Thursday, June 6, 2013

Time to Buy Dollar Tree?

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:

DG data by YCharts

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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