(Fortune Magazine) -- Since losing her job at a local auto dealership last month, Ana Foley, 37, is buying less, which is bad news for stores like Macy's and J.C. Penney. But that doesn't mean she has stopped shopping. On a recent afternoon, she browsed the racks at a Family Dollar store in Peekskill, N.Y., and bought a brown tank top with decorative shirring. The price: $4. "A top like this," she says, "would have cost triple at Macy's."
Another Family Dollar (FDO, Fortune 500) shopper, Maggie Cruz, went on a little spree. At first the 46-year-old teacher agonized over whether to buy an animal-print top. "I should really wait until I get my paycheck," Cruz said. But she ended up buying three tops, at $9 apiece. "If I wait until Friday," she explained, "they'll all be gone."
Like Foley and Cruz, lots of customers are trading down these days, and that's a boon for Family Dollar. With 6,600 stores and nearly $7 billion in sales, Family Dollar is one of several thriving rival chains of "dollar stores," which offer most items for $10 or less. Dollar General is the largest among them, followed by Family Dollar and Dollar Tree (DLTR). (They're based in Tennessee, North Carolina, and Virginia, respectively.)
While most other retailers are taking a box cutter to earnings estimates, the dollar stores have been star performers. Family Dollar, which reported a 6.4% jump in second-quarter sales at stores open more than a year, has been on a stock market tear as well. Shares are up 28% so far this year and rose 36% in 2008, making it a top performer among the Fortune 500.
Back when Leon Levine opened his first Family Dollar in 1959, America was still a manufacturing powerhouse and Levine, whose parents owned a department store in Rockingham, N.C., started selling closeouts from nearby apparel factories. All items were priced under $2. Leon's son, Howard, often helped out at the store after school and accompanied his hard-driving father on field trips to scout new real estate. "It was the only way I was able to spend time with him," Levine says.
After graduating from the University of North Carolina, Howard joined Family Dollar as a trainee, left for several years to explore the outside business world, then returned to the family company. He was named CEO in 1998 (his father retired as chairman in 2003). "Once retailing gets in your blood," he says, "it's hard to get it out."
No longer a closeout shop - factory overruns account for just 2% of today's sales - Family Dollar now carries many of the name-brand products found in supermarkets, including Tide, Colgate, and Clorox. What hasn't changed are the low prices. Analysts estimate that Family Dollar's prices are 20% to 40% cheaper than those found in traditional supermarkets and roughly on par with big-box discounters like Wal-Mart (WMT, Fortune 500) and Target (TGT, Fortune 500) (industry analysts call the dollar stores "small-box discounters").
While other retailers have courted a more upscale clientele by adding fine jewelry and designer clothes, Family Dollar has stayed true to its roots. A typical shopper earns just $35,000 a year. Says Levine: "We want our customers to know they can afford anything in our stores."
How does Family Dollar do it? By selling a greater amount of second- and third-tier brands, which cost less and possess greater margins than do first-tier brands - more Gain laundry detergent than Tide, for instance - and by cherry-picking inexpensive real estate in unglamorous locations. At $2 a square foot, Family Dollar's occupancy costs are a tenth of what a typical supermarket or drugstore pays, and 1/50th the cost of a mainline department store, estimates Burt Flickinger III, managing director of the Strategic Resource Group.
While all the dollar stores operate on a similar model, Family Dollar is benefiting from a five-year overhaul. When Dorlisa Flur, executive vice president of strategy and marketing, joined Family Dollar in 2004, the company didn't even conduct its own customer research, which the former McKinsey partner soon initiated. She found that customers spent about $10 a shopping trip at Family Dollar stores, an amount that didn't vary much whether they shopped once a week or once a month.
To boost sales, Family Dollar needed to increase the frequency of shopping trips. The answer came in the form of milk, eggs, frozen pizza, and other food. "We wanted to be the place people went for their 'ran-out-of' trip," Flur says, as in "ran out of milk" or "ran out of eggs." As leader of the drive to install refrigerators, Flur earned the nickname "the Cooler Queen." The addition of food - Vienna sausage is a bestseller - is a big driver behind the company's growth.
At the same time Family Dollar was changing its product mix, it had a bigger problem. Many of its stores were old and cluttered. Part of the allure of the original locations was their treasure-hunt feel, with piles of merchandise to wade through, but that was losing its appeal for today's shoppers. So the company trimmed inventory by 10%, remodeled stores, and created a more logical layout.
Another change has been the addition of technology that has enabled the stores to accept food stamps and other payment methods. "All the changes are coming at an opportune time," says Craig Johnson, president of Customer Growth Partners, a consulting firm. "With the economy in a ditch, Family Dollar is in a sweet spot."
These changes aren't risk-free. Some analysts fret that Family Dollar's profits could take a hit from the lower-margin food items. And because of its opportunistic buying, Family Dollar stores might carry Green Giant canned corn one week and Libby's the next - an inconsistency that doesn't sit well with food shoppers. Omega Patterson, a 68-year-old retired seamstress who was browsing the aisles of a local Family Dollar recently, groused that the store didn't have the type of Dole's Mixed Fruit Cups that she likes. "They only have the cherry flavor," she said, deciding to pass.
Looming on the horizon for every retailer is the long shadow of Wal-Mart. Levine says Family Dollar, whose stores are much smaller than its big-box competitors - you can fit about 22 of them in a typical Wal-Mart supercenter - stays out of direct competition by offering more convenience. "You can park in front of our stores and get in and out very quickly," Levine says.
And what happens when the recession ends and shoppers start trading up again? Levine says he's not worried. "History has shown we do well in good times and bad." To keep the customers rolling in, Family Dollar is beefing up its food offerings yet again. Soon the company plans to introduce 250 new edible items, including Triscuits and Double Stuf Oreos, in the hope of giving those Vienna sausages a run for their money.