Dollar Tree (DLTR -0.55%) might seem at first glance like an excellent stock for growth-focused investors. The retailer is expanding sales at a solid clip thanks to the combination of rising customer spending and new store openings. Profit margins are higher than those of its peers, too, due to its scale and its merchandising focus on convenience.
Yet there are warning signs suggesting weaker growth trends ahead. And the stock's premium valuation sets a high bar for the business's performance in 2023. Let's look at whether investors should be happily paying that premium for Dollar Tree shares right now.
Growth momentum
On the bright side, Dollar Tree managed to maintain its growth momentum in the past year. Comparable-store sales through late January were up significantly at both its Dollar Tree and Family Dollar franchises. Combined with an increasing store base, these gains allowed reported revenue to rise 8% in fiscal 2022 to $28 billion.
Sales trends are showing signs of weakness, though. Customer traffic fell in the past year and in the fiscal Q4 period, meaning Dollar Tree had to rely entirely on higher spending to drive growth. Contrast that performance with Walmart, which posted a healthy balance between rising spending and higher traffic in the most recent quarter.
Fiscal strength
Dollar Tree lands well ahead of Walmart on profitability, though. Operating profit in the past year was $2.2 billion, or 8% of sales. Walmart's comparable figure is closer to 3% of sales. Target's business briefly reached that 8% level during the pandemic, but its management team projected much weaker results in the next year following declining margins in 2022.
DLTR Operating Margin (TTM) data by YCharts
Dollar Tree has a strong cash position, too. Operating cash flow improved to $1.65 billion last year from $1.4 billion. This gives management plenty of flexibility to invest in growth initiatives like improved merchandising and new store openings. Dollar Tree has a shot at boosting profitability closer to 10% of sales as it cuts costs over the next year or so. "We are committed to driving further store productivity," CEO Rick Dreiling said in a March press release.
Wait and see
The big question for investors going forward is whether Dollar Tree can return to customer traffic gains in an era of rising prices and slowing economic growth. This rebound appears more likely in 2023. Management said traffic levels returned to positive territory at the start of fiscal Q1, after all.
Investors might want to wait for more concrete evidence of steadily rising traffic before concluding that this stock is a clear buy. Dollar Tree does enjoy unusually high profit margins for a consumer staples retailer. And sales growth could be amplified over the next several years by an expanding store base.
But the stock is valued at a price-to sales (P/S) ratio of 1.2 today, or nearly twice the valuation of Walmart and Target. That premium only makes sense to pay for a retailer that has a clear path toward winning market share. Until Dollar Tree can show those share gains, the stock seems like a hold at these prices.
