Dollar Tree: Discount Is Hard To Find In This Retailer

Apr.10.12 | About: Dollar Tree, (DLTR)

Similar to AutoZone and O'Reilly Automotive, Dollar Tree's (DLTR) business is largely driven by macroeconomic conditions. This is very obvious based on the stock performance of Dollar Tree over the past ten years. It had been stagnant until 2008 when the financial crisis broke out. People were hurting, so they switched to bargain retailers like Dollar Tree. From 2008 to 2012, in the high unemployment environment, Dollar Tree's stock has increased 400%.

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More evidence can be observed when putting the stock price history of Dollar Tree and another bargain retailer, Dollar General (DG) together. The stock market performances of these companies are very well correlated, indicating that the economic situation has been a major driving force behind the bullish run of these companies.

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Interestingly, Dollar Tree's gross margin has not changed much from 2002 to 2011, hovering at between 34.2% and 36.4%. Its operating margin has been between 7.8% and 10.9%. Two things are the main driving force behind Dollar Tree's stellar stock performance: 1) Revenue which grows at 12% annually between 2008 and 2012 and 2) stock repurchase which shrunk the floating shares from 172 million in 2002 to 145 million in 2008 and to 121 million in 2012. The shares were decreasing at about 4.4% annually. These two things combined explain roughly 17% out of 26% of the income growth (the rest 9% is explained by improved profit margin). Given Dollar Tree's current price/earnings ratio of 24, it appears fairly valued.

The question is what could happen to Dollar Tree's business next year? Or the year after? To gauge this, we can examine a few different scenarios by the end of 2013.

The best scenario: the economy stays soft and low income people keep suffering. Dollar Tree's business improves further. Its revenue grows at 12% a year, its margin improves by another percentage point to 11.7%, its shares shrink another 4.4%. Under these assumptions, its net income will increase by 28%.

If this happens, Dollar Tree' stock should have a similar P/E ratio as it does now. We should therefore see roughly a 26% increase in its stock price.

The worst scenario: the economy picks up quickly and the unemployment rate drops to less than 8% by the end of 2012 and less than 7% by the end of 2013. Many of Dollar Tree's customers are likely to switch up to Wal-Mart (WMT). Its revenue increases by 6.9% (its worse revenue growth rate, which happened in 2007). Dollar Tree will have to stop share repurchases. Its margins shrink to a low point of 7.8%. Under these assumptions, its net income will decrease by 22%.

If this happens, Dollar Tree's P/E ratio would be severely punished by the stock market, likely dropping to 8 or below. The stock will lose more than 60% of its value.

The most likely scenario: the economy picks up, albeit at a slow pace. Unemployment rate drops to 7.5% by the end of 2013. Dollar Tree's revenue grows at 9%, its profit margin stays at around 10%, its shares shrink another 3% from repurchase. Under these assumptions, its income will increase by 5%.

If this happens, Dollar Tree's P/E ratio would be punished by the stock market, likely dropping to 10-12. The stock will lose 30% of its value.

Although this projection doesn't give a rosy picture of Dollar Tree's stock market returns in the next a couple of years, I have to admit that it seems like a well-managed company. It has been expanding slowly but orderly. It has been consistently using its cash for repurchasing stocks and boosting shareholders' value. The only problem is, its business is heavily dependent on the economy, which is out of Dollar Tree's control.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

This article is part of a series on the companies made Forbes' best CEOs of 2011 list. Earlier articles are on Amazon (AMZN), Chipotle Mexican Grill (CMG), AutoZone (AZO), and O'Reilly Automotive (ORLY).