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Margin and Stock Prices, A Case Study.
On May 9, 2012, I had a conversation on Fox Business about TPX and said people should stay away because the company was cutting prices on its best products- a clear red flag. Others on the show didn't agree saying it was business as usual. The stock was $48.00 that day ($22.39 as of June 7 market close). The greater point is when it comes to investing and share price, the best long term signal is the direction of operating margins. Of course there are a lot of other things that matter and are influential, but for me this is the most critical. When companies grow their top line (revenues) on lower prices and higher volumes, it leads to smaller margins and lower share prices.
So, I was challenged to explain the growth in discount retailers. Here is a look at Dollar Tree (DLTR) and why it's had such a remarkable rally, hint- direction of operating margins.
It should be noted DLTR trades at 8 times book, and even after that gigantic sell off, TPX is changing hands at 14 times book.
The Remarkable DLTR Rally
Pricing power is what it's all about. A company that can charge higher prices without decreasing demand is going to more often than not enjoy a strong stock story. If you can hike prices and see increased demand, it's a dream come true (see Apple). When a company is raising prices for its goods and still seeing higher volume, it's a great sign that it's taking market share. In the stock market, this is critical even in faltering industries.
The second best case scenario is when a company can hold prices steady but see a surge in demand. A great case study for this would be Dollar Tree where all items sell for $1.00. So how does the company grow? Demand! In the most recent quarter, the company added a net of 100 more stores but still what influence the stock are the margins. Operating margins began to soar with the Great Recession and so has the stock.
Historic Share Price
Jan 3, 2007 $31.40
Operating Margin Story for Dollar Tree
The rate of margin expansion has slowed for Dollar Tree, and that's a yellow flag and signal for long term holders to maybe take some off the table or consider defensive strategies like writing calls against their position.
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