Is Dollar Tree Soon to Be a Bargain?

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Earnings season, for better or worse, creates pricing inefficiencies. While it is ill-advised to buy or sell a stock based on one quarter's worth of earnings, if you've been looking at a company for some time and short-term focused earnings push the stock in a favorable direction, it could be a great time to get in.

For my own investing, recent short-term guidance has a great company, Dollar Tree (Nasdaq: DLTR  ) , near a 52-week low and within an attractive buying range. We all know that deep discount stores thrive in down economic times, but how will Dollar Tree and its peers perform in the coming years, when the economic headwinds are predicted to morph into tailwinds? Let's take a closer look at Dollar Tree and see whether it's time to buy.

The fundamentals
Dollar Tree operates a simple, easy-to-understand business: cheap retail. Most of its products fetch, as you might guess, $1. It's very easy to see how a company like this does well in times of economic woes and future uncertainty. During the depths of the financial crisis, Dollar Tree and its peers, such as Family Dollar (NYSE: FDO  ) , made phenomenal triple-digit gains in just a few years. A quick look at Dollar Tree's five-year chart shows a company that traded for less than $10 per share in 2008 and climbed to nearly $55 in July of this year. A 300% gain over a five-year period is certainly worth a dollar of your time.

More interesting than its big gain, though, is the company's recent drop-off. Since that $55 high over the summer, the stock price sank to under $40. The reason? After a small pullback near the end of the summer, the company announced that same-store sales would come in the lower end of its estimates. This caused a multiple contraction, as investors were less willing to pay up for seemingly tepid growth going forward. Now, with the third-quarter earnings report coming up, shares may be in for yet another tumble as that guidance becomes actual earnings. We can expect to find shares of Dollar Tree trading near or at new 52-week lows, but has the company really made a fundamental change that alters it from its previous five-year path?

Current metrics
Today, Dollar Tree is trading at a hair under 14 times forward earnings. This is close to Family Dollar's forward ratio, which is 13.77, and a bit under Dollar General's (NYSE: DG  ) , which comes in at 14.39. The three big dollar retailers look to be hovering around the same valuation on a forward earnings basis, so let's look elsewhere for differentiation.

For retail, EBITDA margins are a crucial metric of profitability. Dollar General leads the pack in this regard, with $1.01  billion in EBITDA on $6.97 billion in sales -- a margin of roughly 14.5%. Dollar General is a couple of points under at 12.03%, and Family Dollar is the worst of the trio at  9.8% (rounded up). On a trailing basis, we see that Dollar Tree has been able to keep the most of its sales compared with its peers and sits in the middle on a forward earnings basis. But when the company announced that same-store sales  were in the lower end of guidance, it scared off investors. Is this a troubling trend, or is it simply a short-term number that Wall Street overemphasized?

The call
Coming into the holiday season, and with long-term metrics holding steady, Dollar Tree isn't likely to see its fundamentals eroding in a way that warrants the multiple contraction. The company still trades at an Enterprise value-to-EBITDA ratio of 8.91, above the 2011 retail industry average of 8.1, but below competitor Dollar General at 9.96.

Dollar Tree should also be growing faster than the retail industry at large. Analyst five-year growth estimates are around 18% for the company. For comparison, Wal Mart's five-year growth rate is around 9. 2%. Now, yes, Wal-Mart (NYSE: WMT  ) is a whole lot bigger than Dollar Tree and isn't the best comparison, but it gives you some perspective as to the attractive rate that Dollar Tree should be hitting in the coming years.

The bottom line here is you have a great company that produces a ton of free cash and should be outperforming its peers in EBITDA margins and growth. The upcoming earnings report will probably send the stock down a bit (or if the market is feeling competent, the stock will stay level), and it wouldn't be a bad time to buy in. If you've been waiting for a correction in Dollar Tree over the past few years, now may be your best chance.

To learn about two retailers with especially good prospects, we invite you to take a look at The Motley Fool's special free report: "The Death of Wal-Mart: The Real Cash Kings Changing the Face of Retail." In it, you'll see how these two cash kings are able to consistently outperform and how they're planning to ride the waves of retail's changing tide. You can access it by clicking here.

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Michael Lewis

Michael is a value-oriented investment analyst with a specific interest in retail and media businesses. Before coming to the Fool, Michael worked with private investment funds focusing on deep value and special situations. Currently living in the media capital of the world--Los Angeles, California.

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