What Investers Saw to Like About Dollar Tree

Online eyeglasses retailer Warby Parker (WRBY 1.33%) goes public via direct listing. Motley Fool analyst Asit Sharma analyzes stock market stories and shares why he's a fan of British software development company Endava.

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This video was recorded on Sept. 29, 2021.

Chris Hill: It's Wednesday, September 29th. Welcome to MarketFoolery. I'm Chris Hill. With me today, Asit Sharma in the house. Good to see you.

Asit Sharma: Good to see you, Chris. Glad to be here.

Chris Hill: We've got software earnings, we've got another new public company, but we're going to start with the stock of the day. Shares of Dollar Tree (DLTR 0.04%) up to 14 percent this morning after the discount retailer increased its share buyback plan from $1.5 billion to $2.5 billion. The company also said they are going to start selling more products at a higher price point due to, let's just call it the usual suspects. Supply chain issues, labor costs, that sort of thing. What do you think of that? It seems like good timing on the company's part because even with the pop today, the stock is still down for the year.

Asit Sharma: Chris you know my initial reaction was, it's not that huge deal. But let's take it in context of the piece of data that you mentioned alongside which is that they are going to be adding new price points above one dollar across their Dollar Tree plus format stores and they're going to keep experimenting in their legacy stores with price points above one dollar. Now let's seems like a very minute shift that a company can make but if you look at Dollar Tree versus its prime competitor, Dollar General, its stock has under-performed miserably over the last five years. Both companies have fairly vigorous, comparable sales growth. Mid to high single-digit in any given quarter, which is pretty good for a dollar store outfit and both have gross margins that fluctuate in the 30, 32, 33 percent range. What's the difference between these two concepts? Well Dollar General has always had a pretty wide price point in their stores. You can buy items for a dollar or you can buy items for $10. Dollar Tree in opposition to this business strategy has clung if I can hit a very awkward sounding past tense here, has clung to a one dollar price point for a very long time.

Now, it acquired Family Dollar several years ago to branch out because Family Dollar primarily offers a wide range of price points. Why is this price-point business so important? It's because all of these stores operate on a very big retail footprint strategy. They're constantly opening up stores in rural areas, expanding to whitespace across the United States. When that's your business model, you want to squeeze every dollar you can out of every selling square foot you can. The problem with Dollar Tree historically is that it's lagged behind the sheer oomph that Dollar General brings because of that price point. If you look at its productivity per square foot, it averages around 100 bucks per square foot in sales. Dollar General averages 30-40 percent above that in any given year which means that Dollar General is squeezing so much more Abbott's operations, enjoying better cash flow, enjoying better operating income. I think the one-two punch is very appealing to shareholders. They want to see that Dollar Tree can compete on a multiple price point basis and lift that square foot selling percentage, and they like frankly, the fact that there's cash on the balance sheet. This is a company that is now back to an investment-grade rating. It's paid down some of the debt that it had on its books. I think they've got reasons to be pleased and maybe this is a reason to not count Dollar Tree out and not call it a perennial also ran, which I have been guilty of [laughs] doing here over the last several years.

Chris Hill: You're not the only one who is called them that and you reminded me of the conversation I had with Jim Gillies last week where the topic of share buybacks came up with something that some companies don't do a great job of in terms of timing they're buying when their stock is really high. In the case of Dollar Tree, this seems like a pretty advantageous way to use the cash on the balance sheet that they have. You're right, if they don't need to radically overhaul their pricing strategy. They don't need to across-the-board, start hiking up prices. They can be very judicious in how they do it and if they're smart about it then a year from now, their numbers start to look a lot better.

Asit Sharma: I think so. Your point is very well taken on the share price. This is a company whose stock has only increased by 25 percent over the last five years. That's a grand five percent a year in share price improvement versus Dollar General, which has increased by 210 percent over the same time period. Both of these are before their dividends. Price return only not total return. There is an argument to be made here that with the slightly new business strategy, the shares are undervalued relative to their potential, relative to a benchmark competitors. They are doing the opposite of what many companies do, which is, as you say, to buy shares when they are too high, and waste capital. This looks on the face of things pretty efficient.

Chris Hill: Warby Parker is going public today. The online eyeglasses retailer is doing a direct listing with a starting price of $40 a share, which gives Warby Parker and initial valuation of close to $5 billion. I'm not going to take any issue with how they're pricing their stock. Not when we've seen what we've seen over the last 18 months in terms of whether it's IPOs, direct listing, SPACS, whatever. Is this a business that interest you as a shareholder? Or potential shareholder?

Asit Sharma: It actually is, Chris. The older I get the more I realize I've been tripped up by not paying attention to strong brands in the marketplace. I think that Warby Parker has an extremely well known brand among consumers. They set out 10 or 11 years ago to reinvent the iWear selling industry. At that time, there were very few companies that were selling online. This company started from scratch, built its own supply chain, controls its own distribution, has a very reasonable price point. I would start to 95 bucks for a pair of very nice glasses. Glasses looks spiffy. I have to say you can't ignore this potential shareholder. Look at the products out in the real world. They've got a very attractive portfolio of eyewear. As I say, it's reasonably priced. It's a direct-to-consumer model. Not only do they sell online, but they have now a very big retail footprint. I think this is a company that potential shareholders may want to pay attention to. Their founder led, the co-founders are still going to own a big chunk of the company and a controlling interest in the company so they can call their own shots. The financials look interesting too. Warby Parker isn't profitable yet, but on an operating basis, they're trending toward breakeven. Chris, when you stack their numbers from 2018-2020, you see a lot of growth. In 2018 the company had revenue of about $273 million. In 2020, they had revenue of about $394 million. Now, they stumbled last year when everything shutdown in the retail world. But looking at their numbers this morning, the first six months of 2021, they show a really fast rate of growth versus that softer period in 2020. They've done about $271 million in revenue in the first six months of this year. You can extrapolate that out to a pretty decent year that's going to be above $500 million in revenue, and as I said, they are trending toward breakeven. With that revenue for the first six months, they've only lost about $7 million on a net income basis. There are lots of things to like about this company. I wanted to ask you generally, are you familiar with this brand? Is it just me who has seen this out in the real-world and things while it's about time they went public?

Chris Hill: I am familiar with the brand. I've owned Warby Parker glasses in the past, and I think they've done a pretty smart job with their physical retail strategy. There are a couple nearby. There's one in Georgia founders, one that went in share in Old Town Alexandria on the main strip, King Street. I think there have been smart about slowly methodically expanding their physical footprint. I also think they have a pretty compelling story in terms of an industry that doesn't really get a lot of attention. I'm not saying it should, but there is essentially a monopoly in the eyeglasses industry or there has been for a very long time, which is why the price of eyeglasses is so expensive. It's why Warby Parker is able to come in with a product that is a quality product at a much lower price. I'm rooting for them just as a consumer and someone who wears eyeglasses. I don't know that I'm going to rush out and buy their stock. I always like to see how companies do those first couple of quarters, both in terms of their results. Are they delivering in the way that they say they're going to deliver? Because it's so much harder to be a public company than a private company, and what is management style? How are they dealing with the questions they get on a conference call? Those are all things I want to see. But a decent opportunity for them, certainly.

Asit Sharma: Yeah, I agree. I like that you mentioned that they are one of the scrappy underdogs in the eyewear world which is, I think dominated by just a few big conglomerates. Luxottica comes to mind.

Chris Hill: Luxottica, yeah. That's the big one.

Asit Sharma: The Italian conglomerate that has given so many small players trouble. They do have a virtual monopoly in this business. Through M&A, they've only gotten bigger in the past few years. It is fun to see an underdog with a great product. I'll ask you in maybe two or three years from now, Chris, that they say in their perspectives that they've got a pretty good success rate with customers coming back. They've got a 50 percent sales retention within the first couple of years of selling a pair of glasses and a nearly 100 percent sales retention within 48 months, which means that Chris Hill might try another pair after his Warby Parker purchase, but within about four years, he's going to come back and buy another pair from them. We need to check-in in a few years on that.

Chris Hill: The one thing that just made me laugh was I went into their store, this is before their store in Old Town existed. I was in Georgetown. I was wearing my Warby Parker glasses. There was just a little problem with the frame and I thought, I feel like I need a little bit of an adjustment, so I go in there. Staff was very helpful. The only thing that made me chuckle was the staff person showed me to a comfortable seating area where I could hang out while she was going to adjust my glasses. Right before she went back to work on my glasses, the last thing she said to me was, ''By all means, if you want to relax here and read one of our magazines, please do.'' I thought, "Yeah, no, I can't do that because I'm not wearing my glasses. I appreciate the offer, but it's a misguided offer because I'm not wearing my glasses." But aside from that, great customer service.

Asit Sharma: They aimed to please.

Chris Hill: [laughs] Exactly. Let's move on to Endava (DAVA 2.47%). Shares of Endava are up this week after ending their fiscal year on a strong note. Fourth-quarter revenue for the British software development company grew in the neighborhood of 50 percent which as revenue growth goes, is a pretty nice neighborhood. This is what you and I were talking about earlier. I'd never heard of this company before. How did Endava come across your radar and what did you think of the results?

Asit Sharma: Yes. There's this big and wide wave of digital transformation going on in every industry. We all know that. But this digital transformation is split up between software that's being offered by umpteen companies and software-consulting services which are offered by only a few. There are the big giants like Accenture, and then there's a series of smaller companies. Globant is one, EPAM Systems, E-P-A-M, is another, and Endava is a third that I follow. These companies are really interesting because there is a need within larger corporations for companies to come in and help improve internal software and software DevOps, provide the glue between different systems, but also to help with customer-facing technology. These smaller companies like Endava, which has a market cap of just $7 billion, help with that. I feel like this is a big playing field if you wanted to construct a basket around this. I like the idea of Accenture. It's this huge mammoth consulting company which can provide a solid base and then you can add the other three companies I mentioned and play this digital transformation wave on the consulting side. I like Endava, because again, it's so small and growing quickly. One of the things I look at in this industry is how a company is growing its headcount. The headcount at June 30th of 2021, which has got these numbers yesterday, is almost around 9,000 employees. You can compare that to about 6,600 employees at the end of the previous fiscal year. You can see that Endava is really hiring people and acquiring smaller consulting companies to be able to meet capacity out there in the marketplace. It's a sign that they see a lot of demand ahead. This hit my radar screens simply because it's just often bewildering to try to sort through the different software-as-a-service companies that offer so many solutions as companies tried to get more proficient in remote work, more proficient in fintech options, more proficient in customer communications. I could go on and on and on. It's almost easier to spend a little bit of time on this space between these four companies I've mentioned. That's how it hit my radar screen. These are the big picture things I like about it. Just to mention a risk which is actually shared by the other two smaller players that I mentioned, EPAM Systems and Globant. The top 10 clients for Endava account for about 36 percent of revenue. 

That's decreasing a bit versus 40 percent last year. But each of these small companies basically has the strategy to go very deep into a few large customers and then pull in new customers and gradually expand out of those concentrations. The other thing that I wanted to mention about this company is that it's got a really great revenue diversity. It's got about 31 percent of revenue in North America, 42 percent in the UK where they're based, and 24 percent in Europe. It's a company that's pretty well spread out across major centers. They need to get a little more representation in Latin America, which is becoming a hotspot for digital transformation. I think they could expand their footprint in Asia. But there's a lot to like in this little story. As you mentioned, Chris, the biggest thing is the eye-popping growth that the company has been able to generate. It's still quite small. Last thing I'll say before we discuss this a little bit, it does have a high-valuation. With that 50 percent range growth comes a 56 times earnings forward multiple, which I think is not too difficult to stomach when you consider that the playing field, the market, is very wide for companies like Endava. There is going to be work for years in the industries that it focuses on. For this company, that's pretty much payments in fintech, financial services, technology, media, and telecom. That's where they focused. They could stay in those industries and do well for quite a number of years to come.

Chris Hill: Two questions. First, I want to make sure I heard the numbers correctly. You said in terms of their top 10 clients, that represents 36 percent of their revenue, do I have that right?

Asit Sharma: Yeah, come back, Chris. Chris, come back. [laughs]

Chris Hill: No. That doesn't seem like a huge risk to me. When you preface it by saying, I think this is a risk, I assumed you were going to say their top 10 clients represent some number north of 50 percent. I thought it was going to be one of those concentrations. But the fact that it's 36 percent down from 40, to the extent that that's a risk, that seems like it's a risk that's getting smaller.

Asit Sharma: I think you've put a reasonable frame on it. Part of this is you get so used to the trees when you're in the forest. For those of you out there who invest in software-as-a-service companies, you're used to seeing zero concentration because a company is selling to thousands and thousands of customers. When you flip over to a consulting business and see a concentration like that, it's scary. But Chris, as you point out, this is actually reasonable. It means that they could still hold a couple 3, 5 of those very important clients and not take it too much on the chin that can probably rebound with the rate of customers they're adding anyway each year in a short amount of time. Yes, thank you for putting a more reasonable layer on that and not running clearway from the company after I said that.

Chris Hill: Second question. As you mentioned, the market cap is around somewhere between 6.5, $7 billion. Given their growth, given the market they operate in, how confident are you that Endava is a stand-alone public company in three years? Because it seems like the type of business that a larger fish could come along and make a big offer to.

Asit Sharma: This is a really good question. I always think about Accenture, which has a market cap of $206 billion and an enormous balance sheet. The three companies that I've mentioned are all quite small, although Globant and EPAM Systems are slightly larger. But it wouldn't be difficult for a company like Accenture to come in with a stock and cash deal and acquire any one of these. Why hasn't it yet? It could be just lack of strategic fit and the fact that Accenture itself is already so entrenched with some of the same customers. They don't see the need to get distracted with the smaller acquisition. Now, could there be mergers between the three companies I've been talking about? Potentially in the future, we could see one or two of these outfits merge. But because each of the companies that I'm talking about, again, to give you the name is one more time, EPAM Systems, Globant, and Endava, because they're all founder-led companies where the initial founders still hold some type of appreciable stake, most would be with this company Endava, but to some degree with the other two. I think that the founders are very focused on doing their own thing and pursuing their own vision. I'm going to give you a 65-70 percent confidence interval that they'll still be public in a few years.

Chris Hill: Asit Sharma, great talking to you as always. Thanks for being here.

Asit Sharma: It's a lot of fun. Thanks so much, Chris.

Chris Hill: As always, people on the program may have interest in the stocks they talk about on The Motley Fool may have formal recommendations for or against. So don't buy yourself stocks based solely on what your hear. That's going to do it for this edition of MarketFoolery. This show is mixed by Dan Boyd. I'm Chris Hill. Thanks for listening. See you tomorrow.