Dollar Tree at the Limits of Growth

Dollar Tree (NASDAQ: DLTR) may have reached its limits of growth. That might have some nasty implications for the entire discount sector.

During the year and a half after it acquired almost defunct rival Family Dollar, Dollar Tree saw its revenues shoot up from $8.602 billion in January 2015 to $20.39 billion in July 2016. That meant revenues more than doubled by increasing by $11.788 billion.

Yet between July and January Dollar Tree’s revenues went from $20.39 billion to $20.72 billion; an increase of just $330 million. That’s pretty good but it is chump change next to the post-acquisition jump.

Is Dollar Tree Capable of More Growth?

This raises some profound and troubling questions about Dollar Tree and dollar stores. The biggest of which is Dollar Tree capable of organic growth? The only way it seems to grow is by acquisition, yet there might be nothing else for it acquire.

An exterior view of a Dollar Tree store is seen in Pasadena, California August 31, 2015. REUTERS/Mario Anzuoni

If this is true it means there are serious limits to Dollar Tree’s business model. One major restraint it faces might be that there are simply not enough markets capable of supporting its stores. Another is that there might be only so much demand for its products which sell for one dollar.

Dollar Tree’s market might be more limited than we think. There are only so many people willing to shop at dollar stores. A lot of people avoid dollar stores like the plague because they associate such establishments with poverty, or remind them of their own poverty.

These suspicions; if true, certainly justify the Family Dollar acquisition. Family Dollar serves a more general clientele; and also serves many more communities because of its rural focus. Nor is Family Dollar limited to the $1 cost restriction which limits Dollar Tree’s inventory.

Dollar Tree is Closer to the Spiral than you might Think

Beyond the potential limits to growth there is a greater problem at Dollar Tree that some investors do not seem to understand. This chain’s resources are far more limited than you might think.

It reported a net income of $896.30 million and a free cash flow of just $903.9 million despite a 5.71% profit margin on January 31, 2017. That indicates a low cash flow which is confirmed by a cash from operations figure of $1.673 billion reported on the same day.

This means that like many discounters, Dollar Tree operates fairly close to the death spiral. That is too close for my tastes because it had just $870.4 million in cash and short-term investments at the end of the last quarter.

Therefore it is entirely possible that Dollar Tree might collapse suddenly much like Dollar General did. All it would take is a couple of bad quarters to drive the chain into the death spiral.

Dollar Tree is Overvalued

All this means that Dollar Tree is definitely overvalued. There’s nothing here that justifies the $73.94 share price it was selling for on March 15, 2017.

Nor does it even pay a dividend like Dollar General (NYSE: DG) does. Ycharts indicates that Dollar Tree has not paid a dividend for a while. Dollar General shareholders took home a dividend of 25¢ on December 19, 2016.

Dollar Tree shareholders did receive a return of equity of 18.36% on January 31, 2017 which is nice. Still there are less risky retail stocks with better returns that pay bigger dividends out there.

Lowes (NYSE: LOW) investors received a return on equity of 44.41% on January 31, 2017, for example. They also took home a dividend of 35¢ on January 23, 2017. Yet Lowes was trading at $82.75a share on March 15, 2017, just a few dollars more. To add icing to the cake, my take is that Lowe’s is less risky than Dollar Tree and far less vulnerable to Amazon (NASDAQ: AMZN).

How Amazon Threatens Dollar Tree

There’s a final reason why investors should stay away from Dollar Tree, it is far more vulnerable to Amazon than many investors realize. Amazon is making a strong push into some of Dollar Tree’s core markets with products such as its Household Essentials.

The Everything Store is also stocking large amounts of name brand cleaning supplies such as Bounty Paper Towels and Cascade Dishwasher packs. Many of which are available through Prime which means free two-day shipping for members.

This threatens Dollar Tree because Amazon now provides a more convenient source of many of the products people run to dollar stores before. Another threat from Amazon is Dash which allows people to restock popular household items; like Tide laundry detergent, Glad trash bags, Ziploc bags and Charmin toilet paper, at the push of a button.

That limits the need for shopping trips; which lead to the kind of impulse buying that Dollar Tree relies on for extra revenue. Many customers; who might normally shop at Dollar Tree or run in while at the strip mall, will no longer be there. To make matters worse these are the more affluent shoppers with more disposable income.

These are also the people most likely to drop $20 to $30 at Dollar Tree at the spur of a moment. An important component of Dollar Tree’s business model is “treasure hunt;” shoppers spotting and buying something they did not anticipate because it is cheap. Treasure hunt only occurs if customers have lots of disposable income; that requires middle or upper-class professionals – not welfare mothers.

Interestingly enough, Amazon’s consumer products push might threaten Family Dollar, the source of Dollar Tree’s revenue growth, even more than the flagship brand. Family Dollar is more of a general merchant; that sells a lot of household essentials, such as laundry detergent. Now it is competing directly with Amazon, something I don’t envy.

Therefore we are likely to see Dollar Tree’s revenues start dropping just like those at Target as Amazon and other online retailers like Walmart.com grow. All this makes Dollar Tree a very poor long term investment that you should drop from your portfolio now.