3 Reasons Dollar Tree's Stock Could Rise

For good or bad, the Dollar Tree (NASDAQ: DLTR  ) acquisition of rival deep discount variety store Family Dollar (NYSE: FDO  ) has already been factored into the company's stock price. Although there's the possibility of a bidding war with Dollar General (NYSE: DG  ) breaking out, Dollar Tree enjoys some fundamental advantages that can propel it higher in the future.

Here are three of the top reasons why Dollar Tree's stock can rise in the future.

Like dollars growing on tree for Dollar Tree. Photo: Dollar Tree.

It's more profitable than its rivals
When it comes to turning revenues into profits, no other dollar store chain does it as well as Dollar Tree, realizing 20% more in operating profits than Dollar General and almost 60% more than Family Dollar.

For every $1 in revenues it generates, it sees $0.12 in operating profits and $0.07 in net profits. In contrast, Dollar General generates $0.096 and less than $0.06, respectively, and Family Dollar is even worse at $0.05 and $0.03, respectively.

Data: Morningstar.

There's a reason for the disparity, too. Unlike its rivals, which offer a range of price points, Dollar Tree sells everything in its stores for a dollar. There may be a bit of a treasure hunt in the search for deals, but the flat pricing policy gives consumers a sense of consistency, allowing them to budget better when shopping.

An economy that may be souring could send its customers into its stores in droves again.

Dollar Tree's target customer is more valuable
A recent Bloomberg Businessweek story highlighted that when it comes to dollar store consumers, there are distinct differences between the demographics they're targeting. Where shoppers at Family Dollar and Dollar General tend to be lower income, Dollar Tree's customers are typically middle income. And The Wall Street Journal says that while the two former deep discounters skew toward rural customers, Dollar Tree's are more often than not suburbanites.

While the rich have gotten richer and the poor have suffered disproportionately from the economic malaise -- though there are support programs in place to help them -- the middle income consumer, the one that for decades drove the economy higher, has been really getting squeezed in this sideways economy. 

Census data shows average income for these families has fallen from $65,672 to $62,464, with more than half of the drop coming after the economy supposedly began its recovery back in 2009.

With household debt once again on the rise, the need to stretch every paycheck becomes even more critical and Dollar Tree looks even more valuable.

Deal$concept complements the $1 for everything pricing
While Dollar Tree is leading the industry thanks to its pricing policies, it's also tapping into the chance to "break the buck" through its Deal$stores, which have prices above the dollar threshold. 

It ended the second quarter with just 216 Deal$stores, meaning Dollar Tree isn't abandoning its core mission. But by lifting the restriction of the $1 price point it's able to gives customers more choices, which are skewed more toward consumable products.

You know what you're getting with the flat-pricing policy at Dollar Tree.

At Dollar Tree, goods sold are split pretty evenly between consumable and non-consumable goods; at Deal$, it's 62% to 38%. 

Now consumables tend to be slightly lower margin goods, but they generate higher traffic, allowing the deep discounter to make up in volume what it loses in profit. That's resulted in higher basket size at Deal$, where the customer is spending on average about $9.51 each trip compared to about $7.80 at Dollar Tree. Moreover, 54% of all transactions at Deal$had items greater than a dollar, pushing the average ticket for those baskets to $14.23. 

Foolish investment takeaway
Of course, there's no guarantee  Dollar Tree's plans will pan out. It got no bounce from the merger announcement, and though Family Dollar has rejected Dollar General's overtures thus far, a sweetened deal could trap Dollar Tree in a bidding war that would sap its financial position.

But up till now Dollar Tree has proved to be a good steward of shareholder resources, investing in the business first before returning value to shareholders via avenues such as stock buybacks. I think it's likely it will continue on that path, whether it wins the Family Dollar battle or not.

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