Dollar Tree Shows Discounters that Prices Can Still Go Lower
Eric is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Many shoppers have had the experience of walking into a big box store and spending much more than they anticipated. The attraction of dollar stores has always been their fixed prices, as a shopper can frequently find items that typically cost much more at other retailers, even retailers that are generally considered low end or discount stores. Because of this draw, Dollar Tree (NASDAQ: DLTR) has performed well during the long recession, as shoppers on fixed budgets flocked to the discount chain.
The stock price of the company has recently shown steady growth. Its price a year ago, $50.47, was almost the same as its yearly low, at $49.97, as investors eagerly purchased the stock after every dip. Now Dollar Tree shares are worth $87.82 each, as the shares cooled off slightly after Dollar Tree management made a conservative earnings estimate for 2012.
The fixed price policy does make it more difficult for Dollar Tree to deal with inflation, as it cannot simply raise the sticker price of items on the shelf like other types of discounters. Although Dollar Tree will likely have to pay more for many of the products it stocks in the future, its competitors remain vulnerable to rising costs themselves, as their customers remain very price sensitive. A significant inflation shock could convert Dollar Tree into a 2-dollar store, as the predecessors of dollar stores were five and dimes.
Dollar Tree's growth strategy revolves around food sales. The trend toward food sales reduces Dollar Tree's margins, as low cost food products frequently have very small profit margins, but the company's attractive prices in comparison to other discount retailers have produced rising sales volume. Dollar Tree has the potential to attract customers away from supermarkets, convenience stores, and other types of food vendors, along with its traditional big box and dollar store competitors. The company recently demonstrated strong fourth quarter results when it earned $188 million, significantly surpassing its 4Q 2010 earnings of $163 million.
Dollar Tree does have a higher price to earnings ratio, at 21.79, than either Family Dollar (NYSE: FDO) at 16.79 or Dollar General (NYSE: DG) at 20.73. Investors may be willing to pay more for Dollar Tree because of its 11.8 percent operating margin, which beats Family Dollar's 7.5 percent and Dollar General's 10 percent.
Dollar General is larger than its two main competitors, and its share price has also demonstrated steady growth throughout 2011, rising from $28 per share to $41.67. Even though Dollar General does sell products for more than a dollar, it does not beat the margin of Dollar Tree. Store placement may partially explain the weaker margin. Dollar General often places stores in isolated rural towns that cannot support a mall, a big box store, or another larger competitor. Although this strategy allows Dollar General to dominate the local markets, few customers can spend much money. Dollar Tree is willing to compete in city markets, and its stores often appear in malls and shopping complexes in which other retailers sell much more expensive products. Dollar Tree can attract a wealthier customer who sees a product he likes in the window with this strategy, although the company does have to pay higher rent to sell its products in a desirable location.
Family Dollar has had a relatively steady stock price over the last year while the value of its competitors rose. The stock price only rose from $50.54 to $54.33, with several wide swings. Although Family Dollar has the lowest operating margin of the three companies, it hired former CVS (NYSE: CVS) executive Michael Bloom to run the company late last year. The discount drug store chain CVS is well known for its cost efficiency, and the new CEO has not had much time to make operational changes. All three of these stocks show growth potential in 2012, especially Dollar Tree, with its high operating margin and stores in prime locations.
CVS itself shows great potential for investors. The company released its earnings results on February 8, and reported that its revenue for the fourth quarter rose 15 percent compared to the last quarter of 2010, reaching $28.3 billion. As dollar stores capture more of the market for low cost goods, CVS has increased its focus on providing pharmacy services, which has produced good results for the company. Pharmacy Services was especially strong in the last quarter of 2011, showing a 32 percent gain in revenue over the quarter last year, and the company predicted higher earnings for 2012.
Out of the three dollar stores, Dollar Tree shows the best potential. The company can maintain its core market while attracting richer impulse shoppers, and its move toward food sales should boost its revenue. Dollar General is also a buy because it successfully competes in markets in which other discount retailers can not easily expand, so it is less vulnerable to competitive pressure. Out of the three dollar stores, Family Dollar showed the weakest performance in the past, but the change in leadership should help the company, and the general economic trend favors its business model. CVS is a buy because the company has adjusted its strategy to capture a market where dollar stores do not compete, while maintaining its traditional market.
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