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For some, discount stores merit top-dollar evaluations

The conventional wisdom is that dollar stores do best when consumers are most squeezed. That means the private equity investors who bought the Dollar General Corp. and Dollarama Inc. chains during the previous economic expansion, then took them public again in 2009, had the timing just right.

The conventional wisdom also suggests that activist investor Nelson Peltz is doing things backward by launching a bid for U.S.-based Family Dollar Stores Inc. right now, as economic recovery is turning to expansion. But his bid should prompt investors to take a second look at the entire industry - and realize that dollar stores may not be a cyclical story.

Mr. Peltz, who has previously invested in consumer products companies such as Wendy's and H.J. Heinz, bought into Family Dollar last year. In a securities filing this past week, his Trian Group said it had subsequently boosted its ownership in Family Dollar to roughly 8 per cent and was interested in acquiring the rest for a price between $55 (U.S.) and $60 a share.

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With 6,800 stores and more than $8-billion in revenue over the past 12 months, Family Dollar is among the bigger players in a deep-discount sector that includes Dollarama in Canada and Dollar General , Dollar Tree Inc. , 99 Cents Only Stores Inc. and Big Lots Stores Inc. in the United States. Some of the chains offer all or most of their products at a dollar apiece. Others, such as Big Lots, stock bigger-ticket items such as furniture and electronics.

Still Cheap

As the North American economy slid into crushing recession in 2008, the deep-discount retailers thrived. Many grew their earnings before interest and taxes at double-digit rates.

Yet the sector is still not expensive. Most dollar store operators trade between 13 and 16 times forward earnings, according to Standard & Poor's Capital IQ.

One way to assess the bid from Mr. Peltz is calculate each company's enterprise value - the market capitalization of all its common and preferred shares plus net debt - then compare that figure to each firm's earnings before interest, taxes, depreciation and amortization (EBITDA).

Analyst Dan Wewer of Raymond James says Mr. Peltz is putting an enterprise value on Family Dollar that is equal to 8.5 to 9.3 times its forward EBITDA.

Applying similar multiples to the other companies in the sector yields share prices that are 20 to 31 per cent higher than Tuesday's closing levels. By this yardstick, Big Lots is worth $51.81, Dollar General, $34.37; Dollar Tree, $65.09; and 99 Cents Only, $22.11.

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Mr. Wewer does not cover Dollarama, but analyst Irene Nattel of RBC Dominion Securities Inc. does. She says the Family Dollar offer implies a range of $24.77 to $27.40 on an EV/EBITDA basis, and a price of up to $37.50 on a P/E basis.

Is It Worth the Risk?

There is risk, however, that Mr. Peltz is basing his multiple not on current performance, but on the higher levels of profit he hopes to extract from the company under new ownership.

Family Dollar has lagged industry leader Dollar General in margins, notes Scot Ciccarelli, an analyst at the U.S.-based RBC Capital Markets LLC. Family Dollar's EBIT margin over the past 12 months is 7.3 per cent versus 9.0 per cent for Dollar General, according to CapitalIQ.

If Family Dollar were able to increase its EBIT margin to around 10 per cent, similar to what Dollar General was able to achieve recently as a private company, Mr. Ciccarelli said, the multiple that Mr. Peltz is offering falls to somewhere between 6 and 7.5.

The short-term hazard is that Mr. Peltz fails to finance his bid and the industry's stocks take a step back as a result.

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That may present even more of an opportunity, however, if you buy the idea that the dollar stores can build on their recessionary gains.

Still Going Strong

Meredith Adler of Barclays Capital notes that the U.S recovery appears limited to the upper-income groups, while low-income households "are still pressured by high unemployment, weak disposable income, a depressed housing market, and rising gas prices." Meanwhile, the chains "are also working hard to improve the customer shopping experience, which we think will limit defections by any middle-income customers that began shopping at these stores simply because of the economic slowdown."

Ms. Adler had the misfortune of downgrading Family Dollar immediately before the offer from Mr. Peltz, as she believes the company has limited ability to do share buybacks and instead will be pumping cash into a renovation program expected to cost more than $100,000 per store. Her favourite stock in the sector? Dollar Tree, which she believes can add at least 3,000 stores to its existing U.S. base of 4,000, plus 900 new Dollar Giant stores in Canada.

Analyst Dan Wewer of Raymond James says the offer for Family Dollar - an enterprise value of nine times EBITDA - would yield big price jumps for other companies in the industry:



Close (Feb. 22, $US)

At 9 times EBITDA


Big Lots





Dollar Tree





Dollar General





99 Cents Only Stores





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About the Author
Business and investing reporter and columnist

A business journalist since 1994, David Milstead began writing for The Globe and Mail in 2009. During eight years at the Rocky Mountain News in Denver, Colo., he individually or jointly won nine national awards from SABEW, the Society of American Business Editors and Writers. He has also worked at the Wall Street Journal. More

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