Canada's Champion of Cheap

02/22/2011 12:58 pm EST


Gavin Graham

Chief Strategy Officer, INTEGRIS Pension Management Ltd

Dollarama shares are more expensive than the items the chain sells in its dollar stores, yet they may be a better buy, writes Gavin Graham in the Internet Wealth Builder.

Dollar stores are a familiar feature on the retail scene, selling a wide variety of low-priced items—usually for a dollar or less, hence their name.

The success of dollar stores depends upon management's ability to continually source low-cost merchandise of reasonable quality from a variety of suppliers. The Rossy family, which founded and runs Dollarama (Toronto: DOL), the largest dollar-store chain in Canada, has been in retailing for four generations and has proven itself adept at this skill.

The present business was founded in 1992 in Montreal by CEO Larry Rossy, whose son, Neil Rossy, works as chief merchandising officer and whose family owns 6% of the company.

In 2004, Dollarama's largest shareholder, the US-based private equity firm Bain Capital, bought a majority stake from Mr. Rossy and management for $1 billion and helped the company expand from its base in Quebec and Ontario. [All figures are in Canadian currency.] Once that was done, Dollarama went public.

Nine Years Without a Hitch
Over the nine years to January 2010, sales grew 16% per annum and EBITDA by 20% before taking into account the expenses of the IPO and the early repayment of $300 million of debt in 2009.

On the all-important issue of same-store sales growth, which compares growth only from stores that have been open for a year, the addition of goods priced between $1 and $2 has seen same-store sales more than double, from 3% per year from 2003-09 to more than 7% in 2009-10—and 7.8%-8.3% in the first three quarters of 2010-11.

Dollarama offers attractive new-store economics, requiring only $400,000 in leasehold improvements and fixtures and $200,000 of inventory to open a store and achieve a quick payback. With first-year stores averaging $1.8 million in revenue and low maintenance capital expenditures, new openings achieve payback within two years. This accounts for the rapid pace of new openings, with an average of 51 new stores being opened in each of the last four years. In the most recent quarter, the company opened 17 stores and closed one.

Dollarama believes the Canadian market is still significantly under-penetrated compared to the US, where there are 15,000 people per dollar store, compared to 32,000 in Canada.

Like all stocks, this one is not without risks. While a dollar store would seem to be about the most recession-proof business imaginable, as evidenced by Dollarama`s effortless progress through the 2008-09 recession, there are a couple of concerns to consider. For example, if the cost of the $1 and $2 items that Dollarama sells were to increase because of rising inflation in China or elsewhere, it would be hard for the company to pass on those added expenses, given its pricing policy. Investors would have to rely on the Rossy family`s track record of finding other low-cost supply lines.

Competition Could Heat Up
Also, if a major US dollar store chain with greater economies of scale due to its size were to move into Canada, the competition could make it more difficult for Dollarama to continue its rapid growth. One such potential entrant is Dollar General (NYSE: DG), which also went public in an IPO in 2009.

Lastly, when the one-off benefits of the introduction of higher-priced items, accepting debit cards, and introducing scanners reach full penetration, same-store growth will likely fall back to the 3% level experienced during the previous decade.

However, there are several years to go before these trends mature, meaning that Dollarama`s price/earnings ratio of 18 times last year's earnings will become more reasonable, with analysts expecting it to decline to 15 times.

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