FORTUNE – During the recession, the nation’s dollar stores suddenly became the “it” places to shop. The once frumpish retailers offering aisles upon aisles of heavily discounted products – everything from diapers to cereal to jeans – were the obvious answer for millions of jobless workers and struggling homeowners. Now as the economy improves, albeit slowly, the question is could the momentum last?
It’s easy to assume dollar stores will lose their allure. But the story behind America’s big three – Dollar General (DG), Dollar Tree (DLTR) and Family Dollar (FDO) – isn’t just a recession story. They’ve been growing over the past decade, making up a mere 0.5% of the retail market in 2000 to an impressive 1.5% today, says Craig Johnson, president of Customer Growth Partners, a Connecticut-based retail consultancy firm. And in recent years, they’ve undergone makeovers that have made them more competitive with the Wal-Marts and Targets of the world.
In essence, it’s no longer your grandma’s dollar store. Whereas years ago deep discounters were the place for cheap generic products that embarrassingly reminded shoppers they were somehow second-class consumers, many of today’s chains have stocked up on better-known brand names from Coca-Cola (KO) to Procter & Gamble (PG). Executives have also spruced up existing stores with better lighting and fresh paint. And new locations – some even popping up in higher income areas (hello San Diego!) – are being outfitted with refrigerators and freezers, offering more food items for shoppers.
Last week, Family Dollar reported higher-than-expected quarterly profits as it sold more food items at its stores. For the second quarter ended Feb. 25, the second-largest U.S. dollar-store behind Dollar General saw net profit soar to $136.4 million, or $1.15 a share. That compares with $123.2 million, or 98 cents a share, a year earlier.
“Shoppers have come to know that we can give them the brands they want,” says Kiley Rawlins, vice president of investor relations and communications at Family Dollar. By the end of its fiscal year ending in August, the chain plans to open up to 500 new stores. So far, it has opened approximately 200, bringing its total to 7,100 in 45 states.
Of course, not all dollar stores are created equal. While analysts say Family Dollar’s performance has been encouraging, the chain, where most items are $10 or less, has continued to lag behind Dollar General and Dollar Tree. Earlier this month, Dollar General reported strong profits as customers spent more. For its fiscal fourth-quarter ended Feb. 3, the Goodlettsville, TN-based discounter saw profits rise by 32% on a 20% rise in revenue. And at Dollar Tree, profits for the fourth quarter ended Jan. 28 rose more than 15%.
Together, the three chains have been nibbling at market share from a spectrum of retailers – from grocery stores to pharmacies. They’ve gained from America’s newfound frugality. But as much as the chains have stressed deeply low prices, executives have been building a business that embraces convenience in a way big-box chains really haven’t.
Dollar stores are responding to so-called “fill-in” trips — like the mid-week need to make a quick stop for more milk or pet food. The heavy discounters aren’t necessarily looking to be the primary place shoppers go to stock up for the week. They fall short of Wal-Mart (WMT) or a full-scale neighborhood grocer, and are markedly less pricey than your corner convenience store.
“As we recover we may lose some customers that were trading down but probably not by much,” says Anthony Chukumba, senior equity research analyst for BB&T Capital Markets. “I think customers are pleasantly surprised in terms of what they’re finding at these stores.”
What’s more, there are plenty of them, making it relatively quick for shoppers to access. In a November 2010 report, Credit Suisse noted that the average round trip to a dollar store is six miles, compared with 30 miles for a typical Wal-Mart trip.
To be sure, Wal-Mart has continued to overwhelmingly dominate, making up 10% of the retail market. Although the Bentonville, AR-based big-box chain makes it clear that its test openings of smaller-scale stores is in no way a response to the growth of dollar stores, the new Walmart Express stores appear to serve a similar purpose as dollar stores in the sense that they cater to fill-in trips, among other things. Fourteen stores have opened so far in Chicago, as well as parts of North Carolina and Arkansas. A spokesperson says the retailer has not made any plans for more such stores and has continued to focus on opening supercenters.
It remains to be seen how other retailers will respond. For now, dollar stores have found a niche that has positioned them to grow in good and bad times.