It’s been about six months since we initiated short positions in two dollar store stocks:  Dollar Tree (DLTR) and Dollar General (DG).  No one, at the time, liked my thesis.  In fact, as I wrote in June, many of the fund managers I spoke with tried to talk me out of it…Well, they’re eating their words today.  We’ve made about 30% on the Dollar Tree short and 20% on Dollar General—and suddenly everyone’s getting on the bandwagon:

• Cramer: Buy Cisco and Sell Dollar Tree, EMC and This Underperformer  (Thu, Jan 17)
• Cramer’s Mad Money – The Dollar Store Debacle (1/16/13) (Thu, Jan 17)
• Cramer: Are Dollar Stores Worth a Dime? (Wed, Jan 16)
• Higher taxes on customers could hurt Dollar General, report says (Wed, Jan 9)
• Dollar General downgraded to Sector Perform from Outperform at RBC Capital (Wed, Jan 9)
• Family Dollar Squeezing its Rivals (Tue, Jan 8 )
• Even dollar stores find it hard to make a buck (Thu, Jan 3)
• Family Dollar Falls Most Since 2000 After Forecast Cut (Thu, Jan 3)

Wow!  That’s a lot of negativity, although of course following the recent declines there are those who are saying it’s time to buy.  I disagree.  Jim Cramer, my long-time friend and mentor, called the dollar stores a sell just last week, and I’m still with him on that, although I did trim a few of my DG short shares near the lows back in December.  I’m generally a contrarian, so we’ll be watching closely—if the sentiment becomes overwhelmingly negative on these stocks, we’ll consider covering the shorts.  But we’re not there yet, and here’s why.

First, off, while the valuations on DG and DLTR are certainly ‘less unattractive’ than they were last summer, they’re still high.  Back in June DG and DLTR were trading at 22 and 26 times earnings, respectively.  Today, DG trades for 16.3x forward earnings while DLTR trades at 13.9x forward earnings.  But after Family Dollar’s big miss earlier this month, it wouldn’t surprise me to see those estimates start to come down…pushing those multiples even higher.

Second, and more importantly, the same problems that I highlighted six months ago for these stocks are still there!  The dollar stores are still building hundreds and hundreds of more stores—why?  Because that’s the ONLY way to keep the top line growing.  But when every small town across America already has four, five, ten dollar stores—there’s simply not going to be enough demand to support ever more retail square footage.

Third, margin compression.  Gross margins are getting hit as the dollar stores rely increasingly upon consumables to keep sales growing.  Margins for these products are notoriously slim—and of course, these stores sell a LOT of product for a loss just to keep the traffic coming.  It’s an unsustainable model.

Fourth.  Wal-Mart, which was losing share at the hands of the dollar stores two and three years ago, has gotten its act together.  It’s changed its product mix and the retail behemoth is now competing effectively with the Dollar Generals and Dollar Trees.  That means dollar stores will have to discount even further in order to compete—creating yet more pressure on margins.

Fifth.  This one could go either way, but the new old payroll tax that went into effect January first means that an average household earning $40,000 a year will take home about $800 less this year.  Some argue that the hit to pocketbooks might send more customers to the dollar store aisles, but I’m thinking that throughout the course of the Great Recession, the dollar stores have pulled in about as many new customers as they’re going to get.  If you didn’t shop at Dollar General in 2009 or 2010, you’re unlikely to start now.  But that existing customer base will now have less disposable income—less money to spend on all those ‘bargain’ products.  Meanwhile, unemployment is a lot lower now than it was two years ago, so some shoppers who were forced into the dollar stores during a time of hardship may now start trading back up.

Finally, our two specific dollar store shorts are starting to feel the pinch of increased consumables competition from Family Dollar (FDO).  Barron’s ran an article (link above) earlier this month highlighting statistics developed by analysts at Nomura:

“From 2009 to 2011, Family Dollar represented 23-25% of the channel’s incremental Consumables sales. But as that company accelerated new store growth (from 1.3% in 2009 to 6% in 2012) and relied more heavily on Consumables to drive sales in existing stores, Family Dollar grew to represent 36% of the channel’s incremental Consumable sales in 2012. By going from a share donor (inside the Dollar Store channel) to a share gainer, Family Dollar’s moves may have jilted the [dollar store] Gravy Train.”

The article added that the shift is a threat to both Dollar General and Dollar Tree, though Nomura considers Dollar Tree the most vulnerable, and it lowered its price target to $45 from $50.

Rick Dreiling, chairman and ceo of Dollar General had this to say upon release of the company’s third quarter results back in December:  “Although our performance over the Thanksgiving weekend and start of the holiday season has been encouraging, we continue to be cautious for the remainder of the year. We are facing a significant same-store sales comparison from our 2011 fourth quarter, which included very strong January sales, growing near-term pressures that are impacting our customers’ confidence and spending, and a challenging competitive environment.”

That’s a cautious tone, and we think there’s still room for these stocks to fall. The retail sales growth for the holiday selling season was at its lowest level in years, and if you really, really want to go long the retail sector, there are better plays to be found.