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Will These Discount Retailers Beat Inflation?

Prices of goods have been running rampant with the highest recorded inflation in decades. To try to ease this, the Federal Reserve has been incrementally increasing interest rates over the past few months and just raised rates 75 bps. Despite the moves, inflation reached a 40-year high in May 2022, forcing many consumers to cut spending and look for cheaper places to shop for grocery items and other goods. This has created a strong tailwind for discount stores and low-cost retailers that are somewhat immune to the inflationary pressures visible across sectors of the economy.

For many larger retailers, labor inflation has created concern over the past year. Finding the staffing necessary is proving to be a challenge. Turnover has always been an issue with these jobs, but it has accelerated even further because of the pandemic’s additional pressures on workers.

Many discount retailers are still facing supply chain issues, like many other industries. Shipping costs have increased significantly, which has put pressure on margins. As a result, discount retailers have been looking for ways to cut costs.

For nearly all discount retailers, switching costs by customers are negligible, forcing companies to face intense competition from convenience stores, mass merchandisers, hard discounters, grocery stores, pharmacy chains and online retailers such as AmazonAMZN
. To combat this, the discounters are beginning to fully embrace the digitization of retail. Recently, Dollar General introduced a mobile app featuring digital coupons and expanded use of self-checkout in select stores. Self-checkout could help to reduce labor costs even as wages rise.

Despite the challenges caused by wage inflation and supply chain issues, discount retailers could perform well in 2022. With inflation causing consumers to cut back, many may look for cheaper alternatives when shopping. Further, the expansion of technology and e-commerce provides an opportunity to streamline discount retailers’ business and prevent shrinkage of margins.

Grading Discount Retailer Stocks With AAII’s A+ Stock Grades

When analyzing a company, it is helpful to have an objective framework that allows you to compare companies in the same way. This is why AAII created the A+ Stock Grades, which evaluate companies across five factors that research and real-world investment results indicate to identify market-beating stocks in the long run: value, growth, momentum, earnings estimate revisions (and surprises) and quality.

Using AAII’s A+ Stock Grades, the following table summarizes the attractiveness of three discount retailer stocks—Dollar General, Dollar Tree and PriceSmart—based on their fundamentals.

AAII’s A+ Stock Grade Summary for Three Discount Retailer Stocks

What the A+ Stock Grades Reveal

Dollar Gene(DG) is a discount retailer that offers merchandise in the categories of consumable items, seasonal items, home products and apparel. It offers brands from manufacturers, as well as its own private brand selections with prices at discounts to brands. The consumables category includes paper and cleaning products, packaged food, perishables, snacks, health and beauty, pet and tobacco products. Seasonal products include holiday items, toys, batteries, small electronics, greeting cards, stationery, prepaid phones and accessories, gardening supplies, hardware, automotive and home office supplies. Home products include kitchen supplies, cookware, small appliances, light bulbs, storage containers, frames, candles, craft supplies and kitchen, bed and bath soft goods. Apparel products include casual everyday apparel for infants, toddlers, girls, boys, women and men, as well as socks, underwear, disposable diapers, shoes and accessories.

Dollar General has a Momentum Grade of A, based on its Momentum Score of 89. This means that it ranks highly in terms of its weighted relative strength over the last four quarters. This score is derived from an above-average relative price strength of 20.3% in the most recent quarter, 7.0% in the second-most-recent quarter, –0.9% in the third-most-recent quarter and –3.2% in the fourth-most-recent quarter. The scores are 89, 58, 72 and 73 sequentially from the most recent quarter. The weighted four-quarter relative price strength is 8.7%, which translates to a score of 89. The weighted four-quarter relative strength rank is the relative price change for each of the past four quarters, with the most recent quarterly price change given a weight of 40% and each of the three previous quarters given a weighting of 20%.

A higher-quality stock possesses traits associated with upside potential and reduced downside risk. Backtesting of the Quality Grade shows that stocks with higher grades, on average, outperformed stocks with lower grades over the period from 1998 through 2019.

Dollar General has a Quality Grade of A with a score of 82. The A+ Quality Grade is the percentile rank of the average of the percentile ranks of return on assets (ROA), return on invested capital (ROIC), gross profit to assets, buyback yield, change in total liabilities to assets, accruals to assets, Z double prime bankruptcy risk (Z) score and F-Score. The score is variable, meaning it can consider all eight measures or, should any of the eight measures not be valid, the valid remaining measures. To be assigned a Quality Score, though, stocks must have a valid (non-null) measure and corresponding ranking for at least four of the eight quality measures.

The company ranks strongly in terms of its return on assets and buyback yield. Dollar General has a return on assets of 8.7% and a buyback yield of 4.2%. The industry median return on assets is 3.7% and for buyback yield it is –0.5%. The return on assets indicates how profitable a company is in relation to its total assets. The higher the return on assets, the more efficient and productive a company is at managing its balance sheet to generate profits. However, Dollar General ranks poorly in terms of its change in total liabilities to assets, in the 34th percentile.

The company has a Value Grade of D, based on its Value Score of 67, which is considered expensive. This is derived from a high price-to-free-cash-flow (P/FCF) ratio of 48.2 and a high price-to-book (P/B) ratio of 8.85. In addition, Dollar General has a Growth Grade of C based on strong five-year earnings growth rate of 18.1%, offset by poor quarterly year-over-year sales growth of 4.2%.

Dollar Tree (DLTR) is an operator of discount variety stores whose business segments include Dollar Tree and Family Dollar. The Dollar Tree segment is the operator of discount variety stores offering merchandise predominantly at a fixed price. Its stores are operating under the brand names Dollar Tree and Dollar Tree Canada. It operates 15 distribution centers in the U.S. and two in Canada. The Family Dollar segment operates general merchandise retail discount stores in neighborhood settings. The Family Dollar segment consists of its store operations under the Family Dollar brand and 11 distribution centers. The Family Dollar stores segment consists of consumable merchandise, hardware and automotive supplies, diapers, batteries, pet food and supplies, seasonal and electronics merchandise, as well as apparel and accessories merchandise. It also owns trademarks, including Family Dollar and Family Dollar Stores.

The company has a Value Grade of C, based on its Value Score of 55, which is considered average. Lower scores indicate a more attractive stock for value investors and, thus, a higher grade.

Dollar Tree’s Value Score ranking is based on several traditional valuation metrics. The company has a score of 19 for shareholder yield, 37 for the price-to-sales (P/S) ratio and 67 for the ratio of enterprise value to earnings before interest, taxes, depreciation and amortization (Ebitda), with the lower the score the better for value. The company has a shareholder yield of 3.4%, a price-to-sales ratio of 1.31 and a 14.0 enterprise-value-to-Ebitda ratio. The price-to-book-value ratio is 4.24, which translates to a score of 84.

The Value Grade is the percentile rank of the average of the percentile ranks of the valuation metrics mentioned above, along with the price-to-free-cash-flow ratio and the price-earnings (P/E) ratio.

Earnings estimate revisions offer an indication of how analysts view the short-term prospects of a firm. For example, Dollar Tree has an Earnings Estimate Revisions Grade of B, which is positive. The grade is based on the statistical significance of its latest two quarterly earnings surprises and the percentage change in its consensus estimate for the current fiscal year over the past month and past three months.

Dollar Tree reported a positive earnings surprise for first-quarter 2022 of 18.3%, and in the prior quarter reported a positive earnings surprise of 13.5%. Over the last month, the consensus earnings estimate for the second quarter of 2022 has decreased from $1.736 to $1.571 per share due to 19 downward revisions. Over the last three months, the consensus earnings estimate for full-year 2022 has increased 1.3% from $8.041 to $8.145 per share, based on 20 upward and three downward revisions.

Dollar Tree has a Quality Grade of A with a score of 82. The company ranks strongly in terms of its buyback yield and return on assets. Dollar Tree has a buyback yield of 3.4% and a return on assets of 6.9%. However, Dollar Tree ranks poorly in terms of its accruals to assets, in the 28th percentile.

PriceSmart (PSMT) is an owner and operator of a U.S. style membership shopping warehouse club. The company and its subsidiaries are principally engaged in the international operation of membership shopping in approximately 47 warehouse clubs located in over 12 countries and one U.S. territory. In addition, it operates distribution centers in the U.S. The company’s segments include the U.S., Central America, the Caribbean and Colombia. It sells private label consumer products, offers prepared foods through its bakeries and food courts with the option for delivery, and in certain clubs it provides services such as optical and tires to individuals and businesses. The company also operates a package-forwarding business and marketplace business under the Aeropost banner in approximately 38 countries in Latin America and the Caribbean.

PriceSmart has a Value Grade of B based on a score of 40, which is considered to be in the value range. The company has a score of 32 for shareholder yield and 18 for the price-to-sales ratio. The company has a shareholder yield of 0.5% and a price-to-sales ratio of 0.58. A lower price-earnings ratio is considered a better value, and PriceSmart’s price-earnings ratio is about double the sector median of 11.5. The enterprise-value-to-EBITDA ratio is 9.6, which translates to a score of 43.

PriceSmart has a Quality Grade of B with a score of 74. The company ranks strongly in terms of its gross income to assets and F-Score. PriceSmart has a gross-income-to-assets ratio of 37.6% and an F-Score of 6. The industry average gross income to assets is 29.3%. The F-Score is a number between 0 and 9 that assesses the strength of a company’s financial position. It considers the profitability, leverage, liquidity and operating efficiency of a company. However, PriceSmart ranks poorly in terms of its accruals to assets, in the 26th percentile.

PriceSmart reported a negative earnings surprise for second-quarter 2022 of 3.0%, and in the prior quarter reported a positive earnings surprise of 5.4%. Over the last month, the consensus earnings estimate for the third quarter of 2022 has remained the same at $0.805 per share despite two downward revisions. Over the last three months, the consensus earnings estimate for full-year 2022 has decreased 2.3% from $3.655 to $3.570 per share, based on one upward and one downward revision.

PriceSmart has a Growth Grade of D based on a score of 39. The only growth metric that is above the industry median is quarterly year-over-year earnings growth, at 11.0%. The company has a Momentum Grade of B, with a score of 62. PriceSmart has strong relative price strength in the first- and second-most recent quarters.

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The stocks meeting the criteria of the approach do not represent a recommended” or “buy” list. It is important to perform due diligence.

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