Dollarama: Be Patient
- Dollarama is a wonderful company that has managed a successful IPO, high brand recognition, and the introduction of multiple pricing points.
- Earnings growth is nearly perfectly correlated with revenue. It has also reduced its shares outstanding while paying a small dividend.
- Since one of the largest expenses for companies is paying salaries, Dollarama's ability to leverage its fixed costs is another good sign for shareholders.
- There is one caveat: the stock. It's expensive. With a forward P/E of 28.81, Dollarama has a price-implied one-year earnings growth rate expectation of nearly 20%. I think that's optimistic.
- I suggest investors pay no more than about $115-125, based on recent EPS growth and a P/E multiplier that is more in line with historical averages. Patience is a virtue.
I don't often get excited by narratives. I'll openly confess to a bearish bias--a personally high hurdle rate before I get too excited about a stock. Yet, as a Canadian, I can't deny that I really do love Dollarama (OTC:DLMAF), the leading operator of dollar stores here. I love its product selection, occasionally finding the same brands I might have bought at a store like Shoppers Drug Mart on Dollarama shelves for a quarter of the price.
Whenever I walk into Dollarama, I know exactly what season it is, what major holiday is coming up. I was in Dollarama last week--clearly, Easter is coming!
While liking a company's brand and products alone isn't a reason to buy a company, its strong same-store sales growth, its revenue growth that near-perfectly translates into earnings growth, its ability to leverage its major expenses like salaries, and its sustained share reduction efforts, I think there are many reasons to give it a second look.
An HBR case study on Dollarama describes it well:
The firm performed extraordinarily well after a leveraged buyout in 2004, and recently executed a highly successful IPO. The company sources its goods primarily from Asia. It has strong brand recognition and competitive advantages in operations, purchasing, and merchandising. In the face of margin pressures, Dollarama recently took the risky decision to move from the single one dollar price point to multiple price points.
While the company looks strong, it may come with one caveat: the stock. At a P/E of ~34, it is, in my opinion, a little expensive. Sometimes, of course, things are expensive for a reason; so I'll examine whether or not it is justified by unpacking its built-in price-implied one-year earnings growth expectation near the end of the article.
First, let's get into the fundamentals.
As it reported in its recent earnings call, both sales and earnings are increasing, with same-store sales growth up over 6% over and above its 5.7% same-store sales growth last year. As Neil Rossy explains,
Our results reflect a strong operational and financial performance with higher sales and improved gross margin, a tightly managed overhead structure and growth in net earnings. [...]
Same-store sales in Q2 increased 6.1% over and above SSS growth of 5.7% recorded last year. Our customers responded well to our product offering during the quarter despite a slower and colder start to the summer season in some of our largest markets. The sustained growth in same-store sales demonstrates that consumers continue to appreciate the compelling value we offer through our broad range of products at low fixed price points.
Running a correlation analysis, it appears that, TTM, its revenue is correlated with its net income to a point of 0.994. This means that its revenue growth nearly perfectly corresponds to its earnings growth. Wonderful. Profitability is critical to a company's long-term success, as we know, and Dollarama appears to be delivering growing profitability to shareholders.
To that point, we can see that its revenue is increasing at a faster rate than its total expenses, suggesting that Dollarama is able to translate top line growth into increasing bottom line growth. Similarly, revenue per employee and earnings per employee are up 10% and 14%, respectively. Since one of the largest expenses for a company is salary, further leveraging that large fixed cost is a good sign for shareholders.
As my readers certainly know, I am not a fan of dilution. When a company issues additional shares, an existing investor's proportional ownership in that company is reduced. In contrast, when a company engages in share reduction, an investor's ownership stake is - obviously - increased.
Research suggests that well-executed stock buybacks have a positive impact on price return, as Ken C. Yook writes in The Quarterly Review of Economics and Finance:
[...] Chan, Ikenberrry, and Lee (2004, 2007) reexamined long-term stock return drifts following openmarket repurchase announcements. Their study found robust and significant evidence of positive long-term stock return, using both the buy-and-hold returns method and calendar-time portfolio method. They concluded that managers possess some timing ability and that pseudo-market timing explains, at best, only a small portion of the buyback return drift.
Appropriately, firms that effect buybacks enjoy significant price returns in the following three-year period:
[...] firms that initiate repurchasing shares during the four quarters from the announcement quarter experience significant returns over a 3-year period after the announcement. Firms that do not initiate repurchasing shares experience negative return, although not significant, over the same period.
This is good news for shareholders of Dollarama, which has engaged in a significant reduction in shares outstanding over the last several years--reducing shares outstanding by over 6% in the last three years alone.
To demonstrate how this positively impacts shareholder value, let's see how share reduction would impact a theoretical long position in Dollarama going forward, assuming conservative growth rates and a constant rate of share reduction.
Source: Author's Work
Let's say you buy 100 shares of Dollarama today at ~$149.62, when it has ~111.68m million shares outstanding. Let's assume a conservative growth rate, and assume that Dollarama achieves analyst estimates for the current fiscal year, growing revenue to about $3.612b. Let's assume the stock prices rise in tandem to reflect that.
Source: Author's Work
If Dollarama hadn't bought back its shares, your investment would have grown from about $14.9k to $16.98k--assuming, again, a highly conservative growth rate. And because of its sustained effort to reduce shares, your return is magnified well beyond that.
In this, I've assumed there will be -6% fewer shares on the market, as per the previous three years, leaving about 104.565m shares outstanding.
So holding all else constant, because of the share reduction, revenue per share would have increased from $28.50 to $34.55. That means that your ownership stake has grown to over $18.1k.
We're rewarded on a per share basis. And because of share reduction, your return is amplified. That's excellent for shareholder value. And this doesn't include the 0.29% dividend yield that Dollarama pays to its investors.
Reviewing the quality of the company is only half the battle to valuing a stock; we also need to look at the quality of the stock. At the moment, its EV/EBIT is 24.79. If we take the reciprocal of that, it translates into an earnings yield of about 4%, about 200 basis points above a two-year t-bill.
At the same time, however, its P/E is about 32. This is higher than historical P/E averages, as the Kansas City Fed finds:
The P/E ratio varied mostly between 5 and 27 from 1872 to 1998, averaging only 14 for the entire 127-year period. The P/E ratio moved above 27 in mid-1998 and has since stayed above that level. In June 2000, the P/E ratio was slightly above 29. While this value was lower than a year earlier, when the ratio was close to 36, it was still high by historical standards.
With a forward P/E of 28.81, holding all else constant, Dollarama has a price-implied one-year earnings growth rate expectation of nearly 20%. Yet, Dollarama has achieved a normalized diluted EPS CAGR of 13.7% over the last five-year period. Its earnings growth for the trailing twelve months was a still impressive ~10%. While that is impressive, it falls short of that 20% assumption, which seems a little too optimistic even for a company as strong as Dollarama.
Based on that, I believe at current prices, investors would be paying a little too much on a risk-adjusted basis for Dollarama. I believe that, instead, for a better risk-adjusted return, investors should pay no more than about $115-$125, extrapolating its TTM earnings growth of 9% and assuming a P/E multiplier of 25, which is more in line with current market averages, as per the Kansas City Fed quoted above. I believe this price point will offer investors more upside with less downside. Unfortunately, this will require patience, which is traditionally considered a virtue.
Dollarama is a wonderful company, that has managed a successful IPO, brand recognition, and introduced multiple pricing points. It has also reduced its shares outstanding, which as we have seen, amplifies investor returns. Finally, with a dividend of about 0.30% - sustainable given its TTM payout ratio of only 9.63% - is clearly a company that aims to reward its shareholders. While it may be a great company, it may not be the best stock, with investors paying a little too high a premium for its earnings. For the time being, Dollarama is a stock I will put on the watch list, and wait for the dip. Patience is a virtue.
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