Oh, baby, I never thought I’d say that I love those dollar stores, but I love them. I remember walking into one back in the mid-1990s, bought some items and was incredibly disappointed. Everything was garbage. The soap was barely soapy. The pens didn’t write. The toilet paper felt like sandpaper, and let me tell you, that’s one product you don’t want to skimp on.
And after that one bad experience, I never went in to one again … until 2009. Everything had changed.
Now, stores like Dollar Tree (NASDAQ:DLTR), Dollar General (NYSE:DG), Family Dollar (NYSE:FDO) and privately held Ninety-Nine Cent Stores carry name-brand quality merchandise. They’re even attacking the sacred ground of Safeway (NYSE:SWY) by selling grocery items. In the midst of a terrible economy, the earnings of all these companies have been on a tear.
However, there was a wrinkle in Dollar Tree’s earnings guidance, despite an otherwise strong Q2. The company said revenues would be in the range of $1.71 billion to $1.75 billion, some $20 million to $60 million below analyst forecasts. And it forecast earnings per share of 47 cents to 51 cents, below the 52-cent estimate of analysts. That’s not much of a shortfall, but with a growth stock, any shortfall is a big shortfall.
One thing to watch for is the mix of consumer staples and consumer discretionary at Dollar Tree stores. A decline in the latter will indicate economic weakness, as people pass over the discretionary items for things they really need. Although everything is sold at the same price point, margins differ. Discretionary items have larger margins, so if sales decline with those items, overall gross and net margins will contract. Thus, you should see any significant change in purchase behavior also reflect in that metric.
However, management has always been adept at adapting to the customer’s needs. If discretionary isn’t selling as much, they’ll decrease that inventory and bump up staple inventory. You should only become worried about Dollar Tree specifically if those gross margins continue to decline. The company has always managed those gross margins very well, running between 34.2% and 36.4%.
Dollar Tree remains a great company, with $380 million in cash and $250 million in low-cost debt. The store count is at 4,523, and the company thinks it can raise it to 7,000 in the U.S. and 1,000 in Canada. Long-term growth is pegged at 18%, with 25% for this fiscal year. Dollar Tree will generate more than $400 million in free cash flow and spend some of it on buybacks. It’s in great shape and worth buying here at 20x earnings.
But let’s look beyond Dollar Tree for a moment to the larger economic picture. InvestorPlace Editor Jeff Reeves recently commented on the “paycheck cycle” factor — as customers get their paycheck, they buy what they need and then spend smaller amounts as that money runs out. There’s been some concern about this affecting discounters, and Wal-Mart (NYSE:WMT) has noted that it’s having an impact there.
I’m actually not concerned about this factor regarding the dollar stores, because the first items that people buy are consumer staples. That means they’ll go and buy those essentials at Dollar Tree first. I believe, from my experience in the payday loan industry, that consumers are smarter than most people think. They know how to shop around. They’ll buy the staples first, and if they can’t find what they need, then they’ll go to Wal-Mart. So, yes, Wal-Mart should be concerned. But not Dollar Tree.
I think the dollar stores have a long way to go in the growth phase, and they’ve shown they can innovate and react to consumer needs. Dollar Tree remains at the top of the heap.
Lawrence Meyers does not own shares of any company mentioned here.