BANGALORE Discount and dollar stores have seen a flurry of deal activity in recent months, and it looks like Wall Street can wring a few billion dollars more out of them.
These retailers, which sell low-priced and close-out goods, have little chance of running short of customers who cannot afford higher-quality and more expensive items, especially after the global recession.
But investors have cast the discount retailing business out of favor even though their fundamental financial condition is good.
The cheap valuations, along with their respectable free cash flow, and extensive real estate assets, make these companies attractive targets for companies and private equity firms hunting for buyout quarry.
"Sales (at discount retailers) are fairly steady and are selling a lot of consumable products and a lot of necessities," said FBR Focus Fund portfolio manager Brian Macauley.
The most recent example of the discount store buyout plan in action was 99 Cent Only Stores NDN.N. The company's founding family teamed up with private equity firm Leonard Green to take the company private for $1.34 billion.
Meanwhile, close-out retailer Big Lots Inc (BIG.N) is reported to be considering a sale. Also available is Family Dollar Stores Inc FDO.N, which recently rejected a $7 billion offer from Nelson Peltz's Trian Group.
Global private equity-backed deals totaled $43 billion so far this year, up 52 percent over the first quarter of 2010, Thomson Reuters data show.
"Normally, private equity guys are attracted by the cash flows. Most of the discount retailers that are in the middle of takeover talks have good amount of cash flows," said Wall Street Strategies analyst Brian Sozzi.
While Big Lots might be a good bet for private equity, the pharmacies owned by discount store Fred's Inc (FRED.O) could make it a good fit for the big drugstore operators, CVS Caremark Inc (CVS.N) and Walgreen Co WAG.N.
"Both these companies (CVS and Walgreen) don't have great presence across the country," Sozzi said. "Instead of building brand equity from the ground up ... in states where they are not present, they can buy Fred's."
Dollar stores, which sometimes appear mere blocks from one another in poorer neighborhoods with few or no other retail competition, also sit on real estate that could be sold or used as collateral for financing a deal.
Investors might want to see a repeat of Dollar General Corp's (DG.N) $7.3 billion deal to go private in 2007. Wall Street saw that as a successful deal, and one that private equity investors might want to try again.
Fred's has improved its operating margin to an expected 2.6 percent in fiscal 2010, said Adam Peck, portfolio manager at Heartland Advisors Inc, which owns about 2.6 million shares of Fred's and is one of the four largest investors in the company.
Fred's private label business, which has represented about 3.5 percent of its sales in 2008, has since grown to about 20 percent. Private label margins, sold under the company's name, are twice that of what the company earns on branded items.
DISCOUNT STORES: CHEAPER THAN YOU THINK
The other reason these companies could be ripe for buying: their stocks are cheap, analysts say.
Fred's, which operates 676 stores in the southeastern United States, last week commented on its declining stock price and said that its store operations remain consistent and that it would repurchase shares.
"On strategic value, they are cheaper as Peltz is offering Family Dollar about 9.5 times EBITDA and Leonard Green is offering 8.3 times EBITDA for 99 Cents Only," Peck said.
Fred's is trading at less than 6.5 times EBITDA. Peck thinks Fred's is worth at least $15 a share and perhaps attract $20 a share as a buyout offer. It trades around $13 now.
Andy Knuth, a portfolio manager at Westport Asset Management, which owned about 2.7 million shares in Big Lots as of December 2010, said that the market is eyeing a price of about $45-$47 a share for Big Lots, given its price-to-earnings multiple of 13.6.
The stock, which has gone up 25 percent since Bloomberg reported last month that the company was considering a sale, is now trading at around $42 per share.
"There is a lot of frustration on the part of management and shareholders about the discounted valuation that the market was giving to BIG's stock, and this is a way to see if they can do something about it," Knuth said.
FBR's Macauley sees another reason for why discount store stocks are valuable: the people who shop in the stores are not denizens of the world of couture.
"They are not driven by fashion or trend, which should be a more predictable business," he said.
(Reporting by NR Sethuraman and Editing by Robert MacMillan and Anthony Kurian)