Dollar Tree's (NASDAQ:DLTR) stock price has increased by about 11%, despite the relatively high volatility, compared to the 20% decline of the broader market year to date.
Although DLTR has a strong track record of outperforming the broader market in times of low consumer confidence, in our opinion the stock is significantly overvalued at the current price level.
In light of the current macroeconomic environment, and the high valuation, we believe that Dollar Tree's stock is a sell now.
In this article, we will dig deeper into why DLTR could be an attractive addition to your portfolio in times of low consumer confidence, and why we still believe that the valuation is too high.
Let us start with taking a look at the U.S. consumer confidence.
Consumer confidence is often used as a leading economic indicator, as it can signal potential trend changes in consumer spending in the near term. Therefore, it could be used to gauge, where we are in the current business cycle and form expectations about the spending behavior in the near future.
The U.S. consumer confidence has been declining steadily in the past months, declining to levels even lower than observed during the financial crisis in 2008-2009. Although consumer spending has remained strong in 2022, we expect the low consumer confidence to have severe implications in the near future.
Low consumer confidence is likely to lead to a change in the consumer spending behavior. This change is likely to impact firms, which are selling durable goods first. Customers typically tend to cut or delay the purchase of durable goods, when confidence is low. After durable goods, non-essential, consumer discretionary products are impacted and last the services.
Firms in the consumer staples sector are likely to remain relatively unaffected, as they are selling essential goods. Although DLTR is in the consumer discretionary sector because it sells a wide variety of products, discount retailers are actually positioned favorably during such times. This is because consumers are looking to reduce their spending, and they often switch to lower cost alternatives in cheaper stores. One of these lower cost alternatives could be Dollar Tree.
Let us actually take a look at, Dollar Tree's stock price development during times of low consumer confidence in the last 20 years.
In this 2-year time period, despite the high volatility of DLTR's stock price, it significantly outperformed the overall market. While DLTR remained flat, the broader market (SPY) has declined by as much as 33%.
Between 2007 and 2010, DLTR's outperformance was even more impressive. While SPY has lost about 21%, Dollar Tree's share price has surged by more than 60%.
While in this time frame, both DLTR and SPY have produced positive returns, once again DLT has substantially outperformed the market.
Although past performance is not always a good indicator of the future performance, we believe that in the current low consumer confidence environment, the firm is well-situated to outperform the broader market.
Even though we like the stock from this perspective, we believe that the macroeconomic headwinds are likely to create significant downward pressure on the firm's margins and earnings. Due to the high uncertainty with regard to commodity prices, transportation costs, supply chain disruptions and tight labor market, we expect the firm to face substantial challenges in the near term.
DLTR's stock appears to be trading at a significant premium compared to the consumer discretionary sector median.
The firm's P/E Non-GAAP (FWD) is 18.8x, compared with the sector median of 11.1x. This indicates a premium of about 70%. In terms of EV/EBITDA and P/CF, a similar trend can be observed.
In our opinion, such an overvaluation is not justified, despite the strong financial performance in the first quarter.
During the first quarter, DLTR has managed to open a significant amount of new stores and expand some of its already existing locations. The firm has also expanded its operating margin, despite the macroeconomic headwinds, and achieved record diluted earnings per share for the first quarter.
We expect the demand for DLTR's products to remain high and even increase in the near term. However, in our opinion the margins are likely to decline due to the elevated energy prices, increased freight costs, supply chain disruptions and the tight labor market. Many firms in the first quarter have struggled with these macroeconomic headwinds, including other larger retailers. We expect that DLTR will face the same problems.
Further, DLTR does not pay dividends, which make the stock an unattractive choice for many investors, who are looking for regular quarterly income in the volatile market environment.
Last, but not least, Dollar Tree also has not returned any value to its shareholders by reducing the number of outstanding shares in the last decade.
Although DLTR has not diluted its shareholders by issuing even more shares, we prefer to invest in firms, which have a strong track record of consistent share buyback programs.
Before concluding, we also have to point out the recent announcement for leadership change in the company. The change of CFO and COO could also have implications for the performance of the firm in the near term.
Due to the highly uncertain macroeconomic environment in the near term, we believe that the price multiples should contract before we could rate the stock as a buy.
If you are interested in other stocks, which have been outperforming the market during times of low consumer confidence, and we also rated them as “buy”, check out our previous article on Colgate-Palmolive (CL).
Despite Dollar Tree's historic outperformance during times of low consumer confidence, we believe that the stock is not a buy at the current valuation.
According to a set of traditional price multiples, DLTR is trading at a significant premium compared to the consumer discretionary sector median.
In our opinion, despite the strong first quarter financial performance, this premium is not justified, due to the highly uncertain macroeconomic environment, including elevated energy prices, a tight labor market and supply chain disruptions.
Last, but not least, DLTR does not pay dividends and has not been reducing its number of shares outstanding in the last decade.
This article was written by
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.
Additional disclosure: Past performance is not an indicator of future performance. This post is illustrative and educational and is not a specific offer of products or services or financial advice. Information in this article is not an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. Expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change. This article has been co-authored by Mark Lakos.