Dollarama Inc.

  • Dollarama (DOL or “the Company”) is a dollar store which, following a series of price hikes over the course of several years, is no longer a true “dollar store.” As a result, DOL has fallen out of favor with value-oriented customers, causing average store traffic to contract and thus necessitating further price hikes to support SSS growth. Management is nonetheless aggressively pursuing unrealistic growth targets even as competitors flood the discount retail market and threaten its improbable margins. DOL’s shares trade at a 50% premium to peers in the value retail space – even following a ~20% drop after a disappointing Q2 – questionable governance and poor earnings quality notwithstanding. We believe that DOL will continue to miss lofty investor expectations, and that its premium valuation will continue to be pressured.

  • Undifferentiated Products: Dollarama sells a variety of low-priced products, mostly sourced directly from China. Its purported advantage in “sourcing” is contradicted by conversations with industry sources as well as numerous IP infringement lawsuits filed against the Company.

  • Moving Upmarket Is A Risky Strategy: Faced with years of negative average traffic growth and an increasingly saturated market, Dollarama is driving comparable store sales growth by selling higher-priced items. However, in doing so, it is quickly losing its reputation as a true “dollar store,” and per-store traffic numbers are declining as a result. Big Lots (NYSE: BIG) undertook a similar strategy in the 2000s, but reversed course after admitting its failure.

  • Saturation Is Imminent: Dollarama cited a 900 store target at the time of its IPO in 2009, when it had just 585 stores. Management has since revised this number upwards multiple times: first to 1,200, then to 1,400, and most recently to 1,700. Our analysis shows that this target is unrealistic, and that the market is already bordering on oversaturation. Dollarama’s FY ‘19 store opening pace has thus far been its slowest in years.

  • Margins Inexplicably High And Likely Unsustainable: Gross margins of 39-40% are remarkably high for a discount retailer, but intensifying competition, rising labor costs, rising transportation costs, and a lapsing currency hedge benefit all threaten Dollarama’s high profitability levels. Patterns in Dollarama’s hedging profits and gross margins ex-hedging suggest that management may be leaning on its FX-related profits to prevent its headline gross margin number from declining (see note on next page).

  • Founding Family (And A Director) Have Significant Related-Party Deals: The Rossy family launched Dollarama from its legacy retail chain in 1992 and owns significant real estate assets that are employed by the enterprise. This may have played a role in management’s recent decision to acquire Dollarama’s existing Montreal distribution center from the Rossys rather than open a second distribution facility in western Canada, as have most peers.

  • CEO Stepped Down And Installed His Son: Larry Rossy stepped down as CEO in 2016 (and as Chairman in 2018), selecting as his replacement his son Neil – previously Dollarama’s Chief Merchandising Officer. We question whether a thorough and arms-length search was conducted to fill this position.

  • Opaque Supplier Relationship: As part of a deal struck in 2013, Dollarama supplies goods (at an undisclosed profit margin) to Central American discount retailer Dollar City in exchange for an option to acquire the chain in 2020. However, Dollarama currently has no formal stake in Dollar City, and therefore does not consolidate Dollar City’s results. We are concerned that Dollar City could be overpaying its vendors to lessen the financial burden on Dollarama.

  • Insider Ownership Declining: Former CEO Larry Rossy has sold or transferred ~75% of his shares since the 2009 IPO. Bain Capital liquidated the last of its shares in 2011 at a split-adjusted price of $5 per share, 1/8th the current price. The current CFO owns no shares and regularly liquidates options.

  • Currency Hedge Supposedly A Pure Offset To CAD Depreciation, But Has Been A Material Profit Center: Dollarama claims to hedge currencies only to lock in consistent prices (in CAD) on which its customers can rely. However, in practice, the Company adjusts prices to match non-hedged competitors, leaving us to wonder why it hedges at all. Much of the recent hedge benefit appears to have reversed, but gross margins ex-hedges conveniently rose by just enough over the last two years to maintain steady profitability. If nothing else, we question whether Dollarama’s elevated margins are sustainable.

  • Tenant Allowances And Leasehold Improvements Are Amortized Over Very Different Periods: While accounting rules may give sufficient leeway to permit this difference, we question why lease term assumptions should differ for these two capital accounts. Earnings quality suffers notwithstanding.

  • Leverage Is Increasing: Dollarama makes long-term financing decisions using short-term debt, the cost of which has risen with recent debt issuances and is likely to continue to increase with rising interest rates – and as the Company’s credit profile grows riskier. We question management’s decision to increase leverage to support buybacks and dividends simply because the earnings yield is above the after-tax cost of debt. We also worry about the state of the balance sheet should the economic environment turn, or should the business decline more rapidly.

  • Depreciation Is Well Below Capex And Has Been For Years: Capital spending easily bests industry peers, both as a percentage of sales and vis-à-vis steadier D&A charges. The mismatch with D&A suggests poor quality of earnings at the very least. Meanwhile, management’s growth orientation has diverted capital spending away from store remodeling, giving stores a stale and dated feel despite rising price points.

  • Valuation Is Indefensible: DOL currently trades at a ~50% premium to peers and carries among the highest multiples of any global retailer. Higher only are the valuations of crème de la crème global fashion brands – Hermes, Prada, Ferragamo, etc. Such lofty multiples are inappropriate for a dollar store with serious near-to-medium-term business risks. Analyst estimates are not sufficiently skeptical of management’s targets in light of these concerns.

  • Even If Nothing Goes Wrong, The Stock Is Overvalued: Even if Dollarama executes its growth plan perfectly, maintains its world-leading margin, and retains a hefty valuation premium to its peers, the stock is at best fairly valued at ~$43.

  • Under More Reasonable Assumptions, DOL Stock Is Overvalued By 40% At Current Levels: Even assuming that Dollarama achieves full market penetration – with no negative impact on per-store revenues from competition or cannibalization – the stock is worth $28 under normalized margins and at a multiple closer to peer norms, down ~40% from current levels.

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