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Wal-Mart's Neighborhood Markets Pose Threat to Dollar Stores


Although they are safe for the next one to three years, a consumer stock analyst runs the numbers and shows what will happen to dollar stores if Wal-Mart accelerates the roll-out of its Neighborhood Markets concept.

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.
No positions in stocks mentioned.
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