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Recovery Lags, Shoppers Buck Up

Hungry for deals in a still-soft economy, bargainistas have been out in full force recently scouring the nation's deep discounters.

Dollar Tree (DLTR), Dollar General (DG) and Five Below (FIVE) kept their profits fat and comps healthy through the second quarter, even as many apparel retailers and others foundered amid pockets of weak consumer demand.

Variety discounters Dollar Tree and Dollar General racked up double-digit earnings growth during the quarter. Teen-focused value chain Five Below managed a triple-digit surge by offering younger shoppers a wide array of cheap, trendy, fun items.

The message: The value proposition of deep discounters continues to strike a chord with consumers.

"The environment has gotten better more recently for the dollar stores," said MKM Partners analyst Patrick McKeever. "You've seen consumers migrate more toward bigger-ticket purchases like home furnishings and autos, which has had a crowding-out effect on some of the mainstream retailers like Target (TGT) .

Dollar stores don't feel that impact.

"The small-ticket purchases, the fill-in shopping trips and convenience that dollar stores offer are in favor with consumers," McKeever said.

The Trade-Down Dynamic

Dollar chains tend to outperform other retailers in a challenging economy. The mid- to lower-income customers they target are more economically sensitive, says Michael Niemira, chief economist at the International Council of Shopping Centers.

The chains continue to see a "trade-down dynamic." Both Family Dollar Stores (FDO) and Dollar General say their fastest-growing customer segment earns $60,000 to $70,000 a year, according to Wedbush analyst Joan Storms, vs. their traditional customer base with average annual incomes of $35,000 to $50,000. Dollar Tree customers typically have higher incomes because its stores are in more suburban locales.

The proposition of brand-name basic goods at ultralow prices is a big draw for consumers under pressure from the payroll tax hike, ongoing high unemployment and limited wage gains.

"The weakness we've seen in the economy that started late last year and sort of lingers currently is actually a helpful environment for the dollar-store segment," Niemira said, noting the group's same-store sales performance is, in some cases, "really outpacing the whole industry.

He cites Dollar General's 5.1% pop in comps in the second quarter as a standout.

The group, which includes Dollar Tree, Dollar General and Family Dollar, saw second-quarter same-store sales rise 3.7% vs. a year ago. The industry saw a 1.3% rise, according to an index of 125 retailers compiled by Niemira.

Overall, the group has outrun the broader industry in same-store sales growth since the second quarter of 2006, Niemira says. It saw some slowing in comp growth in the back half of last year and has since seen a re-acceleration in growth, says McKeever.

Elbow Room For Five Below

McKeever says the chains are still expanding.

"It's one of the better growth areas of retail. There's still lots of square footage growth," he said.

Five Below has even more fresh market to pursue. The teen-focused value chain saw a 6.6% surge in same-store sales growth in the second quarter. Earnings soared 175%. Sales climbed 35%, breaking a decelerating trend over the past several quarters. Still, Five Below has booked double-digit sales gains every quarter since its July 2012 IPO.

"This is a company very early in its growth cycle," said Dougherty & Co. analyst Jeremy Hamblin.

The company opened 18 stores and ended Q2 with 276 stores in 19 states, up 22% vs. a year earlier. Hamblin says it could have "in excess of" 2,000 stores over time.

And it continues to do well with new stores.

"The company wants the average new store to generate $1.6 million in first-year sales," Hamblin said. "However, new units have actually been delivering closer to $1.8 million in (first-year) sales — even as the company has pushed into newer geographies like Illinois and Michigan.

Secret Sauce Recipes

The chains use slightly different models.

Family Dollar stores feature national brands generally priced between $1 to $10. Dollar Tree focuses on prices of $1 or less.

Dollar General is the largest discount variety chain, with 10,866 stores in 40 states as of Aug. 2. It offers merchandise priced typically below $10.

Most dollar chains might not be racking up the gains Five Below is seeing. But recent results from Dollar Tree and Dollar General are encouraging, says Storms.

"They're clearly driving traffic with merchandising initiatives such as expanded back-to-school assortments at Dollar Tree and more consumables at Dollar General," she said.

Storms sees the outlook as positive, with potential upside going into 2014 if economic conditions improve for lower- and middle-income consumers Dollar General saw its shares move to record highs after it reported a better-than-expected 12% pop in second-quarter profit. Sales increased 11%, also topping forecasts. It was its 16th straight quarter of at least double-digit profit growth.

Its same-store sales gain of 5.1% was above estimates for a 4.2% rise. Much of that growth came from its newly introduced tobacco products and strong sales of perishables, candy and snacks.

Analysts polled by Thomson Reuters see full-year earnings rising 11%. They see a 17% gain in 2014, 2015 and 2016.

"I see strong growth ahead for Dollar General, given its ongoing expansion of consumables like tobacco, beer, and wine as well as implementing better management of the more discretionary categories such as apparel and home," said Storms.

Dollar Tree's profit rose 10% in the second quarter, its slowest earnings growth in years. But it was still a 16th straight quarter of double-digit gains. Sales rose 9%.

The Street sees a 12% rise in profits for all of 2013, with a pickup to 17% growth in 2014.

"Dollar Tree is our favorite stock in our discount retailer universe," Storms wrote in a report, rating the stock outperform. She cited its role as the only $1-price-point retailer, its more economically resilient customer base and greater exposure to more discretionary merchandise.

Five Below namesake stores sell a variety of fun, trend-sensitive merchandise for the teen and preteen crowd. It features all sorts of items the fickle teen crowd enjoys, such as stickers to decorate a locker, magnets, inexpensive apparel such as T-shirts, board games and low-priced basketballs — all for $1 to $5.

The "secret sauce" at Five Below is its merchandising team, says Hamblin.

"They really do very well in finding interesting, new merchandise," he said.

Five Below has been able to connect with teens by offering value in a few ways. It "aggregates" its assortment under one roof and pulls a lot of on-trend items together that appeal to the teen and preteen crowd, says McKeever. That helps Five Below stand out amid a crowd of youth-oriented retailers.

Cross-Fire Head Winds

The outlook for dollar stores is a mixed bag.

The prospects for 2014 remain positive, says Storms. Dollar stores have become a staple retail concept, she says, with competitive advantages such as convenience and a better shopping experience than in the past, with nice store formats and remodeled stores.

While Dollar Tree is her favorite, "we also like Dollar General because they've executed extremely well," she said.

Piper Jaffray analyst Peter Keith's outlook is less rosy.

"The environment remains challenged through the end of the year largely until we anniversary the payroll tax increase," he said. "A lot of their core customers have less discretionary income year-over-year.

Some of the head winds from the payroll tax hike will moderate early in 2014, he adds.

"There's still tremendous growth opportunities across the space," he said. "They serve a very good niche and they're a convenience play for consumers.

Niemira forecasts real GDP growth of 2.1% in the 2013 second half, a little stronger than the first half's 1.2% growth.

He sees 2.9% growth in the 2014 first half and 2.8% growth in the year's second half.

"As we get into next year, I'm more optimistic some of the head winds will disappear," he said. That could be both a plus and a minus for dollar stores, as big retailers such as Wal-Mart (WMT) are also likely to start to rebound.

"In that kind of profile we expect the dollar stores' strength may wane a bit," he adds, "as some of the other discounters pick up the demand."