sign of the feverish optimism with which people are viewing the dollar-store sector.

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But why? Dollar stores thrived in the Great Recession as consumers rationed their pennies and cut back on big shopping trips. While deep discounters such as Wal-Mart Stores Inc. struggled to find growth, dollar stores swooped in – not with cheaper offerings necessarily, but with more convenient locations closer to shoppers' homes.

That advantage is waning. Wal-Mart is busily opening up smaller stores known as Neighborhood Markets and Wal-Mart Express in residential neighbourhoods. As the world's biggest retailer moves into dollar stores' turf, it's likely to put a lid on the sector's growth.

An analysis last year by Bloomberg Industries found that Wal-Mart offered better prices than Dollar General on 100 per cent of household goods and 85 per cent of auto supplies, groceries, and health and beauty products. Without any price advantage, dollar stores will find it tough to compete against Wal-Mart's new locations.

There's also the risk – if you can call it that – of an improving economy. Since consumers were initially attracted to dollar stores by tight budgets that ruled out a more extensive shopping expedition to Wal-Mart or Costco, they may go back to the big-box retailers as their finances improve.

For now, that's mere speculation. What is beyond dispute, however, is that investors are paying a lofty amount for dollar-store stocks. To illustrate this, imagine the stock market as a vast discount store and consider your choices.

On one hand, there's Wal-Mart shares. The huge retailer has a net profit margin of about 3.4 per cent and a return on equity of just under 21 per cent.

On the other hand, there's Family Dollar, which has close to an identical profit margin, as well as a return on equity of just over 22 per cent – again, nearly the same as its larger competitor.

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The only glaring difference between the two? You can buy Wal-Mart shares for about 15 times earnings, but you'll have to pay nearly 26 times for Family Dollar.

The only way to justify this huge valuation gap is to assume that Family Dollar will continue to grow its earnings per share faster than Wal-Mart. But that's a highly optimistic assumption. The dollar-store retailer announced earlier this year that it was closing 370 underperforming locations and most analysts have distinctly muted expectations for both its revenue and earnings-per-share growth over this fiscal year and next.

Dollar stores have thrived in recent years in part because they occupied a niche too small for bigger retailers to care much about. With roughly $10-billion in annual revenue, Family Dollar is basically a rounding error in Wal-Mart's annual sales of more than $476-billion. The danger in this David-and-Goliath battle is that the dollar-store heyday may end abruptly as larger retailers put more effort into contesting the sector.

In fact, one reason for the surge in Family Dollar's share price is speculation that Wal-Mart may decide to buy the chain to bolster its own growth. It's not clear, though, why the larger retailer would be willing to pay such a stiff price – or, for that matter, why small investors should be willing to bet on a sector that may have seen its best days.

Disclosure: The author owns shares in Wal-Mart Stores Inc.

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About the Author

Ian McGugan is a reporter with The Globe and Mail's Report on Business and has been writing about investing, economics and business for more than 20 years. He joined the Globe and Mail in 2010. He has been executive editor of Canadian Business magazine and founding editor of MoneySense magazine. More

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