Investing

Value Conundrum: Dollar Store M&A Creates High Premium in Sector (NDN, APO, KKR, BRK-A, WMT, DG, FDO, DLTR, BIG, TUES, M, TGT)

99 Cents Only Stores (NYSE: NDN) was supposed to be acquired for somewhere between $22.00 and $24.00 per share according to reports in mid-September.  The company was supposed to have interest from Apollo Global Management, LLC (NYSE: APO) in a bid that would have topped a prior buyout offer from Leonard Green & Partners at about $19.09 earlier in the year.  The dollar store chain is being acquired, but by a group led by Ares Management LLC and Canada Pension Plan Investment Board in a deal valued at $1.6 billion in equity or $22.00 per share in cash.  This changes some key observations about the dollar sector: we love the sector, but valuations are starting to look stretched even with its growth opportunities.

24/7 Wall St. has been calling for higher and higher prices in the dollar store sector and we have discussed consolidation in the other discount store and close-out stores.  Dollar stores will be a secular winner over the years ahead unless we get a sudden return to a booming economy.  We have even gone as far as to showing that dollar store chains are now where Wal-Mart Stores Inc. (NYSE: WMT) was back in the early 1990s.  Private equity and other savvy investors like Warren Buffett’s Berkshire Hathaway Inc. (NYSE: BRK-A) have been active in this space

Dollar General Corporation (NYSE: DG) remains a Stock to Own for the Next Decade, but we are growing to accept the math here: shares hit a new all-time high of $39.22 today and the consensus price target is only $39.94.  We have chatted this one up over and over since the stock was well into the $20 stock handles.  Kohlberg Kravis Roberts & Co. (NYSE: KKR) continues to sell stock that it still owns and we would just expect that the firm will continue to sell shares.  It is when those price drops occur that you get your chance to enter the stock on the cheap.  Please be advised, we expect that Warren Buffett will have added to this position.

There has also been buyout interest in Family Dollar Stores Inc. (NYSE: FDO), up only marginally at $54.05 versus a 52-week range of $41.31 to $56.92.  Dollar Tree, Inc. (NASDAQ: DLTR) has also been under private equity interest and its shares are up 2% at $80.92 and its stock hit a new high of $80.99 this morning.  Analysts have consensus price targets of $56.87 for Family Dollar and $77.67 for Dollar Tree.

Big Lots Inc. (NYSE: BIG) is a close-out store with many low-priced items but is no dollar store.  There was a while where it was also considered takeover bait but that failed to materialize.  At $34.33, the 52-week range is $27.82 to $44.44.  Tuesday Morning Corp. (NASDAQ: TUES) is another close-out store and it is often overlooked because it has a mere $158 million market capitalization rate.  At $3.71 after a 2.6% drop today, its 52-week range is $3.22 to $5.93.

99 Cents only is up 4.2% at $21.36 this morning. The news and the reaction may seem anti-climactic, but this brings an end to what was a long and arduous buyout process that has been going on since at least March of this year.

The growth of discounters and the growth of dollar stores says something awful about America.  If these trends continue, it simply means we have more and more of the population at the lower-end of the spectrum seeking deals wherever they can be found.  Still, business is business.  If Warren Buffett and private equity giants have so much interest in this sector, ask yourself if there is money to be made. Again: Dollar Stores Are The Next Wal-Mart!

The sad thing is that there is now a market premium in the sector.  Our favorite remains Dollar General, but it now trades at 15-times 2012 (actually January 2013) fiscal earnings estimates from Thomson Reuters.  Another premium is there for Dollar Tree with a forward 2012 ratio of 17.5-times expected earnings.  Family Dollar has a different fiscal year-end (august) but if we blend the estimates we get a stock trading at close to 14-times the same earnings estimate periods of the peers.   

We will start to grow a bit more cautious on the sector of dollar stores if the price appreciates too much more.  The fact that we and others are excited about the dollar store and close-out store sector does not bode for much growth and does not bode well for the middle class.  These stocks now trade at richer multiples than many normal retailers: Macy’s Inc. (NYSE: M) trades at 9-times expected 2012 (January 2013) earnings estimates and Target Corporation (NYSE: TGT) trades at 12-times the same period’s estimates.  Wal-Mart Stores Inc. (NYSE: WMT) trades closer to 11-times next year’s expected earnings and that is after the stock enjoyed a significant pop of late.

For a comparison, 99 Cents Only at $22.00 per share values the company at about 17.5-times what was the expected 2012 (March 2013) fiscal earnings expectations.  This still leaves some room higher for dollar stores, but this is a premium to peers and to the broad market.  The secular trend is what is driving the value of dollar stores and investors are willing to pay a premium for that.  The questions will start to arise if these premiums grow much further.  How much of a premium can a discount sector command?

JON C. OGG

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