Description

Dollarama (DOL-TSX): A compelling short opportunity

Section A | Company Overview

• Dollarama (“DOL”) is a Canadian dollar-store retail chain founded in 1992 by Larry Rossy

• Larry Rossy stepped back the CEO role earlier this year, while continuing to serve as DOL’s Executive Chairman

• As of on May 1st, 2016, Neil Rossy, Larry’s son, is CEO of DOL. Neil was formerly DOL’s Chief Merchandising Officer

• DOL launched its IPO in late 2009 and trades as DOL on the Toronto Stock Exchange (TSX)

• DOL currently has 1,038 stores across Canada: management has guided growth to 1,400 stores in Canada, targeting completion in the 2022 timeframe

• DOL’s stores are typically just under 10,000 square foot in size

• Historically focused on $1 and $2 items, since IPO DOL doubled its top selling price from $2.00 to $4.00 today

Section B | Short Thesis Summary

• DOL has an unsustainable valuation:

• Enterprise Value (“EV”)/FY2017 EBITDA of 18.4x, in-line with high growth tech companies, and exceeds the levels of comparable grocers and dollar store operators

• EV has expanded >5x since 2010 with EBITDA growing only 2.5x during the same period

• EV/sqft of approx. $1,170, vs comparable retailers at $250-450/sqft. Note that DOL also has no intrinsic real estate value as they lease all their locations

• A price to book valuation of 34x – surpassing the levels of TSLA

• A discounted cash flow (“DCF”) valuation using bullish analyst growth assumptions implies downside to share price and price targets

• A FY2017E Free Cash Flow (“FCF”) yield of 2.6% vs. Peers at 4-5%

• A cursory Bloomberg screen leads us to believe DOL to be one of the most expensive physical retailers globally

• Recently reported EBITDA is misleading:

• Income from foreign exchange (“FX”) hedging contracts has been presented as part of EBITDA (operating earnings), despite the fact that they have been windfalls gains and are non-recurring in nature

• FX hedges boosted EBITDA by approximately 17% in the last 12 months – reported EV/LTM EBITDA is 19.3x vs. actual 22.5x when we exclude hedges

• We expect in-the-money hedges to fully roll off in the next 6 months

• Structural devaluation of the Canadian Dollar (“CAD”) is less favorable for DOL’s business:

• Significant majority of merchandise purchase prices are tied to the US dollar (“USD”)

• The devaluation of the CAD vs. USD (1.27 today vs parity in 2012), forced DOL to introduce higher price point categories to counteract margin pressures, meanwhile gross margins have dropped since its peak in 2012

• High rate of product inflation will have to be borne by increasingly cost-conscious consumers

• Price increases into new range will likely incite competitive response

• Relying on same store sales (“SSS”) growth as proxy for underlying growth is misleading:

• Metric growth is significantly boosted by DOL’s rapid price point increases, which are sustainable long-term

• CAD weakening has spurred DOL to offer some ‘phased-out’ items at new higher prices while trying to sustaining margin targets – value proposition is eroding for consumers

• While we understand that new stores are not included in figures until a year in operation: aggressive new stores openings, may have role of inflating SSS growth – as new store revenue ramp-up takes a few years to fully penetrate a market

• Overly bullish consensus forecast implies aggressive profitability growth:

• Street projections imply 3-year avg. gross profit / sqft growth of 6.2% per year vs. 3-year trailing avg. of 1.2% - DOL is unlikely to hit these targets

• Market growth opportunity is nearing saturation point:

• Guidance of 1,400 stores appears to be aggressive. Previous target was 1,200 locations (announced in 2012), and 900 in late 2009, the time of IPO

• Market giving full credit to store guidance, prices in no deterioration to store economics, and assumes further growth; even as management openly admits that they haven’t mapped out the next 362 store locations to hit 1,400 target

• Competitive pressures are growing - DOL is increasingly in competitors’ crosshairs:

• Dollar Tree (NYSE: DLTR) commented that they see opportunity to grow its Canadian franchise by another 1,000 stores

• High return on capital that DOL is enjoying (<2 year paybacks) should theoretically be reduced by competition: Low barrier to entry business, ($400k to build a new location and $230k to stock inventory)

• Introduction of higher priced point items places DOL in direct competition with Wal-Mart, Amazon and other retailers, which should pressure margins

• Operating expenses and capital expenditures will be higher than what market appreciates:

• Market did not anticipate DOL’s recent $60mm warehouse build announced in February 2016

• Consensus generally incorporates a level of capital investment and expense inflation incongruous with its assigned growth profile. Over the last decade, DOL has spent minimally on marketing and SG&A per store has been largely flat. DOL may need to spend more to respond to competitive dynamics, and in order to reverse eroding value proposition

• High growth over the last few years means older stores are due for refreshes as well

• Mounting external pressures:

• Although not central to our thesis, the recent commodity downturn in the Canadian markets could have a longer-term effect on consumers and hurt retailers in general

• A destabilization of the Canadian real estate market could hurt consumer spending

• Evolving consumer habits: more and more purchases of done online via Amazon, Wal-Mart, Amazon, and others

Section C | Why DOL trades at an absurd valuation

• Analysts and the street misunderstand the story and irrationally raise long-term price targets and EBITDA forecasts in reaction to short-term headline results

• Scarcity of large, liquid, non-resource investments for Canadian-focused investors –a measurable phenomenon that leads to ridiculous multiple premiums in times of resource market weakness.

• Artificially appears cheaper than it is as a result of EPS beats fueled by non-recurring FX hedges (which will roll off) and unsustainable SSS growth from price increases

• A relatively untested perception that dollar-stores are recession proof and deserves a premium valuation

• The company continues to support the stock through buybacks

Section D | The Short Case Detailed

True operating EBITDA is overstated by 17%+ in the last twelve months

• Hedges are rolling off, i.e. one-time gains are done with, DOL is more expensive on a trailing basis than it screens

• As part of their procurement process, DOL buys into USD/CAD FX hedges 9-12 months ahead of product delivery

• A weak CAD has distinctly enhanced DOL’s results as cost of sales are net of hedging gains

• DOL’s results have benefitted greatly from the hedges entered in previous periods: 2016 EBITDA and LTM EBITDA were 15% and 17% higher as a result

• This means that DOL trades 3x higher on a trailing EV/EBITDA basis than it screens

• In Q1, DOL realized $22mm from hedges and as of Q1 2017, DOL has:

• US$196mm notional of hedges at an average contract rate of 1.22, that we believe were entered into in Q2 2016 and will present a realized gain of $7-10 mm in the next quarter

• US$455mm notion of hedges with an average contract rate of 1.33, that should be realized over the following 9 months at a loss of $30mm (assuming the CAD stays constant)

• Adding gains realized in Q1 to DOL's outstanding hedges: FY2017's hedging should net off and have little net gain or loss

• DOL management quietly recognized this and has already guided to softer margins going forward

• We believe that consensus has not fully appreciated the contribution of these FX hedges to it’s earnings beats, and as a result the street continues to assign DOL an unrealistic growth trajectory

SSS growth is an unreliable predictor for sustainable growth

• Headline SSS growth metrics are often cited to justify the prediction of the company’s continued success, but we believe that SSS growth is a noisy measure in DOL’s situation and not helpful in developing forecasts

• We know that the company has gradually increased average selling prices, as well the top end of selling price (making room for price increases of existing goods and to offer new products), but using SSS growth alone we cannot draw direct conclusions as to whether people are spending more per bill and/or changes in foot traffic

• DOL’s pipeline of new stores openings in the last few years may have contributed to the strong headline growth, despite not being included in the metric until a full year after opening, we believe these new locations would have better adapted to shoppers’ schedules and improved visibility in the neighbourhood

• We believe the above has enabled DOL to screen highly on SSS metrics. The metric looks good, and is often used to support the bull case, but we believe that in itself is inadequate to predict DOL’s growth.

CAD Devaluation has provided a short-term boost ahead of longer-term challenges:

• DOL’s strong profitability trends are a focus of bullish street commentary

• Commentary understates the increased challenges associated with procurement: a weaker CAD is a disadvantage for Canadian retailers compared to U.S. peers when it comes to buying USD-linked products

• While profitability has increased over the last several years, and in part due to the success of DOL’s operations, profitability was distinctly boosted by one time hedges:

• Profitability growth really slowed down by FY2014 before making a subsequent rebound

• One-time derivative gains aside, the weak CAD also served as a catalyst for all Canadian retailers to raise prices:

• From our understanding, retailers often raise prices beyond the additional cost of the product, capturing additional margins

• While DOL only recently announced a price increase into the $3.50-4.00 price range, we understand that DOL has supported margins by been offering ‘less bang for the buck’ (e.g. offering 10 pens for $3 instead of 15 pens for $3 bucks)

• DOL isn’t alone in its productivity growth – Canadian grocers have also boosted their square foot profitability:

• We believe the economy has yet to fully feel the fallout of the commodity market slowdown, and there are limits to price increases and what Canadians are willing to bear. We will re-visit this thought later in this write-up

• DOL already more profitable on square foot basis: DOL closer to grocer square footage profitability than U.S. peers are. However, expectations of profitability and profitability growth should be sense checked:

• U.S. dollar stores are $70/sqft behind their U.S. grocers – and the spread is higher in reality as U.S. Comps generally provide gross square footage vs DOL providing retail square footage. In the same comparison DOL is only $40-50 behind the Canadian grocers per retail sq ft.

• Structural reasons likely behind Canadian retailers’ higher store profitability: less competition, density, less perishables, FX as a significant driver of product inflation

• As a company that offers a vastly different shopping experience and the role it plays in their lives than that of grocers, to what extent can expect this spread to further compress?

• We do not believe sell-side expectations appropriately incorporate the competitive challenges and costs of mounting a continued climb in profitability. We will re-visit this point

Ample near-term challenges for DOL: their market penetration is approaching saturation; product pricing hikes near their limits; competition heats up

• EBITDA growth expectations cannot be met with new store openings and pricing increases alone. Achieving street targets will require continued productivity growth, likely requiring greater capital investment and operating expenses.

• Store count hitting 1,400 (and beyond) isn’t guaranteed, hints of saturation:

• In DOL’s annual information form, they openly admit that the U.S. business model is different (primarily selling more perishables), so dollar store/ capita is not a good comparison when judging store saturation.  

• Cannibalization is acknowledged by company, highlights worsening payback and profitability: “As the Corporation gets closer to 1,400 stores, the cannibalization is expected to increase which, in turn, will likely have an impact on new store payback periods. The average capital payback period, now of approximately two years, could eventually range between two and three years.”

• Management details that cannibalization an accepted part of DOL’s business operations, is a balancing act. Cannibalization should be more pronounced at 1,000 stores today vs. 500 stores at IPO

• In the Q1 2017 call, management mention that 1,400 locations isn’t a capped number, but neither have they planned out all future locations yet, and continues to stress the importance of sourcing quality locations.

• Theoretically attractive paybacks and low barrier of entry not gone unnoticed:

• $400k per new store and another $230k to stock inventory

• Dollar Tree stated that they saw opportunity to grow Canadian franchise by another 1,000 stores

• We also believe pricing increases have limits:

• As previously discussed, Canadian shoppers will have difficulty underwriting greater price inflation

• On a recent earnings call: an analyst asked about further pricing increases to extract additional value, but management stressed that their gross margin guidance is within their comfort zone: we sense that risks of spending slowdown and increased competition are real

• Encroaching into the space of big box and traditional retailers: DOL mentions that a small share of their total SKUs are priced at the higher price points and shouldn’t attract excessive competition. We believe the extent of competition remains debatable, but we still highlight it was a natural barrier to DOL’s evolution and growth

• We believe the overall product selection and the shopping experience at a traditional retailer is more compelling for shoppers expecting a bigger shopping bill

• Informed shoppers increasingly rely on Amazon.ca and other online retailers to price compare – Amazon prime and Wal-Mart unlimited shipping arrangements for nominal costs should slowly infringe on DOL’s sales (these natural and growing competitive pressures have yet to be fully appreciated)

• Higher priced items may also spur more demand for a corporate refund and/or exchange policy

• Cost cutting at 9th inning already

• With stores already minimally staffed, DOL is now moving to experiment with credit cards, and instore wifi, presumably as the lower-hanging fruit / high-IRR projects are depleted

• DOL leases all its store locations and is potentially subject to rising rents

Capital intensity is higher than the market appreciates: DOL either invests in their growth and has meaningful FCF pressures or it does not and cannot yield profitability growth / productivity gains

• Getting to the ‘next level’ requires a substantial capital plan, a concern that is underappreciated by analysts. Increasing store profitability isn’t a zero-cost proposition:

• Investors haven’t fully appreciated the capital required to support continued growth: the announcement of $60mm warehouse facility in February caught markets off guard. The warehouse provides the necessary space to house additional imports.

• but prior to company announcement, no street analyst correctly gauged the backbone and investments required for continued growth, and yet all of them had largely given credit for DOL’s 1,400 build-out.

• DOL may need to substantially invest in its network to achieve higher profitability – e.g. grocers and other retailers pursue facelift every several years:

• DOL has spent substantially less than most of its Canadian retailing comps:

• DOL’s capex has largely been directed to new store openings

• Peers have grown their network at a slower rate than DOL, but have higher square foot profitability, continuing to direct significant capex on existing square footage

• At the retailing peers, we don’t have access to a good breakdown of new store expansion capital vs. maintenance capex. However, we know the cost of a new DOL location, and for reference we can break out what we estimate to be the maintenance dollars spent per existing DOL square footage. We can only imagine that grocers invest substantially more on their existing network

• If foot traffic falls, will DOL invest more in lower-margin perishables? Expanded food logistics, storage, security and safety, will likely incur increased capital costs. A substantial reworking of its entire network could demand a meaningful capex budget. This is just one potential plan for DOL. We haven’t considered all possible scenarios and their associated capital budgets but we do not believe these scenarios are factored into the stock price

• But why is improving productivity gains and profitability growth important? Because it is central to meeting street expectations as we later illustrate

Section E | Bull Case Reviewed

• 1) Offers above-average growth potential, citing profitability and square footage growth potential

• We address these points above, and the expectation that DOL’s growth trajectory continues is unlikely based on SSS pressures, competition and required investment

• Square footage growth doesn’t translate to an equally effective bottom line growth – grocers and other retailer do deep studies on new entrants and effect on square footage sales metrics.

• Projections embodying continued profitability growth often exclude consideration for additional capex spend

• 2) Superior merchandising skill from talented management team

• Management has done a tremendous job growing the company from ground up, but will likely face challenges in further squeezing material incremental profitability at these levels

• Perhaps less so in DOL’s infancy, especially as product and prices point are increasingly in overlap with competitors: DOL and its management are increasingly in the crosshairs of competing retailers

• 3) FCF generation potentiation should allow it to return capital to shareholders

• We believe that DOL would need to further invest in its network, to meet growth expectations placed upon it, thereby bounding free cash flows.

• Projected FCF does not compensate investors for the risk of owning the stock today (2.4% yield)

• 4) Defensive and cyclical business independent of broader spending and economic cycles

• We believe this is hard to test, as the market rewarded the company for successfully establishing an interesting value proposition in the Canadian marketplace

• Until the recent commodity downturn, Canada faced limited headwinds during U.S. subprime financial crisis – employment levels and housing starts were healthy

• We believe the product mix is still low in consumables, and has a substantial tilt towards discretionary items, than vital staple goods or perishables

• Our discussion report highlights issues with assumptions used by research forecasts, but as an illustrative exercise we use sell-side consensus figures, as provided up to FY2019, which we extrapolate to 2022E. This generous exercise assumes that DOL increases profitability, and location guidance –yields a implied stock price below the current stock price and well below average consensus targets ($100/share):

• Note that we are using consensus capex here, and as earlier highlighted, we believe analysts may be underestimating the opex/capex spend to achieve targeted profitability levels as well:

Section F | Street assumptions disconnected from reality

• Sell-side commentary focuses on DOL’s store growth and maps EBITDA with straight-line growth:

• There’s a lack of critical discussion regarding growth constraints, and the dominant narrative does not properly address the operational risks and capital investment required to maintain a meaningful presence in the Canadian market

• Our short premise isn’t predicated on DOL failing to achieve their store count target, but we highlight the false equivalency of store growth to profitability growth

• With DOL’s current metrics, still generously assigning zero risk to their 1,400 roll out plans or current profitability levels, this is a path we see playing out:

• Assuming DOL’s metrics doesn’t falter, this would imply a valuation of 15.2x 2022E EBITDA – still higher than EV/EBITDA of relevant comps on a CY2016 basis

• Seeing that SG&A/store has largely been tightly range bound over the last 6 years, we can work backwards to find the square footage profitability implied – We point out the consensus projected for next several years is largely driven by square footage productivity growth:

• The above would imply that excluding hedges, DOL would need to grow square foot profitability over 6% per year for the next three years – a contrast to the 1.2% average of the trailing three

• And in just three years, at 116 gross margin dollars per square foot, DOL would rival Canadian grocer Metro’s (TSX:MRU) current square footage profitability – we find this difficult to underwrite

• In light of the various issues highlighted in our discussion, we find the above assumption aggressive. And we recap the issues:

• Hedges are rolling off in the next 6 months

• Price (and margin) increases have their limits

• Competition is heating up

• Store saturation is higher than perceived with cannibalization a key ongoing risk

• Announced capital plans are non-transformative

• We believe that sell side analysts grossly ignore the notable risks facing DOL, and publish assumptions and price targets that are disconnected from reality

Section G | Our view of valuation

• DOL trades with a high multiple compared to all retail peers:

• Observations:

• DOL has a higher valuation per square foot than any North American or Europe retailing peer – DOL owns no real estate, while most Canadian grocers have some ownership of real estate. The high implied replacement value is contrary to our belief that the stores are very basic in nature, and business model is theoretically susceptible to upstart competition if the store economics holds

• DOL’s Price to Book ratio is higher than TSLA

• DOL’s EV/CY18 multiple Is even higher than high-growth tech peer group multiple

• DOL still more expensive on FCF yield basis than vast majority of retailing peers and tech companies – and we still think analyst FCF estimates are generous

• We believe that consensus growth targets are predicated on DOL’s ability to further enhance profitability

• At these valuations we see a good margin of safety for a short position

• Our short premise isn’t predicated on them failing to achieve their store count, but the challenges ahead to meet the expectations of profitability built into the stock

• Any cutback in store plans (or incremental cannibalization) will destabilize the math for bullish analysts

• Cash flows growth is constrained

• Not a realistic acquisition target at these prices

• A modified DCF yields an approximate value of $60/share for DOL, and still gives them the benefit of rolling out all 1,400 stores on time, with no erosion to margins from current levels and a generously low capex line:

• Based on comps, we value DOL at roughly 11x its FY2017 EBITDA, in our view a fair multiple that still offers DOL substantial growth from our levels, implying approximately $50/share today

• Considering both valuation approaches, we assign a $55/share price target for DOL, a 40% downside from today’s price. We feel this price target is appropriate having considered the various opportunities, risks and challenges present

Catalyst

• FX Hedges Rolling Off
• Missing Street Expectations
• Market Saturation and Cannabilization of sales
• Slowing of Location Growth
• Increased Competition
• Increased Operating and Capital Expenditures