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Why deep discount is winning retail

The two major dollar stores—Dollar General (DG) and Dollar Tree (DLTR)—both traded down sharply, 11% and 7% respectively, after releasing second quarter reports.

The headlines focused on declining enrollment in food stamps just as pressure on food prices picks up.

But one quarter’s worth of disappointing results doesn’t mean business is going south.

In fact, in Dollar General’s second quarter report management reported that sales rose 5.8%, with same-store sales up 0.7%. Dollar Tree also reported an increase in same-store sales of 1.7%.

Instead, the deep discount arena has been the very area of retail outperformance, with expectations much higher than their department stores peers—like Macy’s (M) and Nordstrom (JWN).

In particular, Dollar General and Dollar Tree have well outperformed the market in 2016, each up over 20%. Over the last five years the stocks are both up 160%, just about double the S&P, which has gained 85% during that period.

Meanwhile, as expectations for traditional department stores have diminished, discount and dollar stores are the one area—outside of ecommerce—that has been able to surge amid a difficult environment.

In fact, expectations for earnings in this subgroup have been high. While Amazon (AMZN) dominates growth in retail, Dollar Tree and Dollar General are right behind for upside.

And while the latest quarter for the dollar stores underwhelmed against heightened expectations, trends are still working in their favor.

Stagnant wages

As the median wage has stagnated, this has benefited discount-oriented names. Recently, a slight uptick in wage gains—with average hourly earnings up 2.0%—has helped the purchase of discretionary items to some degree, but has kept interest in this group.

Meanwhile, the dollar stores have taken advantage of the “sweet spot” in the industry.

Dollar Tree, which acquired competitor Family Dollar in 2015, has focused on improving their national brand representation along with private label.

According to BTIG’s Alan Rifkin, while Dollar General has 13,000 stores currently, it can double its base. In an $800 billion market, dollar stores have only a 5% share, he explained, and the company’s 900 new stores in 2016 and 1,000 in 2017—all opened with minimal upfront cost—is proof of upside potential.

“Sales ramp quickly but still have room to grow,” Rifkin said.

Meanwhile, the integration of Family Dollar into Dollar Tree is a strong opportunity, with $300 million in synergies through 2018 likely conservative, according to Rifkin, who added that store growth potential for these chains also remains strong.

The bottom line: these companies disappointed relative to expectations this quarter, but a still-tepid consumer and retail environment could continue to work in their favor.