Are Dollar Stores Falling Victim to Grocery Store Competition?

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The knives are out in the grocery sector as major chains begin what may be a prolonged pricing battle. Is some of the conflict already spilling over into the dollar store business? Using Dollar General (NYSE: DG) as a case study, our Industry Focus: Consumer Goods team continues their discussion of how the bigger grocery industry may be inflicting pain on dollar stores -- and whether investors should perhaps give these stocks a second look.

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A full transcript follows the video.

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This video was recorded on Sept. 5, 2017.

Vincent Shen: I think with Dollar General and some of the ongoing strategy that they've had success with, for example, offering the speed and convenience in value that customers want, and also often pushing with locations and expansion into areas that maybe aren't as well served by some of the big chains that we mentioned so far on the show. But ultimately, a thought that I had in terms of Kroger being in the middle -- not premium, not really discount, doesn't have as much of that moat. At the same time, I look at some of the stores in the discount space, these are not destination stores. The way I thought about it, you're unlikely to spend an hour lazily browsing at a Dollar General. But I've done it myself, I can definitely see customers doing that at a Whole Foods or a Costco.

With dollar stores offering that convenience, speed, and value that I mentioned, they're ultimately getting attacked on a few different fronts now. The grocery price war, as you mentioned, chips away at that value proposition. Then the bigger focus the major chains have also made in terms of creating these small-format stores or upgrading their store layouts so that customers can get in and out more easily, it takes away from that speed and convenience advantage as well. I found a report that some of the biggest competitors, like Wal-Mart, have even resorted to undercutting competing dollar stores on staple items, and they will specifically lower prices at stores located nearest to a Dollar General location, for example, to essentially steal some of that traffic and hopefully get a leg up in terms of that competition.

Asit Sharma: I agree with you, Vince, in that dollar stores in general don't have a very wide moat. I would say, though, instead of a moat, they have a really muddy, swampy rivulet running right in front of them. The big stores like Wal-Mart keep looking at the dollar stores, and when they turn their attention to them, they do exactly what you're saying, they try to hurt them and then they get distracted by other bigger competitors.

And one thing that these stores have is a lot of flexibility. They are very light footprint stores, it's easy to close them and open them up. I think Dollar General has about 14,000 stores in 44 states, and it regularly will close or relocate several hundred in a year. They're very good at popping into areas which are underserved by traditional grocers, so they have some insulation against these types of tactics. I want Wall Street at some point to show these guys a little love. Dollar General trades right now at a forward P/E ratio of 16.9 times. Dollar Tree (NASDAQ: DLTR), its competitor, trades at a P/E ratio forward 15.6 times. So these are lower than your average grocery stores, but they have a much higher margin. At the end of the day, Dollar General has a net profit margin of 5%. We were talking about Kroger earlier, their net profit margin is 0.8%, less than 1%, and that's a good quarter for Kroger. Costco, which has a little higher profitability, has a net profit margin of 2.4%.

So you have an industry which is somewhat insulated from these price wars, has better margins, can grow a little quicker, but they don't trade at the high multiples that grocery stores do. And that's because, as you point out, investors have a fear that at some point, Wal-Mart and Costco and these other stores will really get serious about the dollar stores, join hands and try to force them out. But it hasn't happened yet. And I find it interesting that they manage to stick around.

John Mackey, CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. Asit Sharma has no position in any of the stocks mentioned. Vincent Shen has no position in any of the stocks mentioned. The Motley Fool recommends Costco Wholesale. The Motley Fool has a disclosure policy.