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Dollar Tree's (NASDAQ:DLTR) business model is extremely attractive and benefits from a weak economy. The company has solid long-term growth prospects supported by a number of growth initiatives and opportunities to further expand solid margins. Management does an admirable job of creating shareholder value which is reflected in the way that they allocate capital. The valuation is fair currently and Dollar Tree has significant capital appreciation potential given the companies' solid growth prospects in the long term. It is a solid equity to own amid global macro concerns.

Business Differentiation

Dollar Tree is the largest chain of discount stores which have uniform merchandise pricing of $1. Dollar Tree, Family Dollar (NYSE:FDO), and Dollar General (NYSE:DG) all operate smaller square foot stores that are more conveniently located for day to day shopping than Wal-Mart (NYSE:WMT) stores. Single price dollar stores differ from other discounters with multiple price points, such as Family Dollar and Dollar General, in numerous ways. The shopping experience at Dollar Tree is made easier by the fact that all the merchandise is priced at $1. It is easy for the consumer to account for how much they have purchased at the Dollar Tree.

Additionally, the shopper at Dollar Tree does not need to cross shop its competitors with regard to price. Much of Dollar Trees' product assortment and prices are different than Dollar General and Family Dollar. Dollar Tree carries mostly private label whereas Dollar General and Family Dollar carry private label, but also carry many name brand products and very few of their products are priced at $1. The difference in product assortment and pricing makes Dollar Tree less vulnerable to competition from Dollar General and Family Dollar. Additionally, Dollar General and Family Dollar's product assortment and pricing more closely resemble Wal-Mart than Dollar Tree which makes those two chains closer competitors to Wal-Mart than Dollar Tree is.

Dollar Tree tries to differentiate themselves among discounters by making sure their stores are clean, bright, and relatively attractive. The stores are fairly well organized and easy to navigate, making the shopping experience relatively simple. It does not take long to complete a shopping trip at Dollar Tree, which is in sharp contrast to Wal-Mart's big box format in which it takes significant time to navigate the store.

Margins

Dollar Tree has the highest operating margins among discounters that have been expanding for the last 4 years. Their operating margins in 2011 were 11.8% compared to 10.1% for Dollar General and 7.5% for Family Dollar. Dollar Tree has a simple strategy for generating margins which is highly effective. The company leverages SG&A expense through high same store comps. Same store comps have been very solid since 2008. The fact that private label comprises a high percentage of Dollar Tree's product mix compared to their competitors is beneficial to margins since private label often carries higher margins than name brand products. Dollar Tree has been effective in managing its inventory which is evidenced by the fact that inventory turns have increased from 3.4 in 2003 to 5.03 in 2011. Dollar Tree has a great deal of control of their merchandising which has allowed the company to generate close to 35% gross margins. If input costs increase the company can reduce the quality or find alternative suppliers to try to hit the 35% gross margin target or vice versa if input costs decrease. Dollar Tree's goal is to deliver as much value to the consumer for one dollar while maintaining gross margins of approximately 35%. Their business model differs materially from other retailers which have very little control of their merchandise mix.

Growth Initiatives

Dollar Tree's industry possesses characteristics that enable it to grow robustly in numerous ways and the company has the management team to successfully execute initiatives to grow in the long term. The company has undertaking several measures to drive traffic. Dollar Tree is rolling out coolers to increase visits. Coolers are refrigerated units that allow the company to add frozen food. The company is planning on adding 325 coolers for the 2012 calendar year and currently 2,345 of the 4,451 total stores have coolers. Consumables now represent a higher percentage of the mix due to the economic downturn and comprised 50.8% of merchandise mix at the end of 2011. The company is increasing square footage at about 7% annually which is much faster than most retailers.

Dollar Tree is still committed to its single price strategy format and plans to grow its store footprint for years. However, the company sees potential to grow the Deal$ chain which is a multi price point discounter that it acquired in 2006. Deal$ can carry a different merchandise mix than Dollar Tree as a multi price discounter and is situated in different geographic markets. Deal$ stores can also be located in dense urban markets that are not typically as suitable for Dollar Tree stores. Deal$ stores are meant to complement not supplement Dollar Tree stores and the ROIC is typically not as high on Deal$ stores as Dollar Tree stores. However, Deal$ stores have been profitable and provides Dollar Tree with another platform to grow their store base over time. There were 190 Deal$ stores at the end of Q2. Dollar Tree acquired Dollar Giant Store in 2010 which is a Canadian fixed price store in which it sells all its goods at 1.25 Canadian.

Capital Allocation

Dollar Tree invests its capital in a manner that is friendly to maximize shareholder interests. Dollar Tree first invests in the business, next strategically makes acquisitions when available, and lastly returns free cash flow in the form of buybacks. The balance sheet is relatively clean. Dollar Tree takes a conservative approach to financing and the only debt that the company has is a revolving credit line. They have reduced the share count at a rate of approximately 4.8 percent annually for the last 8 years. Dollar Tree completes nip and tuck acquisitions not major disruptive ones.

Macroeconomic Tailwinds

Although Dollar Tree's business is countercyclical, there remains the potential that they will be able to retain many of the customers that they have gained during the recession. Furthermore, the economy is weak and will likely remain so for some time. The median household income was 53,356 in 2007 and it was only 50,046 in 2010. Consumer sentiment dropped to its lowest point in June as measured by the University of Michigan: Consumer Sentiment Index and unemployment is still above 8 percent. Moreover, the fiscal cliff at the end of the year of the end presents another challenge to the economy.

Valuation

Some analysts have expressed concerns about Dollar Tree valuation. It currently trades at 17.91 the forward P/E consensus sell side estimates. Additionally, Dollar Tree stock has risen approximately 31.1% in the last year. The dramatic stock rise has caused some analysts to urge investors to take profits. The stock is not cheap, but it is fairly priced. The company has outstanding earnings power in the foreseeable future and it is stable in a very difficult global macro environment. Dollar Tree has virtually no global exposure and actually benefits if the economy worsens, so the stock could be looked at as a hedge for a weak economy.

The base case scenario in my model has Dollar Tree growing 20 to 25% this year and growing in the low 20% range in the next few years. In a downside scenario in which Dollar Tree's same store comps moderate slightly the company has the potential to grow EPS in the mid to high teens based on effective cost controls and the buyback program. The 5 year PEG ratio is approximately 1 in the base case scenario which is decent in this market. Dollar Tree trades at a slight premium compared to Family Dollar and Dollar General but it is deserved due to its higher margins, return on capital, growth prospects, better management, and a stronger business model.

Recent Stock Volatility

The price of the stock has fallen approximately 14.4% since it peaked in June 19. Some analysts are concerned about the valuation of Dollar Tree. It was until recently that Dollar Tree had a more substantial premium in the deep discounter group that is not deemed to be particularly cheap. The valuation gap between Dollar Tree and Dollar General has closed substantially in the last 10 weeks. Currently Dollar Tree trades at 21.38 trailing earnings whereas Dollar General trades at 21.1 trailing earnings and Family Dollar trades at 17.86 trailing earnings. A number of analysts have expressed concerns that Dollar Tree's same store comps may be slowing and one analyst mentioned the possibility that the company could be losing share to Dollar General.

Analysts expected Dollar Tree's same store comps to increase by at least 5% in Q2 and they only increase by 4.5% in Q2. Moreover, Dollar Tree management cut Q3 guidance modestly which did not improve analyst sentiment. Analysts expect the company to grow EPS by 19.6% in the upcoming year which is still somewhat lofty. However, Dollar Tree still can meet and exceed these bottom line expectations with solid top line growth aided by operating leverage and share repurchases. Meeting and exceeding analysts' expectations regarding same store sales will be a more difficult task compared to meeting EPS expectations.

Conclusion

In short, Dollar Tree's stock has fallen modestly recently, which provides it with more upside than there was a few months ago, but some risks still remain in the short term. Many indicators point to the economy expanding, but it remains to be seen if the economy can rebound to grow at the 3% real GDP growth of the past. The days of debt fuel growth of the past are over as credit remains constrained and banks are reluctant to lend. The US has seen a shift in consumer behavior towards frugality and Dollar Tree is a direct beneficiary. Even when the economy improves, consumers will not forget the catastrophic effects of the downturn in 2008 anytime soon.

Many American consumers enjoy finding deals and Dollar Tree offers value to the consumer. Additionally, the economy outside the US is experiencing even more significant strains than the US and Dollar Tree is nicely insulated from broader macro issues. Dollar Tree has the potential to continue to grow substantially for at least a couple of years out and potentially beyond, which is in opposition to analysts' expectations belief that the companies' earnings potential should drop off substantially over a much shorter time horizon. Investors who are not concerned about near term volatility, but are most interested in long term appreciation, may find Dollar Tree to be a very attractive purchase.

Source: Weak Economy Positions Dollar Tree For Strong Growth