Following an upgrade by Deutsche Bank analyst Paul Trussell, shares of Dollar Tree Inc. (NASDAQ:DLTR) hit a new all-time high yesterday of $97.84 before selling off to close at $97.10.
But given the high valuation, extreme peer comparatives, and bearish price action yesterday, I look for Dollar Tree stock to struggle over the next few months.
One of the biggest concerns surrounding DLTR is valuation. Dollar Tree now has a price-to-earnings ratio above 50, by far the highest level we have seen over the past few months. Dollar Tree is certainly not a cheap stock at these levels.
Click to Enlarge While DLTR did beat earnings estimates last quarter, the previous three quarters saw earnings misses. So over the past four quarters, Dollar Tree has actually fallen just shy of expectations, yet the stock is up nearly 25% in that time frame.
More importantly, DLTR trades at a huge valuation premium to its peer group. Dollar General Corp. (NYSE:DG) carries slightly less than a 23 P/E, while Target Corp. (NYSE: TGT) trades at only 14.
While Dollar Tree may be growing faster than either Dollar General or Target, it certainly isn’t growing THAT much faster to warrant such an extreme valuation gap.
Dollar Tree stock, at a 52 P/E, is also priced well above the company’s five-year P/E average of 28.
Some of the Deutsche Bank reasoning for upgrading Dollar Tree is based on lower gasoline prices and a stronger job market fueling more lower-end consumer spending. All well and good, but with gas prices at recent lows and the unemployment rate looking like it has leveled off and may not head appreciably lower, much of the benefit is likely already priced into Dollar Tree stock.
Yesterday’s price action in DLTR also points to a short term exhaustion in the recent rally, as DLTR made a new intraday high of $97.84 but subsequently sold off.
Click to Enlarge The stock, while closing higher on the day at $97.10, also closed lower than where it opened on the day ($97.48). This sort of indecisiveness, especially at all-time highs, is reflective of a Doji pattern, many times any indication of an intermediate-term top.
So to position for a stall out in the rally in DLTR, a short call spread position makes sense.
DLTR Stock Trade Idea
Buy the DLTR Sept $105 calls and sell the DLTR Sept $100 calls for a $1.25 net credit or better.
Maximum gain on the trade is $125 per spread, with maximum risk of $375 per spread. Return on risk is 33%.
I would look to close out the trade on a meaningful break past $100, while letting the spread expire worthless and keep the initial credit if DLTR remains well-behaved.
As of this writing, Tim Biggam did not hold a position in any of the aforementioned securities. Anyone interested in finding out more about option-based strategies or for a free trial of the Delta Desk Research Report can email Tim at tbiggam@deltaderivatives.com.
