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  • Negative real wages have consumers tapping savings and credit cards.
  • Cash-strapped consumers could shift holiday spending to low-cost retailers.
  • Dollar Tree is a profitable, growing dollar store chain with an intriguing risk to reward.

Consumer confidence is on the ropes because inflation continues to outpace wage growth, causing personal savings to shrink and credit card balances to climb. Those pressures are somewhat offset by the fact that, so far, we haven’t seen widespread layoffs, despite growing certainty we’re on a collision course with recession.

The strong labor market means people are still pocketing paychecks, while negative real wages suggest more consumers will be bargain shopping this holiday season. That should be good news for foot traffic at dollar stores, including Dollar Tree  (DLTR) .

Discretionary spending is under fire

In “As Shoppers Feel Pinched, I'm Betting Money Will Grow on Dollar Tree,” Real Money Pro’s Ed Ponsi outlines a strategy for investors interested in profiting from potential revenue and profit growth associated with budget tightening.

Ponsi points out that while the Federal Reserve is raising rates to quell inflation, prices remain stubbornly too high. He writes:

“Consumers are already being forced to make tough decisions because of inflation, especially for food and fuel. Rather than being transient, inflation has been sticky, with consumer prices now rising at an 8.2% annual pace.”

The negative impact of inflation on spending has been offset somewhat by consumers tapping savings and unused credit. However, those reserves are disappearing quickly. Ponsi explains:

“Savings accounts are being rapidly depleted. According to this chart from the St. Louis Fed, U.S. personal savings, which reached $4.8 trillion at the height of the pandemic, has fallen to just $629 billion. That's a decrease of 87% in just two years. Worse, credit card debt is rising at its fastest pace in 20 years. Debt on credit cards and other revolving credit is $924 billion. This is disturbing because so many American consumers paid down debt early in the pandemic.”

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The COVID-era stimulus that supported consumer balance sheets has officially disappeared, given personal savings have retreated to the lowest levels since the Great Recession in 2008 and 2009. The strain is also evident in the personal savings rate, which shows how much disposable income folks are stashing away. In August, that rate was 3.5%, down from 9.5% one year ago. Again, that’s the lowest since the Great Recession.

The swell in credit card balances is similarly worrisome. Rising interest rates make variable rate credit a last resort option for families trying to bridge gaps between income and expenses. According to LendingTree, credit cards' average interest rate increased to 16.3% in the third quarter, up from 15.1% in Q2 and the highest on record back in 1994.

Despite low unemployment, delinquency and default rates are rising. For example, Synchrony Financial  (SYF)  is a big player in affinity credit cards, such as those issued by retailers. It reported on Tuesday that provisions for losses increased $294 million to $929 million quarter over quarter. Last year, it was just $25 million. The issuer also said 3.28% of accounts were over 30 days late, up from 2.42% last year, and its charge-off rate was 3%, up from 2.18% last year.

The takeaway? Many Americans could be looking for ways to save money this holiday season, shifting buying away from large department stores to dollar stores. In Ponsi’s words, “Add it all together, and we're about to see massive corner-cutting on the part of consumers. One business that is likely to benefit is your neighborhood dollar store.”

How to trade Dollar Tree stock

Ponsi thinks it’s a good time to buy Dollar Tree, which also owns the Family Dollar chain. He writes:

“Looking to the charts, I particularly like Dollar Tree here. Monday marked a two-month closing high for the stock and set up a possible breakout. Dollar Tree could be on the verge of filling a gap from a late-August selloff (point A), a move that should carry the stock to at least $163 (red line, point B).”

If Dollar Tree follows through on its recent strength and marches higher to close the gap Ponsi highlights, it could be a rewarding short-term to intermediate-term trade into the holidays.

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Here’s how Ponsi plans to manage the position:

“I'll use point B as my initial target, and I'll close one-third of the position if that point is reached. I'll close another third if the price reaches Dollar Tree's three-month high, at $174 (blue line, point C). This was the stock's all-time closing high on April 20…I'll squeeze as much as I can out of the final third. Since the all-time closing high is $174, there are no meaningful resistance levels above that point…There is strong support at $135 (black line, point D). If that level is broken in a meaningful way, I'll exit the trade.”

Ponsi will control his risk with a stop loss below $135 and book two-thirds of his position if it moves higher. Since there aren’t any trapped sellers above the all-time high to act as overhead resistance, he’ll be 'data dependent' on the remaining shares.

The Smart Play

Dollar Tree is a dollar-store Goliath, but it’s not immune to inflation or the risk of slower sales if consumer spending declines this holiday season. It's also struggled to make headway with its Family Dollar stores. Despite years having passed since it acquired Family Dollar in 2015, results at the chain still lag the results at Dollar Tree branded stores. For example, comparable store sales at Family Dollar were just 2% in fiscal Q2, significantly lower than Dollar Tree's 7.5% pace. 

The underperformance at Family Dollar prompted a major activist-led shake-up in Dollar Tree's leadership in March that installed former Dollar General CEO Richard Dreiling as executive chairman. Dreiling skillfully managed Dollar General through the Great Recession, so he's got plenty of experience winning market share during a tough economy. Several other key executives have joined since Dreiling's appointment, including a new CFO, so there are plenty of fresh perspectives that could help the company get Family Dollar on track.

It's a little early to say a new strategy is paying off, but the company does appear to be making progress. In addition to new store openings, its co-locating Dollar Tree and Family Dollar stores because the two brands target slightly different consumers. It's also rolling out some higher-priced items at Dollar Tree, putting more Dollar Tree items inside Family Dollar, and lowering prices at Family Dollar to undercut Dollar General this holiday season.

In Q2, revenue grew 6.7% year-over-year to $6.8 billion. Gross margin was 31.4%, up from 29.4% one year ago, and operating margin improved by 1.2% to 7.5%. The company's earnings per share rose 30% year-over-year to $1.60. 

The decision to cut prices at Family Dollar will take a toll on full-year earnings growth, but growth will still be strong. Management lowered its full-year EPS outlook during its last conference call to $7.10 to $7.40 for the year. However, that's still good for 25% year-over-year growth at the midpoint. 

Analysts are modeling $7.28 per share this year and $8.24 next year, so shares boast a forward price-to-earnings ratio of 19. That's arguably fair, given it's about the mid-point of its 5-year P/E range. However, those numbers could be tweaked after Dollar Tree reports its fiscal third quarter performance on November 23.

Longer term, Dollar Tree thinks there are still plenty of opportunities to open new locations. Last quarter, it opened 127 new stores, and although it operates over 16,000 stores, it believes markets can support as many as 26,000 stores. 

If you believe that Dreiling can breathe new life into Family Dollar and struggling consumers will flock to low-priced retailers over the holidays, then consider following in Ponsi’s footsteps. 

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