Discounters Dollar General and 99 Cents Only Stores Selling at Premium

With the economy in the doldrums, there must be millions of people looking to buy what they need at the lowest possible price. But if people don't need what the discount stores sell, then they might pass despite the low price.

This is the dilemma that faces investors considering whether to buy shares of discounters Dollar General (NYSE: DG) and 99 Cents Only (NYSE: NDN). Are these two doing better due to the economic slowdown? Are they likely to exceed future analyst expectations? If so, should you invest?

These dollar stores sell products that manufacturers can't sell in the higher-priced retail stores. But surprisingly, the sales growth among dollar stores has come from affluent consumers.

Sure most of their customers are low-wage earners -- the New York Times reported that 42% earn no more than $30,000; financial anxiety among people earning over $70,000 is driving demand. As Dollar General's CEO, Rick Dreiling, told the Times, those affluent consumers make up 22% of its sales and the vast majority of its growth.

Dollar General was expected to continue to do well -- but it blew through estimates. After all, analysts were looking for it to report Monday a 10.8% increase in revenues to $3.57 billion and a 23% increase in EPS to 48 cents. And Monday it reported an 11.5% revenue increase to nearly $3.6 billion while it reported EPS of $0.50 -- two cents higher than expected.

In announcing Monday's earnings, Dreiling raised its earnings expectations for the full year. As he stated in the announcement, Dollar General's same store sales increased 6.3% for the third consecutive quarter and "we are raising our full year adjusted earnings per share guidance to the range of $2.29 to $2.32."

Competitor, 99 Cents Only Stores  -- it operates 289 discount stores of which 74% are in California and the rest in Texas, Arizona, and Nevada -- had a strong fiscal second quarter when it reported November 10 -- but not as good as Dollar General's report.

99 Cents' revenue was up 8.8% to $363 million and its profit rose a strong 17% to $15.1 million. But its 21 cents a share fell a penny short of analysts' expectations even as sales were 2% above forecasts.

So here's what the investment choice between Dollar General  and Warnaco boils down to:

• Dollar General: fast growing, fair margins; expensive stock. Dollar General's sales have risen 10.5% in the past 12 months to $13.7 billion while its net income soared 85% to $654 million -- yielding a thin 4.8% net margin. Its PEG (where a PEG of 1.0 is considered fairly priced) of 1.36 is a pricey on a P/E of 21 and expected earnings growth of 15.5% to $2.64 in fiscal year 2013.
• 99 Cents Only Stores: growing, fair margins; pricey stock. 99 Cents Only Stores' sales have increased 5.1% in the past 12 months to $1.48 billion, while net income has increased 23% to $77 million – yielding a decent 5.2% net margin. Its PEG of 1.60 is over-valued on a P/E of 20 and expected earnings growth of 12.5% to $1.29 in fiscal 2012.

These two discount retailing stocks are selling at a premium. If forced to choose one, I would go with Dollar General because it is growing faster and it less over-priced. But there is no rush to buy their shares -- consider them more closely the next time the market plunges on bad news from the Eurozone.