Dollar Tree (DLTR) is a leading discount store operator, selling merchandise at $1, which greatly differentiates itself from competitors. The key brands are Dollar Tree and Deal$ in the US and Dollar Giant in Canada. The investment thesis is outlined below.
Positives of the company:
1. Proven track record and highly profitable business.
Earnings speak of the track record. Revenue grew by a strong 12% CAGR for the past five years while earnings grew even faster at 26% CAGR. Few companies grew at such pace.
The profitability of the business is superb. Return on equity and return on invested capital average around 35%-40%, meaning for every one dollar invested by the company will yield 35%-40% return.
2. A hedge to weak economy.
The US economy is recovering with the housing sector and oil & gas sector. However, as we are in middle of the multi-year deleveraging cycle, the overall economy growth will be soft for some years to come. Trade down trend will continue to benefit the discount store sector for many years.
3. A long runway for store expansion.
The store count of Dollar Tree is 4,671 stores, many times smaller than the 10,557 stores, operated by the largest competitor, Dollar General (DG) and the 7,442 stores, operated by Family Dollar (FDO). In average, Dollar Tree is expanding its store count by 7% per annum.
Store count is rising 7% per annum.
Total no. stores
4. Rising operating margin via operating leverage.
From the gross margin perspective, retailing business is inherently unattractive but the ultimate strength of retailing is scalability, economies of scale and operating leverage. A retailer with good merchandising skill will manage to raise inventory turn and sales per store. This means at the fixed cost of rental and employee expense, the sales and gross profit will continue to rise, multiplying the operating margin expansion, as shown by Dollar Tree.
Sales per store rising every year.
Sales per store
Gross margin is stable while operating margin is rising every year.
Negatives of the company:
1. Slowing comp in near term.
Comparable store sales growth slowed down in the recent quarters from 5.6% in 1Q2012 to 2.3% in 4Q2012, roughly in line with the retailing sector. The slow down will continue in the 1H2013 due to high base of 1H2012. However, we look beyond this short-term slightly weaker earnings growth as the underlying thesis of weak economy holds.
Comparable store sales are slowing down.
2. Pressure at gross margin.
Dollar Tree has been raising the revenue contribution from Consumable category from 49.5% three years ago to currently 51.4%. The percentage of stores equipped with freezers and coolers is rising from 44.9% three years ago to currently 54.6%. Consumable carries a lower gross margin but attracts higher traffic. The net effect has been and is expected to be positive. Gross margin will be flat to slightly declining but ultimately, operating margin will still expands via operating leverage. Overall, it is a comfort that the management has been great and is conscious in maintaining gross margin; tobacco items carry lower gross margin hence Dollar Tree is refraining from selling tobacco items though it is done by the peers.
Consumable contribution to revenue is rising.
The number of stores with freezers and coolers is rising.
No. stores with freezers and coolers
As % total stores
3. Limitation of fixed selling price.
One dollar selling price per item is an inherent disadvantage to gross margin control, but it does exhibit the merchandising skill in maintaining 35.9% over the past three years. The good news is the company is expanding another store format, Deal$, which does not carry selling price ceiling and will eliminate this limitation.
Comparison with peers:
Dollar Tree scores better relative to peers in all metrics. First, in terms of inventory days, the holy grail of retailing metrics, Dollar Tree turns the inventory 3-7 days faster than the peers. As a result, sales per store are stronger.
Gross margin is higher because Dollar Tree sources more imports and sells less Consumables. Fixed cost as a percentage revenue is higher than Dollar General because of lower revenue base and higher rental expense for better locations. Imagine the room for margin improvement and operating leverage when Dollar Tree grows as large as Dollar General.
Lastly, only Dollar Tree is in net cash position. Overall, Dollar Tree is better managed than Dollar General and far better than Family Dollar, which explains the premium valuation warranted by Dollar Tree.
Dollar Tree scored better versus Dollar General and Family Dollar across all key metrics.
The low end of expected earnings growth is 5%, driven by 7% increase store count and comparable store sales growth of 5%. The high end of expectation is 10%, assuming margin expansion due to operating leverage. After 2% decrease in number of shares outstanding from share buyback, the low end and high end of expected EPS growths are 7% and 12%, respectively.
Pegging 22x PE for 2013 for the high end EPS, the upside target price is USD60. The downside target price is USD42, which is derived from 15x PE for the low end EPS. At current share price of USD47, PE is 17.3x for 2013 at high end of earnings growth. The upside is 27% versus 10% downside. The upside/downside ratio of 2.7x is very favorable; as always, downside is taken care of before hoping for the upside.
Note that the high end 10% earnings growth is conservative. Another upside is the company is in net cash position, providing the potential for more return to shareholders via more share buyback or initiating dividend.
Share price had been flat at the level of $44-$45 for the last few weeks but share price has broken upward the last few days on the back of expectation of good result from Dollar General. Buying momentum has turned very favorable.
Dollar Tree is a well-managed discount store, which is riding on slow economy growth trend, with a great prospect in store count expansion and margin expansion. The stock is interesting given the 27% upside and the favorable technical share price movement.
Disclaimer: Third Mile is not a registered investment advisor or broker/dealer. All information contained herein is for general information purposes only and does not constitute any investment advice. Third Mile does not guarantee the accuracy or completeness of the information contained herein. Readers are solely responsible for their own investment decisions.