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Investing in the dollar stores has been one of the most profitable
trades since the 2008 financial crisis. With that said, it has been a
bumpy ride along the way with all of the leading players having
experienced a difficult second half to 2012 and then a nice recovery in
2013. In the light of Dollar Tree’s (NASDAQ: DLTR) latest results I thought I would shed some light on what has been happening in the sector.
The dollar stores in 2012
The general story with the dollar stores can be explained by a couple
of charts. The first is the price performance over the last year:
This indicates that the market was very willing to buy their growth stories up until the middle of 2012. So what went wrong?
The answer is that Dollar General(NYSE: DG) and Dollar Tree started experiencing falling same-store sales growth. Meanwhile, Family Dollar(NYSE: FDO)
did experience same-store sales growth in 2012, but this was at the
expense of margins. I’ve discussed its issues at more length in an article linked here.
In summary, Family Dollar had tried to expand its sales of
higher-margin home and apparel goods but ran itself into procurement
difficulties. In a sense, it was guided to make such an attempt because
it tends to sell a lot of consumables (which tend to be lower margin)
and generates significant traffic by doing so. However, the difficulties that it found in trying to expand in these categories speak volumes about the highly competitive nature of its industry.
As for the general growth slowdown, I think it is a normal
consequence of a business development. All three firms have chased
growth by engaging in significant capital expenditures to fund
expansion. It is natural that at some point same-store sales growth will
slow because competitors will be attracted to the industry and start to
encroach on their market share. This can come from things like dollar
stores opening up near each other or from supermarkets like Kroger or Safeway deciding to compete on price through things like loss-leading discounts or promotions in order to drive traffic.
The industry responds
I’ve discussed Family Dollar’s response above. As for Dollar General,
it saw significant competition in the last half of the year and its
story is one of expanding sales in consumables. In particular, its move
into tobacco has caused some margin contraction. The simple fact is that
dollar-store customers remain economically hard-pressed. Any strategy
to expand into higher-margin categories has been met with resistance.
Meanwhile, end markets are getting more competitive.
Turning to Dollar Tree, I think its recent results were quite good and contained a few notable positives.
Discretionary-items sales are growing faster than consumables. This should help margin growth in the future.
Gross margins improved thanks to merchandise leverage and operating margins improved.
E-commerce initiatives are driving growth and opportunities to attract store traffic.
Store openings continue, with 375 new stores and 75 relocations planned planned for 2013.
A wide-scale program to increase the number of stores with freezers and coolers should drive incremental traffic.
The Deals format stores
should allow for growth opportunities with higher-priced ticket items
without compromising the core appeal or recognition of its Dollar Tree
format.
In summary, Dollar Tree has managed to increase margins while
carrying on investing in new stores. It’s guiding towards a 7.3%
increase in square footage for 2013 and forecasts low-single-digit
same-store sales growth.
Where next for the dollar stores?
With all this said, the sector’s strong run doesn’t really leave any
of these companies looking cheap. With companies in their growth phase,
it is important to realize that they will not be generating high cash
flows when they are investing for growth. With that in mind I decided to
adjust their free cash flow figures by taking their depreciation rates
as a proxy for capital expenditures.
The figures for Dollar General and Dollar Tree are for the last full
year but I’ve calculated the numbers for Family Dollar on a trailing
basis because its full year runs to August.
We can see the effect of the poor inventory decisions by Family Dollar in the cash flow numbers.
Frankly none of these stocks looks cheap right now. Even
with adjusting for the extra expenditures implied in their store
roll-outs, I don’t think that the underlying metrics make them
attractive. Despite their attractive growth prospects, the dollar stores
still have competitive conditions, and it probably makes sense to wait a
bit for a better entry point and some confirmation that same-store
sales growth has stabilized.
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