This Stock Promises Quality Growth

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

Dollar Stores´ stocks have performed well over the last few years, attracting investors’ and analysts’ attention. Many have singled out Dollar Tree (NASDAQ: DLTR) as the wisest investment choice in the sector. Nevertheless, as fundamental analysis (and Warren Buffett) taught us, every relevant feature of a company should be assessed before putting our money down. In order to do this, we will examine the main Strengths, Weaknesses, Opportunities, and Threats (SWOT Analysis) to take into account before investing in Dollar Tree.

Strengths

  • Top Management team: Dollar Tree´s management is a key factor to consider when about to invest. The company´s main executives, Bob Strasser (president CEO), Gary Philbin (COO), Kevin Wampler (CFO), and Robert Rudman (CMO), have shown outstanding administration skills in the past (improving sales at a CAGR of 12% between 2007 and 2011, and an EBITDA CAGR of 24%, as well as an EPS CAGR of 30% over the same period) and are quite likely to keep on delivering in the future.

  • Inmune to Wal-Mart´s potential entry: While other Dollar Store corporations watch Wal-Mart’s advance in fear, Dollar Tree seems to be used to the competition already. Although it presents the highest Wal-Mart overlap in the segment (75%, against the 45% average of its main competitors), it provides the highest operating (EBIT) margin of 12% in the sector, against Family Dollar’s (NYSE: FDO) 7.6% and Dollar General’s (NYSE: DG) 10.3%. This fact leads us to believe that Dollar Tree is more immune to Wal-Mart´s strong “price comparison” campaign and its incursion in the small box format, principally because of its highly differential $1 price point.
  • Differentiated model: Dollar Tree’s remarkably differential retail model combines the comfort of small box format shops like drugstores and supermarkets with the low prices offered by large (but uncomfortable) discounters like Wal-Mart. This has been of great relevance to its 62% growth over the past two years and its projected growth rate of 23% for 2013 and 2014. The main difference with other Dollar Stores is their $1 price point, which has no equal in the sector, and proves to be particularly successful in seasonal product sales. This differentiation, combined with a broad customer base (they target most of the middle class, with a higher personal disposable income than their competitors´ low income mix) create a promising outlook for the company.   

Weaknesses

  • Payroll Tax impact: The impact of Social Security payroll tax cuts implemented in January 2011 had been remarkable for Dollar Tree. However, policy analysts assure that this stimulus is bound to be retired or reduced during 2013. If this is the case, Dollar Tree seems to be the most susceptible to the tax increases. The estimated impact of this retreat over sales could reach an estimate of 3%-4% (while competitors only face a 2%-3% reduction), and a negative effect over EPS is also expected to the tune of 7-9% (while Dollar General faces 4%-7% and Family Dollar 4%-9%).
  • Correlation with inflation risks: Inflation (especially in gas prices, which seem to be highly correlated with comparable store sales) is another matter of concern. Although management has shown to be quite effective at coping with price rises in the past, the aforementioned fixed price point considerably limits their flexibility, since it prevents them from transferring these cost increments to the public.

Opportunities

  • Strong balance sheet provides increased flexibility: The company’s leverage ratio is considerably lower than the sector’s average, while the free cash flow is higher than the segment’s mean. These conditions allow Dollar Tree to repurchase stock, generating increases in the EPS. Expert calculations reveal that every $100 million worth of shares that are repurchased by the firm, EPS should increase by $0.02 (assuming a five year-term debt is taken to fund these repurchases). Dollar Tree bought back $600 million worth of stock in 2011, $340.2 million during 2012, and plans to continue repurchasing some of the remaining $859.8 million during 2013.
  • Potential new stores: New store growth opportunities are immense for Dollar Tree. The company possesses under 5,000 stores, less than half as compared to Dollar General and about 3,000 less than Family Dollar. Besides that, the company has not yet penetrated some of the key U.S. markets, such as the Northeast and the Western regions. Given these conditions, the current 7% square footage annual growth looks pretty sustainable as development prospects multiply.

Threats

  • Margins could decrease from record levels: Since Dollar Tree has the highest operating margin in the segment (with 12.4% in 2012, against Dollar General’s 10.39% and Family Dollar’s 7.37%) and a fixed price point of $1, room for improving store operations or merchandising effectiveness is quite limited. Consequently, growth opportunity is limited to expanding sales productivity and comps, unless the $1 price point is modified. If this was not the case, both operating and gross margins seem to be structurally capped for now.
  • Success has been priced in: Given the fact that many stockholders already know that Dollar Tree provides a safe and attractive investment, the promising outlook might already be priced in. This could mean that the expected 17% stock price growth expected for 2013 might not be attained. On the other hand, competing company Family Dollar is expected to be up 18% within the next twelve months, establishing it as this year's top pick as it provides significant income upside (due to its $2/share performance gap with Dollar General and an aggressive organic store growth campaign), but an unstable management has stopped these growth prospects from being already priced-in.

Peer comparison

Let´s check how Dollar Tree stacks up against its peers:


Dollar General trades at a P/E of 17.9x in comparison to Dollar Tree´s 17.55x. Credit Suisse expects solid comparable growth in the 4%-5% range, but the upper level seems more difficult to achieve given that the company´s internal productivity initiatives look to be entering their later innings.  MKM Partners noted that sales slowed a bit, though strong execution, store standards, and operational initiatives are driving high-quality sales and earnings growth. While Dollar General is a superb company, I prefer Dollar Tree.

Family Dollar trades at a P/E of 16.75x, much lower than Dollar General. Family Dollar recently reported projected earnings between $3.73 and $3.93 a share, much lower than the average analyst estimate of $3.96. Family Dollar is accelerating new store growth (from 1.3% in 2009 to 6% in 2012) and relying more heavily on Consumables to drive existing stores. Bolstered by a new management team with critical small box experience, Family Dollar has recently accelerated multiple initiatives that should result in an upward revision in the stock multiple.

Conclusion

Stock price appreciation, several growth prospects, immunity to some of the sector´s main problems, and a good management (with a great track record) compose a luring context to invest in Dollar Tree. However, although all these factors suggest that the company will keep on evolving in the near future, the aforementioned risks and threats should not be disregarded.


Victor Selva 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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