Dollar stores and Dollar Tree (DLTR)

Dollar Tree is a quickly growing retailer with a P/E around 18 and revenue growth in the ballpark of 17%/year.  I don’t think it’s that cheap right now but it’s on my radar since it is a quality business with very high returns on capital.

Investing in retail

I believe that one of the lessons that Warren Buffett learned is this: it is better to buy a fantastic business at a good price than it is to buy a good business at a fantastic price.

Historically in retail, the few superstar CEOs out there grew their businesses like crazy.  Along the way, they put most of their competitors and copycats out of business.  I want to bet on this historical pattern repeating itself, so I would rather buy the See’s Candies of retail than the cigar butts (e.g. retailers trading at a discount to liquidation value).  A small handful of superstar retailers will make almost all of the profits.

These retail superstars have very high ROIC (return on invested capital) and tend to sustain high ROIC over a very long period of time.  However, they eventually start to hit a saturation point.  They are eventually forced to build new stores near existing ones and suffer some sales cannibalization.  Growth slows down and there are no longer opportunities to get unusual returns on capital.  Expanding internationally often doesn’t help as it often ends in failure for even the best retailers out there.  Once a retailer is close to saturating its domestic market, its stock probably isn’t a good candidate for exceptional returns.

So, my strategy going forward will be:

  1. Look for the superstar management teams.
  2. Look for retailers which aren’t close to saturation (and therefore have a runway of growth ahead of them).

Publicly-traded dollar stores

  1. DOL.TO – Dollarama (Canadian)
  2. DLTR – Dollar Tree
  3. DG – Dollar General
  4. FDO – Family Dollar Stores

All of the retailers above are considered dollar stores though there are some differences between them.  Dollar Tree is the “purest” dollar store as virtually all of its items are $1.  It has experimented with a Deal$ format with price points above $1.  The other dollar stores sell more items that are above $1.  Dollar General for example is part-Walmart and part-dollar store.  Its website currently shows such items as $9.50 diapers and a $16 fan.  Dollar Tree is mostly symbiotic with Walmart (it sometimes tries to locate new stores near a Walmart) while Dollar General competes with Walmart.

I believe that the best managed dollar store will have the highest return on invested capital.  As a rough proxy for ROIC, I calculated the following for each retailer:

Annual Operating Profit / (Property & Equipment + Inventory)

PP&E + Inventory slightly understates the capital needed to run the business as each store needs a safety cushion of working capital.  However, I don’t believe that makes a difference when ranking the retailers.  Here are the figures:

  1. DOL – 57.8%
  2. DLTR – 47.6%
  3. DG – 36.90%
  4. FDO – 23.5%

Clearly, Dollarama has the highest returns on capital.  Perhaps in the future I would be more interested in Dollarama if its valuation were lower (its current P/E is around 25).

Why is Dollarama (and Dollar Tree) so much better than their competitors?

I don’t really know.  I’ve only visited Dollarama stores (I live in Canada) and was surprised to find out that they are extremely profitable.  Generally speaking, these stores aren’t that attractive compared to the very best retailers (e.g. Apple store).  Let’s look at lighting for example.

The best lighting can be seen in high-end retailers like Sephora.

sephora-lighting-analysis

The next best thing to do is to implement a strip of lighting above each set of shelves.

lighting-top-shelf

Here’s a picture of Dollar Tree’s shelving.  The shelves cast a shadow on the shelves below.  Diligently moving product to the front of the shelf can make everything look better.

dollar tree shelving

This is what Dollarama looks like:

If I didn’t look up these companies’ financial figures, I would not have guessed that dollar stores are more profitable (on a ROIC basis) than Walmart.  Their appearances are deceiving.  To be fair to the dollar stores, overspending on interior design could be a bad thing.  Additional lighting costs money and the return on investment may not be worth it.  Because I am not an expert in retailing, I don’t know what the optimal tradeoff is between more lighting and less.

At the end of the day, I don’t think I can spot which retailer is better managed than another simply by walking around the stores.  They all look a little worse than Walmart or Walgreen’s… yet they have higher returns on capital.  I think it’s better to simply look at the track records of the CEOs so far.

As to why some dollar stores have higher returns on capital than other, my guess is that part of this has to do with sourcing directly from suppliers.  All of these companies are following in the footsteps of other retailers and are working on vertical integration of distribution and warehousing.  They are also sourcing directly from their suppliers rather than through a middleman.  These behind-the-scenes operations may be an important driver behind higher ROIC.

DOL states that “direct overseas sourcing accounted for 52% of our purchases”.
DLTR imports 40 to 42% of its goods.
DG imported 7% of its merchandise (at cost).
FDO imported 10% (at cost) of their merchandise from overseas.  The total is 24% if you include imports from domestic suppliers.

It’s surprising that DOL and DLTR have that level of vertical integration even though their store counts are lower than their peers:

DOL – 785 (*Canada has roughly a tenth of the population of the US)
DLTR – 4,671
DG – 10,506
FDO – 7442

It seems to me that DOL and DLTR are ahead of their competitors in reducing their costs and finding efficiencies in their operations.

Another possible explanation for DOL and DLTR’s performance is their mix of product.  Both of them don’t compete with stores like Walmart.  DOL/DLTR don’t sell clothing and they don’t everyday household staples like diapers, food in bulk, etc.

Why I’m interested in Dollar Tree

  1. I think that they are the best-managed dollar store in the US.
  2. They aren’t close to saturation at 4671 stores.  Dollar General has over 10,000 stores in only 40 states and isn’t close to saturation.

At $47.47, its current P/E ratio is around 17.6.  So let’s think about what the future might look like.

  1. In the past 5 years, store count has increased by 6.8% / year.
  2. In the past 5 years, net sales has increased by 12.3%/year.
  3. 12.3% – 6.8% = 5.5%.  Let’s suppose that 3% of that is due to inflation and 2.5% due to productivity gains.  Suppose that the productivity gains won’t continue forever.  We will subtract out that 2.5% later.
  4. In the past 5 years, revenue/share increased by roughly 17.5%/year (see Gurufocus).  The additional growth per share came from DLTR plowing its profits into share repurchases.
  5. 17.5% – 2.5% productivity gains = 15%.
  6. At a rate of 6.8% store growth, Dollar Tree will hit 15,000 stores in slightly under 18 years.

So it is possible that Dollar Tree stock grows at 15%/year over the next two decades.  This could be an overly optimistic projection.  If Bob Sasser retires at 65 (he is 60) or dies, I don’t think that Dollar Tree will be able to maintain its high returns on capital.

I’m not too excited by Dollar Tree right now as there are other growth stocks that are more compelling.  Altisource (see my entries on it) has a lower P/E and will likely grow at a much, much higher rate than Dollar Tree.

*Disclosure:  No position.  I may or may not buy some call options in the future.

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2 thoughts on “Dollar stores and Dollar Tree (DLTR)

  1. Pingback: Dollarama: It’s a wonderful business but… | Glenn Chan's Random Notes on Investing

  2. Pingback: Dollarama: The low-tech retailer that could – Glenn Chan's Random Notes on Investing

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