I rarely shop at discount retailers, primarily because there isn’t an Aldi/Lidl where I live, but also because I do all of my grocery shopping online. I do however tend to visit the local Poundland, or 99p store, when I want to buy a large amount of household products cheaply, and in bulk. Whilst there, looking at the vast number of products available that can be bought for one pound, it isn’t hard to see why discount retailers have become such a thorn in the proverbial side of the traditional grocery, and general merchandise (GM) retailers. As the market has slowly realised the disruptive potential of discounters, any retailer which is seen as particularly susceptible to this trend has seen large share price declines, and fallen out of favour with many investors.
At the same time investors, attracted by the structural growth trends, have been seeking exposure to discount retailers. As both Aldi and Lidl are private companies, investors seeking such exposure are required to choose between two GM retailers; Poundland and B&M. When these companies listed earlier this year, I analysed the companies, and the sector they operate in, and whilst I too thought the structural growth trends could be attractive, I was surprised by a number of unattractive characteristics apparent in the GM discount market/companies¹. I was reminded of this fact last week when I read that Poundland and 99p store had started a price war in certain locations (officially labelled as ‘tactical marketing’). Whilst I found it amusing and slightly ironic that a fixed-price discounter finds it necessary to discount as a result of discounting by a rival discounter, it is also a serious issue given how low margins in these businesses are.
Such price wars are reflective of the intensely competitive environment in which GM discounters operate. Unlike the grocery discount sector, which is currently a duopoly, there are 8 GM discounters of noticeable size. This includes, Home Bargains (315 stores), The Range (64 stores), B&M (373 stores), Wilkinson (372 stores), Pound Stretcher (400 stores), Poundworld (210 stores), Poundland (458 stores) and 99p store (217 stores). Competition amongst the fixed-priced stores (last 4 in list), is particularly high, because pricing (c. £1), product offering (mainly non-food) and location (mainly high streets) are all roughly similar. Hence it becomes difficult to differentiate, without reducing profitability either through lower prices, or expanding product sizes.
In addition, as a result of aggressive expansion, GM discounters are increasingly finding themselves in direct competition with each other. Between 2008 and 2013, the total number of GM discount stores doubled from 1154 to 2386. To put this into context, this is the same number of stores as HomeBase (323 stores), Argos (734 stores), WH Smith (615 high street stores), and Woolworths (800 before it went bankrupt) combined. Such expansion has been driven by low upfront store fit out costs, cheap space coming available from the bankruptcy of a number of traditional high street chains, and the attraction of lower unit costs as a result of better purchasing power. As a result, even though the GM discount store footprint is already well established, the sector continues to open stores at a high rate (Poundland and B&M plan on doubling their store base), which will only serve to increase the competitive intensity in the sector.
As well as a tough competitive environment, there are also other aspects about fixed-priced GM discounters which in my view make them lower quality companies. Firstly, they can’t raise headline prices to offset cost inflation (e.g. wages/products), so they face the challenge every year of finding efficiency savings, or tweaking their product range, just to keep margins flat (it also means margin increases are unlikely). Secondly, although there is a structural trend towards discount shopping, sales per square foot in the GM discount sector have been flat for the past 6 years – which implies the main driver of growth in the sector is new space instead of pricing or like-for-like volume growth.
One way of quantitatively assessing the quality of a retailer is to look at the lease-adjusted returns on invested capital (CROIC) that a retailer achieves. This shows the return a retailer might achieve on a new store, adjusting for the fact that some retailers choose to lease their stores, and others choose to own them. Retailers which generate high CROIC are more attractive because they can invest in growth projects which generate high returns for shareholders (these returns can then be reinvested). Poundland generates a CROIC of c. 10%, which is towards the bottom end of the UK midcap retail sector (highest is Dunelm at c. 30%) which reflects the competitive environment mentioned above. This takes some of the excitement out of the growth outlook for Poundland, because shareholder capital is being reinvested into low returning projects. This fact, and their high valuations, means the discounters might not be such a bargain after all.
1. This is no recommendation to buy or sell any particular security