This Dollar Store Will Continue to Outperform

Piyush is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

History has shown that during austerity drives, companies that help in cutting costs are the ones that benefit the most. So it doesn’t take a rocket scientist to figure out why the shares of most discounted variety stores have outperformed over the last couple of years. And since the unemployment rate is still high, while the inflation rate is below 2%, these retail chains will most likely continue their stellar run. But if we talk specifically, I believe that Dollar Tree Stores (NASDAQ: DLTR) has the potential to outperform its rivals.

Small size

To begin with, Dollar Tree operates around 4,700 stores, while its peers, Dollar General (NYSE: DG) and Family Dollar Stores (NYSE: FDO)operate more than 10,700 and 7,100 stores, respectively. Naturally, having a huge network of operating locations adds stability to a business and ensures its steady growth. But Dollar Tree’s significantly smaller size allows it to grow at a relatively faster rate. This is one of the reasons why shares of Dollar Tree have risen by 220% over the last three years, outperforming the returns of its aforementioned peers.

But in order to enjoy a profitable ride, store chains need geographical diversity. Having more stores is always great, but “business expansion 101” says that stores need to be distant from each other to avoid saturation. And to do that, Dollar General operates in 40 states, while Family Dollar is present in 44 states. But Dollar Tree comes out ahead with its presence in 48 different states. This makes it much less saturated and leaves plenty of headroom to expand.

Aggressive expansion strategy

Talking about expansion plans for FY 2013, Dollar Tree plans to open 340 new stores, while Dollar General and Family Dollar plan to debut 500 and 637 locations, respectively. Based on just the numbers, Dollar Tree’s expansion count appears lackluster as compared to its peers. But on a percentage basis, Dollar Tree plans to increase its store count by nearly 7.2%, which is greater than Dollar General and Family Dollar’s planned increments of 5.9% and 7%, respectively.

Understandably, opening new stores doesn’t necessarily translate into greater revenue. But it's worth noting that Dollar Tree enjoys a hefty return on investment (ROI) of 28.9%, while Dollar General and Family Dollar operate with an ROI of 19.5% and 24%, respectively. So if Dollar Tree can sustain its high ROI, it will most likely generate more returns as compared to its peers. But why does Dollar Tree have a higher ROI?

According to a report by Morgan Stanley, 27% of Dollar Tree stores are within one mile from Dollar General stores, while nearly 60% of its stores are within three miles of Dollar General stores. This indicates that instead of venturing into new areas, Dollar Tree is opening new stores near existing retailers to disrupt brand loyalty. Since the mentioned discounted-store chains have similar offerings, consumers often indulge in cross shopping. This way, Dollar Tree develops a consumer base fast, which eventually translates into better ROI and shorter payback periods for its stores.

Clean balance sheet

Apart from that, Dollar Tree also sports better financials. Despite its aggressive expansions, the store chain operates with a debt/equity ratio of just 16%. On the other hand, Family Dollar and Dollar General operate with relatively higher debt/equity ratios of 48% and 55%, respectively. This keeps Dollar Tree’s quarterly interest expenses to as low as $400,000, allowing it to utilize most of its cash inflows for expansion projects

Additionally, Dollar Tree has a relatively better current ratio of 2.2x. For a rapidly expanding company, it's important to monitor this liquidity metric as it measures the company’s ability to meet its short-term liabilities. And finally, Dollar Tree enjoys a hefty net margin of 8.4%, as compared to Dollar General’s 5.9% and Family Dollar’s 4.1%, which highlights more efficient and profitable operations.

After monitoring these three metrics, I believe that Dollar Tree is in a financially better position than its peers. And as of now, analysts estimate the annual EPS of Dollar General, Dollar Tree and Family Dollar to grow by 15.2%, 18.3% and 11.3% for the next five years, respectively.

Final words

Although Dollar Tree is growing at a rapid rate, a major threat comes from the saturation of stores. The company is opening stores near existing ones, which ensures a short payback period but doesn’t offer much headroom for comparable- sales growth. But as long as the store chain is focused on store expansions, I believe that it can enjoy a stellar run.

Its comparable sales during the recent quarter stood at 2.1%, while most of its growth came from new stores. And if this trend continues, Dollar Tree will most likely outperform its peers for at least another year.

Piyush Arora has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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