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Much of Dollarama’s goods, including some seen at this store in Toronto photographed in June, 2012, are purchased from China. (Deborah Baic/The Globe and Mail)
Much of Dollarama’s goods, including some seen at this store in Toronto photographed in June, 2012, are purchased from China. (Deborah Baic/The Globe and Mail)

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Dollarama’s stock: Not cheap, and trouble lies ahead Add to ...

During its nearly five-year life as a public company, Dollarama Inc.’s shares have been expensive, even as its wares have been cheap. It’s put up the numbers to justify that: Dollarama typically has led North American deep-discount retailers in sales and profit growth.

It’s still the leader, but there are now questions of whether the remarkable winning streak will continue. Were it not for an accounting tweak, Dollarama would have missed profit expectations in its first-quarter results, released Thursday. Of longer-term concern are factors out of the company’s control: the weak Canadian dollar, higher tariffs on Chinese imports and Ontario’s rising minimum wage.

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For now, investors continue to put their dollars behind Dollarama: Even with the profit disappointment, the shares are only off about 4 per cent from the record high set Monday. That’s understandable, since Dollarama doubters have consistently looked foolish as the company has continued to execute.

For those who instead want to explore less-expensive U.S. names, there are a couple of options in a sector invigorated by the recent interest of financier Carl Icahn. (Hint: Family Dollar, the beneficiary of Mr. Icahn’s investment, is not one of them.)

First, though, let’s review the bull and bear cases for Dollarama. A number of analysts maintain “buy” ratings on the shares; Irene Nattel of RBC Dominion Securities Inc. and Derek Dley of Canaccord Genuity Corp. have target prices of $114 and $106, respectively, compared with Dollarama’s close Friday of $91.37.

Dollarama continues to increase the value and number of its customer transactions (the first quarter’s poor weather excepted), as the decision to sell merchandise for up to $3, from the legacy $1 price point, has paid off handsomely. The company continues to add stores as well. It should all add up, Ms. Nattel says, to continued earnings-per-share growth of at least 20 per cent. Mr. Dley calls Dollarama “the most visible growth story in our consumer products universe” and says its superior profitability deserves a premium valuation.

A premium valuation is what it has; its forward price-to-earnings ratio of 21 compares with P/Es of about 16 for most of the U.S. dollar and deep-discount stores. To keep that spread up, it will need to hit, not miss, expectations. The company’s gross margins dipped a bit in the first quarter, thanks to increased cost of goods sold. Dollarama only made its target by adding four cents to earnings per share through an accounting-driven reduction in depreciation.

Analysts with “hold” ratings on the shares – about one-third of the 17 providing coverage – are more concerned with two things management can’t change. Ontario’s minimum wage rose 7.3 per cent, from $10.25 per hour to $11, June 1. Analyst Peter Sklar of BMO Nesbitt Burns Inc. estimates the increase will trim five cents per share from earnings this fiscal year and nine cents in the following year.

To be fair, that’s not a huge amount for a company expected to earn north of $4 a share this year, but in EPS, pennies count. What’s less clear, but possibly more material, are the impacts of the declining Canadian dollar and increased tariffs on Chinese goods.

Analysts believe the bulk of Dollarama’s goods are purchased from China with U.S. dollars; the decline of the loonie drives up costs of goods sold. Dollarama hedges its currency exposure roughly six months in advance, Mr. Sklar says, so foreign-exchange pressures on gross margins should show up in the latter half of 2014, he suspects. Also, Canada has withdrawn China’s preferential tariff treatment, so import duties will increase in January, Mr. Sklar says.

So, what to do if you believe Dollarama’s downside might outweigh its upside – and you’d like a dollar store that need not worry about these local factors?

Well, the top pick in the U.S. dollar-store sector, with 18 of its 24 analysts rating it a “buy,” is Dollar Tree Inc. It’s a company that’s still doing what Dollarama used to: selling everything for $1. It is also “a well-oiled machine,” Barclays Capital analyst Meredith Adler said in a recent note, saying it “has again demonstrated it can manage the business well, even in a difficult environment.”

It has same-store sales growth, a measure of revenue at stores open at least one year, of 2 per cent (notably, half the level of Dollarama), is adding stores at a rate of about 7 per cent a year, improving its margins and buying back stock. It also has designs on Canada, another potential avenue of growth. Ms. Adler has a target price of $65 (U.S.), compared with Dollar Tree’s Friday close of $53.92.

Given the woes of Target Corp.’s northern expansion, the idea of a U.S. retailer heading into Canada could make potential investors notably nervous. Fair enough. One of the rising stars in the space spent the first part of the year getting out of Canada. Big Lots Inc., which bought the failing Liquidation World in 2011 and liquidated it in the first quarter, is up 50 per cent since early March. That’s owing more to two consecutive excellent earnings surprises this year, but stripping its income statement of tens of millions of dollars in Canadian losses hasn’t hurt.

Big Lots is more of a closeout retailer than a dollar store; that and its previous languid performance help explain how it required that remarkable rise just to get to a forward P/E of 16, in line with Dollar Tree and others in the sector such as Dollar General Corp., the largest in the space by both revenue and market value.

Analysts are mixed on Dollar General, with some saying that macroeconomic concerns and a lack of growth opportunities outweigh the company’s initiatives to add lower-priced items to compete with Wal-Mart and Target, who have shown interest in competing on dollar-store price points. At $60.69, the shares have outrun Wells Fargo analyst Matt Nemer’s valuation range of $55 to $58.

And Family Dollar Stores Inc.? Mr. Icahn may have taken his sizable stake in the retailer because of a belief that a change in management, or at least in performance, could add value. Investors reacted so favourably to Mr Icahn’s move, however, that the increase in Family Dollar’s shares has driven it to earnings multiples closer to Dollarama’s than to its U.S. peers – no bargain at all.

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