Dollar Tree: Betting On Underemployment

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 |  About: Dollar Tree, Inc. (DLTR), Includes: DG
by: Intangible Valuation

One of the chief characteristics of Costco (NASDAQ:COST) is that its membership structure specifically singles out affluent individuals whom likely have better credit histories and are more likely to spend large amounts on each store transaction. That is to say, Costco -- unlike Walmart (NYSE:WMT) -- markets itself to affluent customers, who, as it turns out, have an average annual income of $96,000 a year [1]. Contrast Costco's membership model with that of a dollar store: the average ticket at Dollar General (NYSE:DG) is $10.89. At Dollar Tree (NASDAQ:DLTR), the current business under our spotlight, it is only $7.99. We will return to this notion of transaction size again towards the end.

(I've written about Costco here, Wal-Mart here, and Dollar General here.)

Dollar Tree Stock

Dollar Tree's stock price has steadily increased over the past few years -- that is, except for the last few months. For those anchored at higher prices, this paints itself as an opportunity:

DLTR Chart

DLTR data by YCharts

Let us evaluate Dollar Tree.

ROE

Dollar Tree's ROE appears as if it is "taking off." Unfortunately, since it is a return metric calculated by dividing GAAP net income by GAAP equity, it would be ridiculous to think such a trend in the percentage return was likely to continue indefinitely. Yet it is a beautiful chart, showing off ROEs greater than 20% since 2008 and increasing each year with the most recent having a ROE 39.5%:

DLTR Return on Equity Chart

DLTR Return on Equity data by YCharts

Earnings Per Share

So ROE has been increasing -- that means that in the net income over equity calculation (i.e., ROE) either: (1) net income is growing relative to equity, or (2) equity is decreasing relative to earnings.

So we can say that earnings are increasing? Yes. Is equity decreasing too? Yes -- due to share buybacks. Take a look at the falling shares outstanding trend:

DLTR Shares Outstanding Chart

DLTR Shares Outstanding data by YCharts

Very nice, share buy backs have decreased the share count by nearly 40% over the past four years. Not bad -- well what about earnings?

DLTR Net Income TTM Chart

DLTR Net Income TTM data by YCharts

Desirable trends, no doubt. As with the ROE question, since earnings are increasing and shares are decreasing, this should greatly effect the earnings per share calculation. Check it out:

DLTR EPS Diluted TTM Chart

DLTR EPS Diluted TTM data by YCharts

With a current share price of $41.74, Dollar tree currently has a TTM PE ratio of 16.8. How does that compare with its historical PE ratios? See below:

DLTR PE Ratio TTM Chart

DLTR PE Ratio TTM data by YCharts

Not bad compared to the glamour and clamor which investors put on the stock through 2011. Therefore, relative to recent history and historic growth the stock is not necessarily overpriced.

Operations

One way of measuring the company's utilization of capital is the return on invested capital calculation. And one way of increasing your return on invested capital is to simply operate the business with as little capital as possible.

In the case of a big player like Costco, they literally don't pay cash (so to speak) for inventory; instead they keep inventory turnover so high (or the number of days which pass on average while the purchased inventory is on the shelf so low) that their accounts payable balance does not need to be paid until well after the product is sold -- which is to say that Costco thereby earns a better return on capital because no capital is actually required to procure their inventory (genius).

Ok, how is Dollar Tree doing on the days inventory outstanding metric?

DLTR Days Inventory Outstanding Chart

DLTR Days Inventory Outstanding data by YCharts

Not as well as Dollar General (or the others) which has an average days inventory outstanding figure of about 70. But as one can see the trend is generally downward which means two possible things (or a blend of the two): (1) management has been managing inventory better, and/or (2) the environment for businesses like Dollar Tree is a positive one and therefore increases in sales have allowed this measurement to fall overtime.

Let us weight option number #2, the macro situation. First we need to ask ourselves a question: Why does someone shop at a dollar store? It is not because things are "cheaper" in the sense of "unit of measure per dollar" (because in which case a shopper would go to Wal-Mart, if they cannot afford to shop at Costco). Further, it is not to get the most bang for your buck. It is rather because shoppers have cash flow limitations, so they are shopping there for the smaller packaged good (which are conveniently priced in $1 dollar packages).

Dollar store customers are basically paying for convenience and small package sizes. Gross margins are, for retail, normally the sales price less the inventory cost (sometimes inclusive of rent or depreciation) -- and, therefore, the gross margin of a retailer can serve as a proxy for the level of mark up. Notice the higher mark up achieved by the dollar stores:

DLTR Gross Profit Margin Quarterly Chart

DLTR Gross Profit Margin Quarterly data by YCharts

So Dollar Tree and Dollar General work because a significant portion of our population is willing to pay higher prices on goods (as measured by gross profit) for the convenience of the small packaging. Which is to say that many people have cash flow problems, otherwise they wouldn't mind buying in bulk (but alas bulk requires excess cash flow).

This narrowing of discretionary expenditure would most likely be one result of the current levels of underemployment:

(Source: Gallup, located here, accessed 2012-12-1)

A similar "underemployment" statistic is measured by the Federal Government in the U6 unemployment rate:

US U-6 Unemployment Rate (Unadjusted) Chart

US U-6 Unemployment Rate (Unadjusted) data by YCharts

We can see that we are still far above average when it comes to the historic levels of underemployment (of which U6 is an attempt at describing). This is to say that I believe the macro environment for Dollar Tree and Dollar General is favorable to their business model.

Take that, and the coming generation of young adults who are condemned to spend most of their discretionary expenditure paying off student debt, and you have a future world in which a significant number of individuals who have to watch their cash flow like a hawk -- or that would be the theory anyways. The point is, that while things are "improving" by some statistical measures, it doesn't look like the economy is taking off -- which in the strictest sense would not necessarily be good for Dollar Stores since they offer consumers worse fundamentals than, say, a Wal-Mart.

Comment on Strategy

Of the many things going on, perhaps one of the better ideas is the installation of freezers and coolers in Dollar Tree stores (currently 54.8% of stores). This will, invariably, increase the amount of capital needed in each store, but the incremental customer shopping which I believe will result from such a plan is worth the extra capital expenditure. The greater the quantity of "consumable goods" which are sold, the better for predictability -- since consumable goods are consumed overtime and therefore need to be repurchased (presumably at Dollar Tree).

Another point of interest is that Dollar Tree is expanding its ability to collect food stamps through the Supplemental Nutrition Assistance Program. As of the most recent quarter, there were 4,150 (92% of all operating stores) qualified stores under the program, in improvement over the 3,500 qualified stores at the end of 2010.

Competition And Valuation

Let us quickly survey the geographic scope of Dollar Tree and Dollar General with Google Maps [2]. Dollar General locations are shown in the map below. Notice, for instance, the lack of a strong presence in California (DG only has 5 locations there):

(Source: Google Maps, accessed 2012-11-30)

Compare that with Dollar Tree locations (it has 363 stores in California):

(Source: Google Maps, accessed 2012-11-30)

If you notice from the underemployment map above, California has "Above average" underemployment -- perhaps the is a macro perk or Dollar Tree.

Dollar General, also, has twice the number of store: 10,203 DG stores verse 4,501 DLTR stores. Dollar Tree, however, believes it can operate 7,000 stores and will therefore continue to grow store count.

Let us compare the two on a valuation basis. In terms of free-cash-flow [3] yield, Dollar Tree is more attractively priced:

DLTR Free Cash Flow Yield Chart

DLTR Free Cash Flow Yield data by YCharts

Both companies have growth priced into them -- but Dollar General has it to a greater extent. Therefore, from an earnings stand point, an investment in Dollar Tree would be safer because the valuations are better.

But at the same time, we must recognize that Dollar General has a brand image that Dollar Tree lacks. According to Interbrand, Dollar General has the 14th most valuable retail brand while Dollar Tree has the 31st most valuable retail brand. Further, it is possible that Dollar General could get, on average, a more affluent customer. For instance, Dollar General's average sales per sq. ft. is $213, verses Dollar Tree's $182 average sales per sq. ft. -- not to mention that Dollar General has a higher average transaction size (as noted in the opening paragraph).

Even if my speculations about brand and customer base are true, Dollar Tree has still managed its assets better than Dollar General -- specifically when viewed from return on assets:

DLTR Return on Assets Chart

DLTR Return on Assets data by YCharts

A better return on assets, all while operating with less leverage:

DLTR Debt to Equity Ratio Chart

DLTR Debt to Equity Ratio data by YCharts

And when we compare the two company's growth history, it doesn't necessarily imply that Dollar General deserves its current premium to Dollar Tree:

DLTR EPS Diluted Quarterly YoY Growth Chart

DLTR EPS Diluted Quarterly YoY Growth data by YCharts

Therefore, Dollar Tree is the better value of the two -- however, I think there are yet better opportunities within the broader market.

Conclusion

Dollar store hype is still around even though the multiples have come down significantly. Dollar Tree is the better value -- yet it lacks the stronger brand of Dollar General. For a long-term investor, the fact that Dollar Tree returns more cash relative to the current price than Dollar General is a solid basis for judgment between the two operations [4].

Notes:

  1. According to the Washington Post, see here.
  2. Using Google Maps to approximate location is problematic. However, I believe that Google uses accurate sampling techniques to correctly communicate the geographic dispersal of store locations.
  3. Free-Cash-Flow = FCF = Operating Cash Flow - Capital Expenditures
  4. Dollar Tree FCF yield = $391.2 million / (227,206,335 * $41.74) = 4.12%; Dollar General FCF Yeild = $425.79 million / (333,695,858 * $50.00) = 2.55%.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.