As Wall Street collapsed in 2008 under the weight of Lehman Brothers, three companies instantly became more profitable: Dollar Tree, Inc. (NASDAQ:DLTR), Family Dollar Stores, Inc. (NYSE:FDO), and Dollar General Corp. (NYSE:DG). The three companies operate in the deep-discount dollar store market, which benefits when people become so poor that even Wal-Mart Stores, Inc. (NYSE:WMT) does not offer a good enough value proposition to keep their business. In other words, when the rest of the economy goes down, these companies go up.
Unique industry dynamic
What is most unique about the dollar store industry is that there should not be any inherent competitive advantages, yet the companies’ results show evidence of economic moats.
Dollar Tree, Inc. (NASDAQ:DLTR) and Family Dollar Stores, Inc. (NYSE:FDO) are virtual copies of each other; there literally is no substantive difference between the two except for the name plastered on the front of the store. Dollar General Corp. (NYSE:DG) is only slightly different in that it carries a differentiated set of SKUs, but is otherwise similar to its peers.
The income statement is about what you would expect for an industry that has virtually identical competitors; margins are roughly equal and so is operating efficiency.
The weak U.S. economy has boosted margins significantly; margins are now higher than their historical norms and will likely revert to 2003 levels if the economy picks up again.
Government programs designed to assist low-income families are largely responsible for the increase in foot traffic in the stores; one of the main reasons people shop at dollar stores is to get an even better deal than they can get at Wal-Mart.
Most customers tend not to be loyal to the dollar stores when their income increases due to a recovering economy, but the stores do benefit from a degree of customer stickiness. While they cannot match Wal-Mart’s unique combination of price and quality, the dollar stores can beat Wal-Mart on convenience. Many of the stores are located in markets that are too small to support a Wal-Mart, thus they are free from significant competition that would otherwise dampen profitability.
The lack of significant competition in the markets in which the stores compete is the primary reason that they are able to earn such high returns on invested capital (ROIC). All three companies earn solidly double-digit ROICs even during normal years. Dollar General Corp. (NYSE:DG) fell behind in in the lead-up to the financial crisis due to mismanagement, but it is capable of earning ROIC similar to that of its peers.