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Dollarama Inc. shares have hit some turbulence because of concerns over the discount retailer’s profit margins. But the sell-off alleviates the biggest downside to the stock: its high valuation.

In August, the shares traded at 30 times reported earnings – a remarkable valuation for a bricks-and-mortar retailer that counts credit-card transactions and self-checkout aisles as key innovations.

Now, the shares trade at 25.6 times earnings. That’s not exactly cheap, but it makes the stock more attractive to long-term investors who stand by Dollarama’s remarkable pace of expansion.

The company’s third-quarter results, released last week, underscored this pace for the most part. The retailer opened 21 net new stores during the period, an acceleration from 14 new stores in the third quarter last year. Overall sales increased by 9.6 per cent, also year-over-year. And profit increased 4.9 per cent, or 10 per cent a share.

The results also underscored impressive operational improvements. Sales at stores open for at least one year increased by 5.3 per cent, up from same-store sales growth of 2.7 per cent in the third quarter last year.

But the market flipped out over a slight compression in gross margins (gross profit divided by sales), which slipped to 43.7 per cent from 44.3 per cent as the company focused on foot traffic rather than price increases. The shares fell 8.9 per cent on Dec. 4, after the release of the financial results, and are now down 13.4 per cent from their record highs in August.

In some ways, the retreat is in line with the gravitational pull that has been exerting itself on other North American discount retailers that sell products for a few bucks or less.

Share prices for Dollar General Corp. and Dollar Tree Inc., both U.S.-based, rose this year by as much as 53.4 per cent and 31.1 per cent, respectively, as investors rushed into stocks that appeared relatively immune to an outright recession – a fear that defined market action earlier this year.

Valuations also rose. Dollar Tree’s price-to-earnings ratio was above 24 as recently as October. And Dollar General’s P/E was 26. According to Goldman Sachs, both stocks were among the 50 most overweighted positions by U.S. mutual funds at the end of June, underscoring the popularity of discount retailers among professional investors.

But fears of an economic downturn have subsided with continuing growth in U.S. employment and three successive cuts to interest rates by the Federal Reserve in the second half of the year.

Stock prices have also subsided: Dollar General is down 6.8 per cent from its high and Dollar Tree is down 21.5 per cent.

Bad news added to the downward pressure in the case of Dollar Tree. The retailer reported in November that its third-quarter earnings on a per-share basis fell 8.5 per cent from last year. The news sent the share price down 15.2 per cent on Nov. 26.

Given this industry-wide backdrop, has the investment case for Dollarama shifted noticeably?

Some analysts believe that the margin compression in the third quarter points to slower profit growth ahead, which could weigh on the share price.

“We expect the stock to remain range-bound in the near term as it still trades at a fairly healthy valuation … and as investors await better earnings visibility,” Chris Li, an analyst at Desjardins Securities Inc., said in a note last week.

Nonetheless, the upside potential here is enticing if you can live with the near-term uncertainty and the fact that the stock is hardly a bargain.

Irene Nattel, an analyst at RBC Dominion Securities, estimates that strong growth in same-store sales, share buybacks and continuing expansion with new store openings will raise the share price to $56 within 12 months, implying gains of 26 per cent from a close of $44.53 in Toronto on Monday.

And if the economy tanks? Discount retailers will be all the rage again.

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