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Dollarama Inc. (TSX:DOL) Is up Big From Its Lows: Should It Be a Top Pick?

Dollarama Inc. (TSX:DOL) is up 28% from its December 2018 lows in a move that is partly a reflection of a strong market and partly a reflection of investors warming up to Dollarama again, especially in light of the new valuation multiples that Dollarama stock is trading at.

Let me explain.

Market moves

The S&P/TSX Composite Index is up 20% from its December lows, so we can see the broad strength in the market as a whole as the threat of interest rate hikes has subsided and investor optimism has soared. This has driven up valuations of stocks in general.

Increasingly attractive valuation

In its former glory, Dollarama stock commanded a price to earnings multiple of 35 times, as sales were skyrocketing and margins continued to rise, but its rapid fall from grace drove valuations down significantly, sparking investors interest.

These days, the stock is trading at multiples of 24.5 times last year’s earnings, and just over 22 times this year’s earnings estimate, but these lower multiples have come as a result of slowing sales growth, earnings growth, and falling gross margins.

The problem is that these lower multiples come with lower earnings growth rates.

The last three quarters saw the company report earnings that were below expectations, and while these misses were not big misses, they are still three consecutive misses.

Earnings growth has come down to levels closer to 10% compared to earnings growth of almost 25% a few years ago.

So if we consider these lower growth rates, we can see that a 22 times earnings multiple doesn’t look that great.

Retail environment

Add to all this the changing retail environment, both the general big picture environment, and the environment for Dollarama in particular, and we can see more trouble that justifies Dollarama’s significantly lower multiples.

Back in its heyday, same-store sales growth topped 8%, as traffic was rising and price points increasing.

Fast forward to today and we can see the opposite trends taking hold. Traffic is falling (40-basis point traffic decline in the latest quarter) and it seems like increases in prices have had a negative effect.

The problem is that as prices at Dollarama rise, it moves the retailer into the same space as other discount chains and eventually leaves it competing squarely against retailers like Walmart, for example. I believe this is changing the competitive environment for the company and the value proposition.

The retail environment is increasingly competitive, the consumer is increasingly tapped out with soaring debt levels, and consumer spending seems to be on its last legs.

Final thoughts

In summary, I would like to go back to my original question: should Dollarama be a top pick?

As much as I admire what the company has done, I have to say no, as both the macro environment looks difficult and the company-specific case is no longer a strong one, notwithstanding the rapid decline in Dollarama’s stock price.

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Fool contributor Karen Thomas has no position in any of the stocks mentioned.

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