Dollar Tree’s Withering Prospects

by Will Ashworth | September 14, 2011 4:00 am

A recent article in Investors Business Daily discussed some of the reasons why dollar stores continue to take market share from Wal-Mart (NYSE:WMT[1]). Dollar Tree’s (NASDAQ:DLTR[2]) tagline: “Everything you need for every day, every holiday, every occasion and every single item is only $1 … or less.” It sounds like a utopian world indeed. Dollar Tree trades within 5% of its all-time high of $74.72. At some point in the not-too-distant future, Americans are going to come to their senses and abandon the need for ultra-cheap. When they do, its stock will drop like a stone.

Number of Stores

Dollar Tree has 4,150 stores. Rivals Family Dollar (NYSE:FDO[3]) and Dollar General (NYSE:DG[4]) have another 17,000 combined. The three chains occupy the equivalent of 172 million square feet of retail space, and there appears to be no end in sight. In the second quarter, Dollar Tree opened 76 stores and expanded or relocated another 23, increasing its retail square footage by 8.6%, to 36.6 million. This expansion, combined with a 4.7% increase in same-store sales, bodes well for the discount chain.

Or does it? Dollar Tree expects to spend $144 million in 2011 to open 352 stores and expand 75 others. That’s $337,000 per store just to get the doors open. Assuming each store’s four-wall contribution is 40% of sales, we’re talking about a bottom line of $600,000 at the store level. Given its current financial situation, a new store pays for itself in less than a year. That’s the good news. What happens when (and not if) the economy grows stronger and the unemployed and underemployed go back to work? The same-store sales increases disappear, the four-wall contribution drops and Dollar Tree is left paying the leases on unproductive stores. Don’t think it can happen? Maybe not tomorrow, but holding this much real estate is always a risk.

Higher Price Points

Where have all the five-and-dimes gone? Inflation has taken a piece of history and gobbled it up. While Dollar Tree sells everything for a buck, it’s a dying breed. Family Dollar and Dollar General sell just 25% of their stuff that cheap. In Canada, the leading dollar store is Dollarama. It introduced $2 pricing at its 667 stores in 2009 and now 44% of its products sell for more than a dollar. At some point, consumers are going to come to the realization they are being played. I’m all for providing cheaper goods for the poor, but somehow I don’t think that’s how Dollar Tree and its rivals are making a go of it.

The Canadian government has produced an excellent report about the U.S. dollar store market. Although the document is a little dated, I’m sure the demographics haven’t changed a great deal since 2008. According to the report, 25% of dollar store shoppers have incomes over $75,000. Further, 42% of consumers with incomes between $100,000 and $149,000 shop in dollar stores at least once a month. As prices continue to creep upward, two things will happen. First, the poor will have a harder time paying for their goods and will end up getting their groceries from food banks, and second, the affluent and high-net-worth crowds will figure out they’re not getting a deal of any description. At that point, you’ll be able to fire a cannon down the store aisles.

Stock Chart

I’m no technical analyst, but if you look at Dollar Tree’s stock chart since it went public in 1995, you’ll notice a few things. First, it went through a straight six-year climb, to about $30 in 2000. Then it went on an eight-year run where it went sideways, until 2008, and now it’s in the middle of an ongoing, four-year run. The question is: Where does it go next? Analysts seem split on this question, giving Dollar Tree a “moderate buy” recommendation with a median price target of $73.50. This tells me much of the good news is already factored into its price.

What speaks volumes about the future direction of its stock is its share repurchase program. In the first six months of the year, it bought back 2 million shares for $105 million, with $249.2 million left on its June 2010 repurchase authorization. Some investors feel this is a great tax-free reward for shareholders. I’m not one of them. Share repurchases, in my opinion, indicate management can’t find any higher-return growth prospects and so it throws free cash at buybacks. It’s a signal that Dollar Tree’s best days are behind it.

Bottom Line

With an economy teetering on a second recession in three years, it seems silly for me to recommend selling Dollar Tree stock. However, that’s exactly what I’m doing.

As of this writing, Will Ashworth did not own a position in any of the stocks named here.

Will Ashworth has written about investments full-time since 2008. Publications where he’s appeared include InvestorPlace, The Motley Fool Canada, Investopedia, Kiplinger, and several others in both the U.S. and Canada. He particularly enjoys creating model portfolios that stand the test of time. He lives in Halifax, Nova Scotia.

Endnotes:

  1. WMT: http://studio-5.financialcontent.com/investplace/quote?Symbol=WMT
  2. DLTR: http://studio-5.financialcontent.com/investplace/quote?Symbol=DLTR
  3. FDO: http://studio-5.financialcontent.com/investplace/quote?Symbol=FDO
  4. DG: http://studio-5.financialcontent.com/investplace/quote?Symbol=DG

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