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Dollarama: A better bargain than we thought

In coming days, we'll look back at VOX's 2012, reviewing the buys and sells to see which calls turned out right and – to the delight of impolitic readers who like to call me stupid – which went wrong.

Today, as a warmup, and a tribute to last-minute holiday shopping, let's look back to one of my most spectacularly wrong pieces of 2011: a skeptical look at Dollarama.

While much of Bay Street labelled the shares, trading at around $32 in June, 2011, as a strong buy with potential to hit $40 or more, I laid out the case for why the stock could disappoint. Of course, it merely doubled by summer 2012.

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I did have a co-conspirator, however: Kathleen Wong of Veritas, the sole analyst at the time with a "sell" rating on the stock. She has finally come around, upgrading Dollarama to a "buy" in September and maintaining it after this month's earnings. And it's instructive, I think, to review where we were wrong and what's changed her mind.

First, let's review the scene in June, 2011: Dollarama had just beaten already lofty expectations for its earnings per share and same-store sales growth. At the same time, gross margins rose as it continued a successful introduction of products selling for more than its traditional $1 price point.

Ms. Wong observed, however, that the company had posted declines in store traffic, as measured by transaction counts, in each of the prior two quarters. She also believed it was reaching the saturation point for selling products at prices above $1. Neither trend could get better as competition intensified, she believed.

Well, traffic counts did decline in the subsequent two quarters, but at not nearly as severe a pace as the 2.8-per-cent decline Dollarama had just posted. Then, the company began posting strong traffic gains as it lapped those four weak quarters.

Where Ms. Wong missed most badly was in the assertion that sales of the higher-priced products would stall. Aided by items selling as much as $3 now, average transaction sizes have continued to grow in the mid-single-digits.

Increasing traffic and larger transaction sizes have combined to push Dollarama's same-store sales growth to as much as 8.1 per cent in the quarter ended April 29; the 6.6-per-cent figure in the most recent quarter was the lowest of the past four. (By contrast, in the four quarters before that – representing most of calendar-year 2011 – same-store sales growth peaked at 5.3 per cent.)

Gross margins, meanwhile, are slightly higher than in early 2011.

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In her September report, Ms. Wong looked back and said the fears about the company's multiple-price-point strategy were that "Dollarama's value proposition would be damaged, and customers would respond by shopping elsewhere for products they felt increased in price, or became too expensive."

However, in August, Ms. Wong updated a Dollarama-versus-Wal-Mart price survey she first did in August, 2010. The result? Dollarama's price advantage is widening. She found 84 per cent of the items she checked were lower at Dollarama, and the average price for the 45-item basket is 35 per cent lower at Dollarama than at Wal-Mart. (The figures were 55 per cent and 16 per cent, respectively, two years ago.)

Competition? Indeed, U.S. store Dollar Tree has Canadian aspirations with its 2009 purchase of Dollar Giant. But Ms. Wong now feels that, while there will be some impact to Dollarama, its successful price-point expansion (versus Dollar Tree's cap of $1.25) will be "a positive catalyst" for the company.

Some suggest the Canadian dollar-store industry can expand to thousands of stores, based on per-capita counts in the United States. Ms. Wong disagrees, citing the U.S. stores' reliance on food (and the federal food-stamp program for the needy).

She now believes, however, that Dollarama can continue on an "aggressive growth" path in the next several years to its goal of 1,000 stores. And that it has enough of a commanding lead in real estate that "Dollar Tree's goal of reaching 1,000 stores from its [September] footprint of 118 is wishful thinking."

Ms. Wong now places an "intrinsic value" on Dollarama of $65 a share, a modest but meaningful level above recent prices around $57. And like the cautious analyst she is, Ms. Wong warns "the market has priced in strong growth assumptions for Dollarama, leaving the company with little room for error. When priced for perfection, perfection must be delivered!"

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True enough. Here at VOX, though, I've periodically warned against expensive stocks from growing companies who seem to face long-term competitive challenges. Quite often, those companies managed that perfection, or something close to it, for several more quarters. Be careful betting against Dollarama doing the same.

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