Dollar Tree Stretches a Buck

The dollar buys much less than it once did. And that's bad news for stores that specialize in selling items for $1 or less. Such retailers are pinching pennies as their aisles are brimming with more customers who want bargains. Among this beleaguered pack, Dollar Tree (symbol DLTR) has managed to keep costs at bay and surprise Wall Street with better-than-expected earnings.

The Chesapeake, Va., company is the nation's third-largest deep-discount retailer, behind Dollar General and Family Dollar. Dollar Tree operates more than 3,470 stores in 48 states. It has staked out the suburbs, while competing dollar stores reside in small towns and inner-city neighborhoods. Most of its stores carry the Dollar Tree name, but the company also runs Dollar Bill$, Dollar Express, Greenbacks, Only $1.00 and Deal$, which sells items for $5 or less.

The company's future hinges heavily on the Deal$ stores. Dollar Tree bought the chain in March 2006 for $30.5 million to test the idea of operating stores with merchandise that costs more than $1.

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The results have been promising. Deal$ stores generate more sales than traditional Dollar Tree locations. A receipt at a Deal$ store is $16, on average, compared with $7 at other Dollar Tree locations. The higher-priced merchandise at Deal$ stores will give Dollar Tree an advantage, considering its rivals are stuck selling their items for about a buck.

The company also has an edge when it comes to controlling costs because of the design of its Dollar Tree stores. "The stores are set up in a treasure-hunt format," says Karen Short, an analyst for Friedman, Billings and Ramsey. Dollar Tree customers don't expect to find the same brands every time they visit. That means the company can use the lowest-cost suppliers without customers being disappointed by the brand switch.

And Dollar Tree has room to spread its roots. This year, the company intends to open 225 to 245 Dollar Tree stores and 25 to 30 Deal$ stores, and it plans to remodel 90 to 100 stores. Management says it eventually expand to 5,000 to 7,000 stores across the country and possibly more if the Deal$ chain takes off.

Dollar Tree is in decent financial shape. The company had $84 million in cash on hand and $269 million in debt at last count. "The company has a clean balance sheet with very low leverage," Short says. Dollar Tree can use the cash to buy back stock, expand to new locations and further develop the Deal$ concept.

Still, oil shocks and high inflation will increase Dollar Tree's costs, especially because it uses so many overseas vendors. But the company has hedged its bets for the rest of the year. "The company does sourcing so much in advance. They already have merchandise for most of the holiday season," Short says. "They know what their costs are for the year and know they can maintain their margins."

Plus, Dollar Tree has a knack for surpassing expectations. For the past three quarters, the company's earnings beat the average of analyst estimates, according to Thomson Financial. In the quarter that ended May 3, Dollar Tree posted a 14% jump in fiscal first-quarter net income because of rising demand for low-priced items in a weak economy. Its net income was $43.6 million, or 48 cents per share, compared with $38.1 million, or 38 cents per share, a year earlier. The average analyst estimate was 42 cents per share.

The company also raised its guidance for the 2008 fiscal year, which ends January 31, 2009, to a range of $2.23 to $2.39 per share (up from $2.17 to $2.35 per share).

The stock, which closed at $33.08 on July 1, looks reasonably priced for its growth prospects. It's up almost 28% so far this year, but it's down 28% since its June 6, 2007, high of $45.98. Shares trade at 14 times the $2.38 per share analysts expect the company to earn in fiscal 2008 and 12 times fiscal 2009 estimated earnings. Not bad, considering analysts forecast a 14% long-term annual earnings growth rate. Short rates Dollar Tree shares an "outperform" and gives a 12-month target price of $38.50.