Extreme value stores: Occupy the poor

Author: Rocco Huang

Covestor model: Tortoise and the Hare

Disclosure: Long DG, CL, K

This is the second in a series on how businesses can prosper in a stagnating economy. You may also be interested in reading Entertainment Stocks: Selling Dreams to the Have-Nots in the same series.

The consumer retail business is all about getting people to part with their money willingly and happily. One of the highest achievements in this trade is to convince someone to walk away with your over-priced product believing that he’s scored a bargain.

In recent years, partly helped by the poor economy, extreme value retail stores such as Dollar General (DG) and Family Dollar (FDO) have steadily taken market share away from Wal-Mart (WMT).

How do they manage to occupy the hearts, minds, and wallets of the poor?

Some say it’s due to offering lower prices than Wal-Mart. However, one can learn from these companies’ financial statements that the gross profit margins of extreme value stores are typically 5 to 10 percentage points higher than Wal-Mart’s. Why would anyone willingly purchase higher-priced products? Why don’t they go to Wal-Mart stores instead?

Well, contrary to common perception, the extreme value stores’ main selling point is not lower prices, but lower price points. What’s the difference between “price” and “price point”? A 3-oz bottle of Procter & Gamble shampoo for $3 is a low price point, but a high price ($1/oz). A larger 14-oz bottle of the same brand for $10 is a high price point, but a relatively low price ($0.71/oz). P&G (and anyone selling its products) certainly is extracting a higher gross profit margin from the smaller 3-oz bottles, but some consumers prefer them.

You can observe that the most popular package sizes are typically smaller in Dollar General or Family Dollar than in Wal-Mart or Costco. What kind of customer is Dollar General trying to appeal to by offering smaller package sizes and thus “lower price points”?

If you are someone living from paycheck to paycheck, and probably a frequent user of payday loans, then I imagine you have something like twenty dollars in your pocket at the end of a work day, and your pantry at home is almost empty most of the time.

You are not likely to go to Wal-Mart to stock up a whole week of groceries. You don’t have enough money in hand, and it is probably not worth the gas to drive there every day to spend $10.

Instead, you walk into a neighborhood Dollar General to get what you need for today.  You pick up a small tube of toothpaste. One dollar. Sound cheap? Not really. You could have saved money buying a larger tube, five times the volume, for three dollars from Wal-Mart. But you go for the smaller tube. You are attracted to the low price point, not the low price.

Dollar General generates more profit from this sale, yet you still feel that you walk away with a bargain. That’s not surprising to me, knowing that last week you took out a payday loan at an annualized interest rate of well above 300% 250%.  You say, “What? 300%? 250%? I took out a one-week loan of $200, and the interest was just $5.”  Unfortunately, you are not good in math.

You are a perfect customer for extreme value stores: cash constrained, not knowledgeable in financial planning, not good in math, not disciplined enough. More and more people fall into this category in this poor economy.

This product pricing strategy has a long history in poor nations. Global consumer packaged goods companies such as P&G sell single-use shampoo packets in India because many local consumers can’t afford to use shampoo every day, or don’t have the cash in hand to stock up a large bottle.

The unit price for a single-use packet is low, but the profit margin is much higher than a large bottle.

Such a strategy, originally designed for poor nations, is coming back home to the United States, because technically we have been converging toward third world income and living standards for awhile now.

In selecting investment targets, I have always favored businesses that sell small-ticket items. Very often they have much higher profit margins and more stable sales. This business model is actually more sustainable than Apple selling over-priced iPads. They can rip off an Apple fanboy only once a year when a new model comes out, but someone is coming to Dollar General every day, emptying his pockets.

How many of you actually pay attention to the price tags of Colgate (CL) toothpaste? Not many. It is a small amount anyway, and it’s not like we are emptying one tube a day. The same applies to Kellogg (K) and H.J. Heinz (HNZ) products. How often do you check the price tag of a bottle of ketchup or a box of breakfast cereal? Probably less frequently than your kids checking for small toys inside the cereal boxes. And certainly less frequently than when you are buying a new flat screen TV. The same absent-minded consumer usually becomes so much more sophisticated, focused, and rational when shopping for larger ticket items. Good for them. Bad for Sony and Samsung.

Yes, buying a jumble-size bottle of shampoo from Costco can save us money in the long-term. Yes, the costs of breakfast cereal may add up to a significant amount over time. But an average consumer typically doesn’t think so far ahead when it comes to small-ticket, low-price-point items. Bad for them,  good for Dollar General, and good for brand-name toothpaste or breakfast cereal companies.

Let me end with an anecdote from FMyLife.com, to illustrate that we should never overestimate the intelligence of consumers:

Today, I bought a bohe box, looking for the small toy. It wasn’t in there. I don’t know what is more sad, the fact that I got ripped off by a children’s cereal or that I’m 21 and upset by it. FML