The Big Reason NOT to Own Dollarama Inc. 

There are lots of reasons to love Dollarama Inc. (TSX:DOL) stock. There’s only one reason not to. Care to guess what it is?

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The Motley Fool

What’s the big reason not to own Dollarama Inc. (TSX:DOL)? One word: it starts with the letter “V” and ends with the letter “N.” Not sure? Let me spare you the agony.

VALUATION.

While plenty of Fool.ca contributors have made the case since Dollarama went public in 2009 that it’s the finest retail stock in the land, at some point, how much you pay for the privilege of owning this stock must be examined.

If an alien were to land on Canadian soil and just happened to be an investor back on his or her own planet, the first question this visitor might ask about the company is, “Why do you people spend so much at Dollarama?” The second question: “How come you’re willing to pay 30 times earnings to own a discount retailer?”

Both are very good questions.

The first has to do with the fact it has almost no competition to speak of in this country with the exception of Wal-Mart Stores, Inc. and other big-box discounters. Sure, U.S.-based Dollar Tree, Inc. (NASDAQ:DLTR) has approximately 225 stores in Canada and will be growing that base of stores over time, but it hardly compares to Dollarama’s 1,030-store network and 10 million square feet of retail selling space.

This lack of competition is especially important in the context of margins.

Dollar Tree sells everything for $1.25 or less. Meanwhile, Dollarama has been pushing the envelope, offering items in its stores for as much as $4 each. With no one to keep Dollarama honest, it’s turning its stores into tiny Wal-Marts rather than large convenience stores.

As a result, it continues to deliver excellent financial returns for shareholders each quarter. Its most recent second-quarter results showed top-line revenue growth of 11% on same-store sales growth of 5.7% along with an 18.9% increase in diluted earnings per share. Those earnings are, in large part, thanks to its gross margins, which are near 40%.

If it had real competition, there’s not a chance that the last number would be nearly as high. The problem here, as I see it, is that investors are currently willing to pay up for margins that inevitably will shrink as Dollar Tree, Family Dollar, and others build out their store networks.

To answer our alien friend’s first question, people buy as much as they do at Dollarama because there really isn’t anyone else offering as many convenient locations as it does. If that were to change, I’d expect some customers to consider the alternatives.

The second question about investors being willing to pay 30 times earnings to own a discount retailer is also fairly straightforward, but will no doubt have value investors shaking their heads.

If, as the argument goes, Dollarama is the finest retail stock in the land, paying these multiples is the price of admission. That doesn’t make it right. It is what it is.

To buy Dollar Tree stock at the moment, you have to pay 25 times earnings; Dollar Tree’s biggest competitor in the U.S. is Dollar General Corp., which also own Family Dollar, another store looking at the Canadian market. To own DG stock, you’ll pay 16 times earnings. or about half what you’d pay for Dollarama.

Now, here’s where valuation comes into play.

Here you have two dollar-store retailers with 27,000 locations between them with only 225 in Canada. Both of their gross margins are around 30%–about 800 basis points lower than Dollarama.

In fiscal 2016, Dollarama generated $2.65 billion in revenue. At 38% gross margins, we’re talking about $1 billion in gross profits. For either Dollar Tree or Dollar General to generate $1 billion in gross profits they would need to generate an additional $683 million or 26% on top of the $2.65 billion. It’s significant.

But is it enough to justify a multiple that’s five to 14 times greater for the same dollar of earnings? I don’t believe it is.

Currently, Dollar General has an enterprise value of US$22.4 billion, or 9.3 times EBITDA. Dollar Tree’s enterprise value is US$24.6 billion or 11 times EBITDA. What about Dollarama? It’s almost 21 times EBITDA.

And what’s the ultimate irony?

Lululemon Athletica Inc. (NASDAQ:LULU), one of Canada’s other great retailers, can be had for 17 times EBITDA, despite the fact its gross margins are considerably higher at almost 50%. Dollarama might be more efficient than LULU at turning gross profits into net profits, but that doesn’t mean valuation isn’t a concern.

If the competitive landscape in Canada ever changes, you can be certain Dollarama’s stock will not be able to maintain an enterprise value 21 times EBITDA. In the meantime, it’s something to consider while you count your capital gains.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Will Ashworth has no position in any stocks mentioned. The Motley Fool owns shares of Lululemon Athletica.

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