2023-12-06 20:36:19 ET
Summary
- Dollarama is a market leader with a defensive business model and low beta that has achieved 27% CAGR over 14 years.
- Returns on invested capital are above 40%, and I expect its store count to increase annually by 4% in Canada and 10% in Latin America.
- The stock is currently undervalued by 13% with a fair price of CAD 113.
- The CEO, who is the great-grandson of the founder, owns over 500x its base salary in Dollarama's shares.
- Next week, Dollarama is set to release its Q3 results, which I expect to be stronger than analyst consensus forecast.
Note: All figures in CAD, unless otherwise indicated.
Investment Thesis
I consider Dollarama ([[DLMAF]], [[DOL:CA]]) a highly defensive business that is unlikely to be disrupted by new technologies or changes in consumer behavior.
Although it looks like an average retail business, Dollarama generates exceptional returns on invested capital and free cash flow margins.
On top of that, the company is still run by the founding family, which has a long proven track record of superior capital allocation and business expansion.
Despite its fast expansion over the last decades, Dollarama still has room to grow in Canada and its recently launched joint venture in Latin America, and I expect the store count to increase by 5% per year, comparable store sales by 4%, and the share count to decrease by 5% annually, providing investors with superior returns compared to the average company, making it a perfect risk-reward opportunity.
Dollarama's Background
Dollarama is the market leader in the dollar store concept in Canada with more than 1,525 stores, providing its customers with proximity and convenient access to everyday items at select fixed price points up to CAD 5.00.
The business is led by Neil Rossy, the great-grandson of Salim Rossy , who emigrated from Lebanon and opened his first store in Quebec in 1910. His son George took over the retailer in 1937 and managed the company until 1973, when Larry Rossy assumed leadership of the 20 stores.
In 1992, with 44 stores, Larry transformed one of his stores into the first Dollarama, based on a simple concept of offering all items for CAD 1.00 or less. After the initial success, all the other stores were converted to this new concept.
Dollarama entered a new phase in 2004 when Bain Capital , a private equity group, acquired an 80% stake for CAD 1.03B, facilitating the expansion of Dollarama into Western Canada. Eventually, in 2009, Dollarama went public at an initial share price of CAD 17.5 (~CAD 3 adjusted for splits ).
Since then, Dollarama has experienced impressive growth, achieving a 27% compound annual growth rate ((CAGR)) or a 30-fold increase.
Profitable Business Model
At first glance, dollar stores could look like an average retail business, but some particular characteristics make it unique and a highly profitable business model.
Dollar stores have higher operating margins than other retailing segments, since they aren’t always as cheap as they seem, and can maintain a lower cost structure.
While it is true their mark-up prices are relatively low, they can sell the same products that larger retailers in smaller package sizes at a higher price per unit, charging an extra for the convenience and proximity.
From the cost perspective, they carry a limited assortment of products, and there’s less pressure to stock a particular brand, which leads to higher bargaining power with suppliers.
Products are sourced from North American suppliers (47%) and imported from overseas, mainly China , where Dollarama started building direct relationships in 1993 to gain a competitive advantage. The largest vendor accounts for less than 6%, suggesting a well-diversified supply base.
Financials
The initial investment for a new Dollarama store for capital expenditures and inventory is approximately CAD 0.92M, and generates over CAD 2.9M in annual sales within the first two years of operation, achieving an average capital payback period of two years, making it a highly profitable business model with low capital requirements, since the stores are leased.
Note: Due to IFRS 16 modifications in 2019, average invested capital has been adjusted for leases to make data comparable.
As shown in the chart above, returns on invested capital are above 40% and have been increasing over the years.
To expand its business, Dollarama doesn't need much debt, and it currently has CAD 1.7B in long-term debt at fixed interest rates maturing in five tranches until 2030, at an average interest rate of 3.2%. Total debt excluding lease obligations to current free cash flow stands at ~2.7x.
While Dollarama could use its strong cash flows to pay down debt in the upcoming years as interest rates rise, during the last decade the company took advantage of the low interest rates and the expansion opportunities, increasing the number of stores and buying back shares.
Dollarama continues to increase its store count by 5% annually in Canada. Although the growth rates diminish as the store count rises, the company has identified a potential for international expansion, which I will elaborate on later.
Since the capital requirements for opening a new store are relatively low, and the total maintenance capex for the entire network is less than CAD 20M annually, Dollarama has been returning the excess capital to shareholders, mainly through share buybacks.
Over the last decade, Dollarama has reduced its share count by an average of 4.3% annually and is currently paying a 0.3% annual dividend (CAD 0.07 quarterly ).
Defensiveness
On top of its strong economics, Dollarama provides an added value that I consider important to take into account when constructing a portfolio, which is the defensiveness of the business.
Its stores offer everyday stuff such as cosmetics, food, beverages, cleaning products, household wares, toys, and pet food, among others, which have a relatively inelastic demand and consumption doesn't decrease significantly during recessionary periods.
Discount stores predominantly address the cash-flow timing of lower-income consumers. While you could go to Costco (NASDAQ: COST ) or Walmart (NYSE: WMT ) and get a better deal on a per-unit basis, if your weekly budget is limited, you might go to Dollarama and buy a smaller quantity at a lower price.
Also, Dollarama's business is not likely to be disrupted soon and e-commerce has not posed a substantial threat, since the economics of the business make it difficult to justify the delivery cost and time.
During the period of the great financial crisis, Dollarama demonstrated resilience by increasing its total revenues from CAD 888 million in 2007 to CAD 1,089 million in 2009, while enhancing its revenue per store.
These characteristics make it a highly defensive business with a good fit in almost every portfolio since its beta of 0.42 and low volatility helps to balance the portfolio's performance.
Latin American Expansion
Dollarama's expansion is not limited to Canada, where the number of stores is expected to reach 2,000 by 2031, but the company also has a 50.1% stake in Dollarcity, which operates in Latin America.
This strategic expansion wasn't a hasty decision, but the result of many years of studying and testing the market before making the call.
Dollarcity was founded in 2009 in El Salvador. When it operated just 10 stores in 2013, Dollarcity signed an agreement with Dollarama to get sourcing services and business expertise. Under the agreement, Dollarama was not required to make any capital investments but included an option to acquire a 50.1% interest in Dollarcity as of the beginning of the seventh year.
After six years of building market knowledge through on-the-ground experience and validating the adaptability of Dollarama's model in Latin American countries, the company exercised the call option in 2019 and has doubled the store count since then.
Dollarama paid a five times multiple of Dollarcity’s EBITDA for the 12 month ended June 30, 2020, minus net debt, which amounted to CAD 122.1M.
The initial investment to open a new Dollarcity store is smaller compared to a Dollarama store and amounts to CAD 0.73M. The head office is located in Panama and there is a local warehouse in each country of operation. While most of the products are sourced through Dollarama, the mix includes local products sourced from the countries in which Dollarcity operates.
If we take into account that Dollarcity has generated CAD 33.2M in Net Earnings during the first half of 2023, its acquisition had a four-year payback period.
Net income margins are lower when compared to Dollarama's stores, but management is expecting to improve them over the years as operations grow in scale, and they consolidate the new markets:
I think there’s potential to continue improving it [EBITDA margin]. Definitely, that’s what we’re looking to do. However, Colombia is a new market. Typically, when you come into a new market, your margins are a bit lower. The other countries are more mature and have grown – improved their EBITDA over time. And so I would say that in a shorter period of time, you’ve got a bit of margin pressure. But over the longer term, the aim is to improve those – that margin.
Source: Michael Ross - Dollarcity Acquisition Conference Call
Latin America has an increasingly young urban population with similar spending habits to North Americans, and the international expansion opens the opportunity to improve its growth rates for many years ahead. While the Canadian population is 38.7M people, in the Latin American countries where Dollarcity operates the total population is 110M people.
Until February 2027, Dollarcity’s founding stockholders have a put right under which they can require Dollarama to purchase shares of Dollarcity at fair market value up to 24.9% of all shares outstanding.
Due to the current success and the increase in store target by 2029 from 600 at the moment of the acquisition to the current target of 850 stores, I am not expecting founding stockholders to exercise the put option.
Expected Growth and Valuation
So far, we've examined Dollarama's past performance, but what can we expect for the future?
Q3 FY2024
Next week, on December 13 at 7:00 a.m. ((ET)), Dollarama is set to release its Q3 results. Traditionally, the third and fourth quarters are the strongest for the company, with December accounting for the highest proportion of sales.
Anticipating a surge in year-end sales, I expect inventories to rise this quarter and an increase in SG&A expenses due to higher minimum wages in many Canadian states from the 1st of October. However, the full impact of this change won't be reflected until the following quarter, as only one month of increased salaries will be accounted for in Q3.
Analyst consensus has been revised upward in recent months from CAD 1.4B in revenues to CAD 1.48B, and earnings per share ((EPS)) from CAD 0.79 to CAD 0.86, representing a year-over-year increase of 15% in revenues and 22% in EPS.
Given Dollarama's favorable trend in transaction volume and average transaction size in recent quarters, along with the stable conditions in the Canadian labor market throughout the three months covered by Q3, I expect the company to slightly exceed both revenue and EPS estimates.
Long-term Expectations
Taking into account Dollarama's current store growth rates and management's guidance (2,000 Dollarama stores by 2031), I expect a 4% annual increase in store count in Canada and 10% in Latin America.
Management has a track record of overdelivering and achieving store count targets before the deadline, but I will take a conservative approach and not include any expansion into new Latin American countries such as Honduras, Costa Rica, Nicaragua, Panama, or Ecuador.
In Canada, the western part I believe still underpenetrated. British Columbia and Alberta have a combined population of ~10M people, and Dollarama only has 297 stores. In Quebec, where the population is ~8.8M people, there are currently 403 Dollarama stores.
On top of the store count growth, over the last decade, Dollarama has increased its like-for-like revenues by 6.37% on average. I am assuming a 4% increase in comparable store sales, between the past growth rates and inflation.
Assuming a 5% annual decrease in share count, using an 8.5% discount rate (3.2% cost of debt, 10% cost of equity, and 26% effective tax rate), a 22x free cash flow multiple, and a 3% long term growth based on inflation, the average fair price is CAD 113 per share.
Valuation
From a valuation perspective, Dollarama has been trading on average between 20x-25x last-twelve-months free cash flow, which I believe is more than fair given Dollarama's predictability, high returns on capital, and expansion opportunities.
Risks
While Dollarama's in-store business model is unlikely to be disrupted by e-commerce and disruptive technologies, and its growing market share in Canada suggests the competitive advantage is becoming stronger, there are a few risks worth monitoring.
Minimum Wage Increases
Inflation has accelerated its growth rates over the last couple of years, and even though Dollarama has managed to benefit from consumers' demand for discount products keeping its operating margins at pre-pandemic levels, the company is highly reliant on low-wage workers .
On average, a Dollarama cashier in Canada earns CAD 15.33 per hour, but this has changed since October, following the minimum wage increases in many Canadian provinces. In Ontario for example, the province with most Dollarama stores, minimum wages are increasing for the next year by 6.7%, driving SG&A expenses up.
It is important to note that management's guidance for the full year regarding SG&A expenses was in the range of 14.7% to 15.2% of sales, but during the first half of the fiscal year, SG&A expenses have been at 14.3%.
Supply Chain Disruptions
Imported goods are generally less expensive than domestic goods and contribute significantly to profit margins. Therefore, maintaining robust political and economic relations between Western nations and China is crucial, and any disruptions in these relations could potentially impact Dollarama's margins until alternative affordable sourcing is established, which won't be easy or fast.
During the pandemic, Dollarama has demonstrated its ability to fill the shelves, continue its international operations without major disruptions, and keep its gross margins at good levels.
Unless international relationships between countries deteriorate, I don't see this as a major risk given Dollarama's strong relationships with suppliers and its efficient sourcing.
Latin American Operations
Dollarcity still represents less than 10% of Dollarama's net income, but as the Latin American operations grow in size, the effect on Dollarama's accounts will increase over time.
Although the company carefully analyzed its expansion into Latin American countries over the years and this could be a great success over time, I believe it also presents some risks.
First, there is the currency risk. Dollarcity imports 65% of the goods sold in USD, since it is the most used currency in international trade, even to import from China.
Dollarcity is not hedging the Latin American currencies through financial instruments, which makes sense given the high costs, and only hedges for its Canadian imports. Instead, they are using natural and contractual hedges to reduce volatility.
To achieve this, it is important to have a high inventory rotation, exchange the local currency to USD or CAD as soon as possible, and keep similar balances between receivables and payables in foreign currencies.
The second risk I'd like to highlight is inflation, which at the same time is one of the reasons causing Latin American currencies to depreciate over time.
As shown in the image above, except for El Salvador, the other three countries where Dollarcity operates, inflation rates are higher compared to Canada. I don't see higher inflation as a major risk as long as it can be passed to customers, since it also affects competitors and shouldn't affect Dollarcity's competitive position, but it could be problematic if it gets too high and damages demand.
Finally, there is a higher political and economic instability risks. Although the situation has improved over the last years in Latin America, the Canadian crime rate per 100,000 people is currently at 42, while the countries where Dollarcity has stores are between 56 (Colombia) and 68 (El Salvador).
As shown by the studies reviewed, this is mainly a result of a shorter democratic history, income inequality, lower urbanization, education levels, and openness to international trade.
Conclusion
The main reasons behind Dollarama's over 50% market share among discount stores in Canada are the value it provides to its customers and a perfect business execution.
As an investor, I believe Dollarama is a perfect fit for most portfolios, especially in turbulent times, where it provides stability to the overall performance without giving away superior returns.
The company is generating returns on capital above 40% and is deploying its strong cash flows into expanding the store count in Canada and internationally while reducing the outstanding shares by 4.3% annually.
This exceptional profitability and capital allocation, combined with the fact that the CEO holds over 500x its base salary in Dollarama's shares, and the 13% discount to the fair price of CAD 113 per share, position Dollarama as one of my highest conviction picks for 2024.
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Dollarama: Defensive Business With Superior Returns