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Dollarama: Wait for the stock to drop before pouncing

Dollarama plans to open more stores this year in head off increased competition.

Kevin Van Paassen/The Globe and Mail

Dollarama Inc. has always had its doubters.

True, the stock is currently trading near an all-time high at a valuation many see as stretched.

But every slight disappointment or rare earnings miss is met with an overreaction to the downside, said Peter Hodson, head of research at 5i Research, an independent stock analysis firm.

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"Investors sell it down and think the game is over," he said. "Whenever they screw up, that's your chance to get it cheaply and ride it for the next couple years."

Dollarama has long-term staying power in Canadian retail and has a competitive advantage that could allow it to continue to defy its skeptics, Mr. Hodson said. But for investors, now might not be the best time to buy.

After beating analyst's forecasts for fiscal fourth-quarter earnings earlier this month, Dollarama's stock soared to a record high of $92.97.

While the stock has eased off a bit, closing at $88.56 on Thursday, it is still trading at about 20.7 times forward earnings, according to Bloomberg. The big U.S. dollar store chains have forward price-to-earnings ratios in the range of 16 to 18.

"For now, I'll sit on the sidelines and wait for a better entry point," said Brian Huen, a managing partner with Toronto's Red Sky Capital.

But if the stock is overpriced, it's not by much, Mr. Huen said. "Until they are unable to deliver growth, I think the stock will continue to trade at a rich valuation."

Investors have traditionally only favoured deep-discount retailers during economic downturns when value trumps all else. The last recession being so severe, the big dollar store chains attained unprecedented profile, resulting in dizzying stock runs.

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Since its 2009 initial public offering, the company has added almost 300 stores to its national chain, now numbering more than 850.

Over that time, Dollarama's earnings before interest, taxes, depreciation, and amortization (EBITDA) has increased by almost 2.5 times, and its share price has risen by 400 per cent.

The fear was that once the economy finally recovered in full, consumers would abandon their frugality, relegating dollar stores to their former low rank in North American retail.

That's not going to happen this time around, as corporate dollar store chains have established themselves as retail mainstays, Mr. Hodson said. "That's a non-thesis now. They're now in good locations and people like their products."

The second fundamental threat often cited as likely to end Dollarama's hot streak is the entry of U.S. chains into Canada. Dollar Tree has predicted it could open as many as 1,000 locations in Canada.

To head off the competition, Dollarama has stepped up the pace of its store expansion, with plans to open 70 to 80 net new stores this year, mostly in Ontario and Western Canada.

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Even at that rate, the company still has a good five years before it saturates the market, Mr. Hodson said.

That's plenty of time to buy into Dollarama's expansion. And there aren't many alternative growth stocks in Canadian retail.

In the meantime, as the chain continues to increase its store count, the company's finances are encouraging.

"The company is generating more cash than it knows what to do with," CIBC analyst Perry Caicco said in a recent research note raising his price target to $100 from $95 while maintaining a "sector outperformer" rating.

Of the 16 analysts covering the stock, 11 rate it a "buy." The average target price is just short of $100.

Mr. Caicco said he expects the company to maintain an aggressive buyback program while regularly increasing dividends. And compared to the U.S. chains, Dollarama generates better operating metrics and much higher margins, he said.

As a result, Dollarama's higher multiple is justified, Mr. Hodson said. "We think it deserves some premium."

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About the Author
Investing reporter

Tim Shufelt joined the Globe and Mail in August, 2013, primarily to cover investments for Report on Business. Prior to the Globe, he worked as a staff writer at Canadian Business magazine, a business reporter at the Financial Post, and covered city news and courts for the Ottawa Citizen. More


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