Treasure Hunt for a Cheap Dollar Store

By William Bias - July 13, 2012 | Tickers: DG, DLTR, FDO, FRED, WMT | 0 Comments

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While researching this article I decided to go to my local Dollar General (NYSE: DG) to do some firsthand research. Walking around the store I began to see the appeal of the dollar discount format. In the front of the store I noticed refrigerators with orange juice and milk. I also noticed grocery items to the left of the store that people could buy on the go. To me this is an item of convenience for people who are in a hurry and don’t want to drive 30 miles to the nearest Wal-Mart. I noticed a yellow cardboard bin filled with yellow envelopes labeled “Treasure Hunt!” with various and sundry DVDs sold for $3 apiece. They are not obviously labeled, so you have to go through them to find your great bargain. Interestingly I found a great old science fiction movie, Deep Impact, for only $3, but I still didn’t buy because I am a real cheapskate.

This is reminiscent of value investing. One goes through a proverbial dollar discount store, call it “Mr. Market’s Place,” that sells stocks. Over in one corner you see the “popular items” such as Amazon.com, Facebook, and Chipotle Mexican Grill selling for expensive prices. Over in the middle aisle you see all the fairly valued companies such as Hershey’s and Yum! Brands.

Mr. Market, who owns this store, is crazy. Sometimes he takes a notion to mark down the good stuff and mark up the bad stuff. On rare occasions he decides to mark down everything. Other times everything is expensive. So finding something good at a cheap price can be tricky and the opportunities could vary day by day. Today I am in the market for bargain-priced shares of a dollar discount chain.

Overview of the Industry

The industry is diversifying and beautifying. Fred’s (NASDAQ: FRED) has been building and buying pharmacies. Dollar General has been multiplying like dandelions and has a new look for its stores. Dollar General, Dollar Tree (NASDAQ: DLTR), and Family Dollar (NYSE: FDO) have been expanding beyond dry good merchandise and are selling convenience foods such as milk, bread and orange juice. Dollar Tree is building larger stores and remodeling old ones to make them bigger to accommodate the new offerings. Which of these companies stands apart and how expensive are these companies?

*Source-Yahoo Finance; **Estimated

Oddly enough it looks like the most expensive of the Dollar Discount items are in the fully priced aisle. So let’s take a look at the labeling to see if any of these companies would be a good buy if Mr. Market decides to go crazy and mark these companies down.

Fred’s looks like it has the lowest p/e ratio at 16.16; however, it doesn’t appear to be a bargain. The return on equity is only 8% and the free cash flow has experienced a per annum decline of 32%. Family Dollar has also experienced negative growth in its free cash flow (-30%). Dollar General has experienced decent growth in its free cash flow (12%) but has a total debt to equity ratio (113%) above my personal threshold of 85%. Its cash to stockholder’s equity position is only 3%. The only company that meets most of my fundamentals criteria is Dollar Tree. Its total declining debt to equity ratio (66%) is below 85% and it has plenty of cash on its balance sheet. I was impressed by the fact that the president and CEO of Dollar Tree was bragging about buying back stock without going into debt. It is difficult to find a company that is focused on keeping its balance sheet conservative.

Weighing the Risks

Obviously these companies bear a great deal of market price risk. The company with the least fundamental risk is Dollar Tree. Fred’s is experiencing difficulty in its pharmaceutical division due to generics pricing, as well as a steep decline in its cash in its most recent quarter. The political risks to these companies are almost nonexistent because all of their operations are confined to North America (Dollar Tree has 99 stores in Canada). Management of these companies seems to behave well especially Dollar Tree, which is reflected in their respect for cash. I guess the CEO decided that the term “Dollar Tree” should be literal. Today (07/09/12) some analysts downgraded the stock and it is down 2.38% for the day because they “have no room to grow.” Maybe the company could very well become cheaper over the next few months.

Competition and Wal-Mart Express on the Horizon

Dollar Tree seems to have a competitive advantage over the other stores in that they locate in areas near an anchor store. Family Dollar and Dollar General tend to locate on main streets or out in some rural field by itself where foot traffic can be smaller. There is less competition in these areas but there are also fewer people as well. If a customer decides the anchor store is too crowded or they want to find a bargain that they weren’t able to find in the anchor store they can go to Dollar Tree.

Of course looking into the past is 20/20 hindsight. An investor’s gain is going to come from the future. Wal-Mart has opened 10 stores called “Wal-Mart Express” that are 12 to 15 thousand square feet, which is roughly the size of the new Dollar Trees being built. Some of these small Wal-Mart stores are going to have pharmacies and gas stations. The question for Dollar Tree is what is going to happen when the anchor store that drives their foot traffic becomes a direct competitor? Some Dollar Trees are located near a Wal-Mart. Will this create conflicts that are detrimental to shareholder interests?

Final Words - Leaving the Treasure Hunt Empty Handed

Given the right price Dollar Tree can still be a good investment despite the Wal-Mart threat. I plan to keep an eye on Wal-Mart Express to see what happens in comparison to Dollar Tree. The p/e ratio of Dollar Tree (25.14) will have to decline a great deal further before I will consider buying it. I guess I am leaving Mr. Market’s store empty handed.

Bibliography:

• Dollar Tree 2011 Annual Report
• Fred’s Report June Sales
• Wal-Mart Said It Plans to Roll Out More Smaller Stores
• Dollar Tree’s Big Run Could End, Says Analyst

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