No Stock Bargains at Dollar Tree, Wal-Mart

Deutsche Bank recently started covering a slew of retail stocks — it put a “buy” on Dollar Tree (NASDAQ:DLTR) and a “sell” on Wal-Mart (NYSE:WMT) — expecting it to drop to $48. Should you follow Deutsche Bank’s advice?

In its Sept. 14 report, Deutsche Bank expressed concern that Wal-Mart was losing market share “at a faster pace than at any point in its history — a phenomenon that we’re not convinced the company can fix.” And�Deutsche Bank expressed concern about the following trends:

• Falling same-store sales. Declining same-store sales for the past nine quarters suggests Wal-Mart’s “low-price image” might be damaged.
• Failure to adapt to consumer preference for convenience. “Despite the consumer’s emerging preference for convenience, Wal-Mart has been slow to adopt a smaller store strategy …”
• Lower level of share buybacks.�A new development as recently as this year, “acquisitions + inventory build + international = less buybacks.”

By contrast, on Sept. 15, Deutsche Bank set an $81 price target when it initiated coverage on Dollar Tree. Deutsche Bank�admires DLTR’s rapid growth in the number of customers in its stores. This so-called�traffic grew at an average of 5.8% during the past 10 quarters — supporting 65% of the same-store sales growth.

The Deutsche Bank report also said that “while strong brand awareness and an attractive value proposition are key ingredients,�Dollar Tree�has augmented its tender offering along with food stamp acceptance. Looking ahead, given these traffic rates, we have greater confidence in the company�s ability to drive comps in 2011 and 2012.”

Is Deutsche Bank right? Should you buy Dollar Tree and sell Wal-Mart? When I wrote about Wal-Mart in August, I was negative on its stock because despite beating analysts’ estimates, paying a decent dividend and out-earning its cost of capital, the retailer was not growing earnings fast enough to justify its P/E. I still believe that. Wal-Mart’s price/earnings-to-growth ratio remains high — a PEG ratio of 1.0 is considered fairly valued — at 1.29 on a P/E of 12 with earnings growth of 9.3% to $4.89 in 2012.

But what about Dollar Tree? Here are three reasons in its favor:

• Great earnings reports. Dollar Tree has been able to beat analysts’ expectations in all of its past five earnings reports.
• Higher sales and profits and decent balance sheet. Dollar Tree sales have grown at a 10.2% annual rate during the past five years, from $4 billion (2007) to $5.9 billion (2011), and its net income has�increased at a 19.9% annual rate, from $192 million (2007) to $397 million (2011) — yielding a solid 7% net margin. Its debt has remained constant at $250 million, and its cash has grown at a 12.2% annual rate, from $307 million (2007) to $486 million (2011).
• Dollar Tree is earning more than its cost of capital — and it�s improving. How so? It�s producing positive EVA momentum, which measures the change in �economic value added� (essentially, after-tax operating profit after deducting capital costs) divided by sales. In 2011, Dollar Tree’s EVA momentum was 2%, based on six months annualized 2010 revenue of $5.5 billion, and EVA that improved from six months annualized 2010′s $162 million to six months annualized 2011′s $254 million, using a 7% weighted average cost of capital.

Here�is one�reason to avoid it:

• High valuation. Dollar Tree trades at a PEG ratio of 1.35 — on a P/E of�21 on earnings forecast to grow 15.6% to $4.55 in 2012 — but is expected to grow 21.8% in 2011.

Deutsche Bank is right on avoiding Wal-Mart and wrong on buying the overpriced Dollar Tree, but if DLTR’s stock price drops — or analysts raise its 2012 growth forecast enough — to get its PEG below 1.0, I would take a fresh look.

Peter Cohan has no financial interest in the securities mentioned.