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Dollar stores attract investors seeking growth in tough times

A Dollarama employee restocks shelves at the Dollarama store in Vaughan, Ont.


The best buy at the dollar store may be the retailer's own stock.

The $1.6-billion purchase (U.S.) of 99 Cents Only Stores by Canada Pension Plan Investment Board (CPPIB) and Ares Management LLC has put the spotlight on the value of discount retailers in difficult times.

As the weak recovery pushes cost-conscious consumers to find smarter ways to shop, low-end retailers are thriving – and 99 Cents is a prime example.

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In the last 12 months, the California-based discount chain has posted profit of $75-million, which is more than twice what it generated in the four years between 2006 and 2009. Across the sector, dollar-store retailers have seen same-store sales and overall revenue rise significantly faster than the rest of the retail segment.

In response, investors have driven up the share prices of discount chains. So far this year, shares of Dollar Tree Inc. have gained 43 per cent, Dollarama Inc. 31 per cent, Dollar General Corp. 27 per cent and Family Dollar Stores Inc. 8 per cent.

A long list of private equity firms has flocked to the sector. CPPIB and Ares Management's bid for 99 Cents, announced Tuesday, reportedly beat a $1.4-billion rival offer from Leonard Green & Partners LP. But the victory cost the winners a 32-per-cent premium to what 99 Cents shares traded for in March when the company went into play.

Earlier this year, Bain Capital reaped a large return for helping to launch Dollarama's initial public offering in 2009, selling off the last of its 29-per-cent stake in the Montreal-based chain this summer. In February, Trian Partners, an investment firm run by Nelson Peltz, sought to buy Family Dollar for about $7.8-billion, but was spurned. Trian still holds a stake of about 8 per cent in the company and last month won a seat on the board of directors.

U.S. retailers in general reported better-than-expected sales growth of 5 per cent at comparable stores in September, and by far the strongest results came from discount stores and wholesale clubs, which saw growth of nearly 9 per cent, says Wayne Hood, an analyst with BMO Nesbitt Burns Inc.

"We expect the discounters to outperform, driven by consumables," Mr. Hood wrote in a research report published last week. "We think the middle-market retailers will be most challenged, as they vie for a stretched consumer."

Dollar stores are now seen as both growth stocks and defensive investments. The tradeoff for that attractive blend of characteristics is relatively high valuations, with some "defensive growth" discounters trading at 20 times earnings, well above the market average.

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RBC Dominion Securities Inc.'s Scot Ciccarelli says the premiums on these stocks are justified. He has raised his price targets this month on both Dollar Tree and Family Dollar Stores. But he warns that if the gap between their valuation and cyclical retailers keep widening, and the economy begins to stabilize over the next six months or more, money will start to flow into cheaper stocks, such as those of Home Depot, Lowe's, CarMax, Williams-Sonoma, Best Buy and RadioShack.

"Don't move away from 'defensive growth' yet, but keep it on the radar," he advises.

Dan Wewer, of Raymond James & Associates Inc., boosted his rating on Family Dollar Stores last week to "strong buy" from "outperform." He notes that the company has grown during the past two recessions, and suggests that a pullback in the share price following the collapse of Trian's takeover bid presents a buying opportunity. The share price rose 44 per cent during the 2001-02 recession, compared with a 36-per-cent drop in the S&P 500 composite index, he noted.

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