Deutsche Bank recently started covering a slew of retail stocks — it put a “buy” on Dollar Tree (NASDAQ:DLTR) and a “sell” on Wal-Mart (NYSE:WMT) — expecting it to drop to $48. Should you follow Deutsche Bank’s advice?
In its Sept. 14 report, Deutsche Bank expressed concern that Wal-Mart was losing market share “at a faster pace than at any point in its history — a phenomenon that we’re not convinced the company can fix.” And Deutsche Bank expressed concern about the following trends:
- Falling same-store sales. Declining same-store sales for the past nine quarters suggests Wal-Mart’s “low-price image” might be damaged.
- Failure to adapt to consumer preference for convenience. “Despite the consumer’s emerging preference for convenience, Wal-Mart has been slow to adopt a smaller store strategy …”
- Lower level of share buybacks. A new development as recently as this year, “acquisitions + inventory build + international = less buybacks.”
By contrast, on Sept. 15, Deutsche Bank set an $81 price target when it initiated coverage on Dollar Tree. Deutsche Bank admires DLTR’s rapid growth in the number of customers in its stores. This so-called traffic grew at an average of 5.8% during the past 10 quarters — supporting 65% of the same-store sales growth.
The Deutsche Bank report also said that “while strong brand awareness and an attractive value proposition are key ingredients, Dollar Tree has augmented its tender offering along with food stamp acceptance. Looking ahead, given these traffic rates, we have greater confidence in the company’s ability to drive comps in 2011 and 2012.”
Is Deutsche Bank right? Should you buy Dollar Tree and sell Wal-Mart? When I wrote about Wal-Mart in August, I was negative on its stock because despite beating analysts’ estimates, paying a decent dividend and out-earning its cost of capital, the retailer was not growing earnings fast enough to justify its P/E. I still believe that. Wal-Mart’s price/earnings-to-growth ratio remains high — a PEG ratio of 1.0 is considered fairly valued — at 1.29 on a P/E of 12 with earnings growth of 9.3% to $4.89 in 2012.
But what about Dollar Tree? Here are three reasons in its favor:
- Great earnings reports. Dollar Tree has been able to beat analysts’ expectations in all of its past five earnings reports.
- Higher sales and profits and decent balance sheet. Dollar Tree sales have grown at a 10.2% annual rate during the past five years, from $4 billion (2007) to $5.9 billion (2011), and its net income has increased at a 19.9% annual rate, from $192 million (2007) to $397 million (2011) — yielding a solid 7% net margin. Its debt has remained constant at $250 million, and its cash has grown at a 12.2% annual rate, from $307 million (2007) to $486 million (2011).
- Dollar Tree is earning more than its cost of capital — and it’s improving. How so? It’s producing positive EVA momentum, which measures the change in “economic value added” (essentially, after-tax operating profit after deducting capital costs) divided by sales. In 2011, Dollar Tree’s EVA momentum was 2%, based on six months annualized 2010 revenue of $5.5 billion, and EVA that improved from six months annualized 2010’s $162 million to six months annualized 2011’s $254 million, using a 7% weighted average cost of capital.
Here is one reason to avoid it:
- High valuation. Dollar Tree trades at a PEG ratio of 1.35 — on a P/E of 21 on earnings forecast to grow 15.6% to $4.55 in 2012 — but is expected to grow 21.8% in 2011.
Deutsche Bank is right on avoiding Wal-Mart and wrong on buying the overpriced Dollar Tree, but if DLTR’s stock price drops — or analysts raise its 2012 growth forecast enough — to get its PEG below 1.0, I would take a fresh look.
Peter Cohan has no financial interest in the securities mentioned.
