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Fool On The Hill

Tuesday, December 15, 1998

FOOL ON THE HILL
An Investment Opinion
by Warren Gump

It Isn't Junk

You've probably seen them while out on your holiday shopping excursions. Tucked into a strip shopping center or nestled in a nearby mall, they are discretely hidden like a pink flamingo in Florida. The dollar store. Unlike a five and dime where things cost anywhere from 5 cents to several hundred dollars, dollar stores are really what they say. Everything in the store costs a dollar. The most prolific company in the business is Dollar Tree (NYSE: DLTR), which had over 1,000 stores at the end of Q3. Most of the other competitors are smaller, privately held regional chains. (In a somewhat confusing name game, Family Dollar (NYSE: FDO) and Dollar General (NYSE: DG) are not dollar stores, as their merchandise is sold at various price points.)

Dollar Tree has not only grown its store base, but profits as well. The First Call analyst earnings estimate for the company is $1.04 in 1998, more than triple the $0.34 earned in 1995. During this period, the store base has grown dramatically, rising to 1,054 on September 30, up from 500 units at the end of 1995. While most of the stores are in the Southeast, Midwest, and Mid-Atlantic regions, the company is branching into the Southcentral and Northeast markets. A recently approved acquisitions of privately announced Step Ahead, which operates the 66-unit 98 cents Clearance Center will give the company an initial presence on the West Coast, laying the base for further expansion.

Many of Dollar Tree's competitors have gone out of business since the dollar store fad began in the 1980s. How has the company been able to thrive? It made some strategic decisions in 1991 that changed its course. First, it decided to primarily forego new mall-based stores in favor of lower-rent strip shopping centers. The company seeks to raise sales by locating its stores near a Wal-Mart, Kmart, Target, or a grocery store that generates high levels of traffic among its targeted clientele.

Another change the company implemented was limiting the closeout portion of its business to 15% of overall sales. The bargains and "surprise" factor of ever-changing closeout merchandise is appealing to many customers, but it also results in inconsistent product availability and requires the development of a special set of purchasing skills. With the company's plans to grow the chain dramatically, it felt that a move to less close-out merchandise would be advantageous. To keep excitement in the store, the company buys from 650-750 vendors and regularly changes some of its product offerings. The best selling merchandise categories, accounting for over half of sales, include housewares, food, seasonal, and toys.

How much can you make when you sell a product for a buck? As it turns out, quite a bit. Gross margins have hovered in the 36.5%-37.5% range over the past five years. Operating margins have edged up from 12.2% in 1995 to 12.4% last year. This high operating margin is possible because only 25% of its sales goes for sales and administrative expenses. As a basis of comparison, even though Consolidated Stores (NYSE: CNS), the operator of Odd Lots, Big Lots, and K-B Toys, had a gross margin of 42%, its operating margin was only 8% in 1996. Consolidated's higher gross margin was more than offset by selling and administrative expenses that ate up 34% of sales. (Consolidated's results for 1997 were a bad comparison as they were skewed by merger activity.)

In addition to having great operating margins, Dollar Tree's earnings have benefited from strong same-store sales growth. Over the past five years, growth has exceeded 6% every year. In 1996, the gain was 6.2% and in 1997 the company posted "comps" of 7.8%. During the first six months of 1998, the same-store sales growth was an impressive 8.8%. Comps in this year's Q3, however, slowed down to 2.9%. The company didn't give a clear explanation for this slowdown in its press release or 10-Q. While it would be jumping the gun for long-term shareholders to worry considerably about one aberrant quarter, this number will need to be watched.

Another number that will need to be monitored is the company's inventory level. At the end of September, the company held $184 million in merchandise, up 39% from the same period last year. The store base during this time had only increased 22%, leaving average inventory per store up nearly 10% to $170,000. In addition to an increasing store size, the company explained that it sped up shipments from Asian countries to ensure its merchandise would arrive in time for Christmas. In a way, this was a shrewd move as many news stories have discussed the difficulty and expense many importers are having this season. At the same time, Dollar Tree could be in trouble if sales growth tempers and it is stuck with a bunch of extra inventory -- that might lead to a temporary name change to "Two for a Dollar Tree."

To be honest with you, without any knowledge of this company except having passed a few of its stores, I expected that my opinion of Dollar Tree would be decidedly negative. Having looked into the financials, however, I am rather impressed. The company has done an excellent job executing a concept that many others have failed at operating. The balance sheet has been managed conservatively and the operating results have been superb for several years.

The recent slowdown in same-store sales and rising inventories is reason to give investors pause, however. While the company is definitely not junk, I'm not fully convinced it's a gem worth 38x this year's earnings estimates (First Call estimates call for 25% long-term growth). To prove that, it will need to pull through this Christmas season with strong comps, flat-to-rising margins, and a slowdown in same-store inventory growth.


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