Description

Executive Summary

Turnarounds rarely go in a straight line and Dollar Tree (DLTR) is proving to be no exception after the recent FQ2-22 earnings and guidance disappointment. The miss was particularly surprising because no one expected management to cut guidance after raising in FQ1-22 and reaffirming in June. The stock had traded up ~30% in the last six months in large part due to excitement about management changes in March, particularly the appointment of Rick Dreiling (former super star CEO of Dollar General) as Executive Chairman, to jumpstart the company, particularly the poorly integrated Family Dollar (FDO) business. But operational and strategic changes seldomly go as smoothly as initially expected and the stock is now trading ~11% below its recent high. While it seems clear that the company’s issues are bigger than the new management team initially anticipated, I think consensus numbers have come down to a point where the risk/reward set up is attractive.  Assuming Dreiling and team can execute on their various turnaround initiatives, investors are getting a very cheap option on DLTR returning to a double-digit earnings compounder with same-store sales growth and operating levers in place at core DT stores and stabilizing/revitalizing the FDO banner:

• The stock is currently ‘cheap’ in historical context – investors can now buy a defensive and leading franchise trading at a ~3x multiple discount relative to the company’s multi-year pre-pandemic average (~15.8x FY‘24e of ~$10 EPS vs ~18-19x in prior years); assuming a return to the prior multiple range, the stock would be worth ~$185 (~15% upside).
• The prospect of significantly higher ‘normalized’ earnings power resulting from a successful turnaround of FDO - the company could add ~$4 in incremental EPS via sales productivity, gross margin improvement and SG&A leverage; this would imply a current multiple of ~11.5x on ~$14 of EPS in FY‘24e and a very attractive entry point; at 18.5x, the stock would be worth ~$250 (~60% upside).

Brief Description/Background

DLTR has been written up several times on VIC and they are worthwhile reading. They provide good background on the business, the FDO acquisition/integration, the rollout of combo and H2/H2.5 stores and the seminal decision last year to ‘break the buck’. This write-up will focus more on the levers that I believe will result in higher normalized earnings power at FDO relative to market expectations after an extended period of supply chain challenges and depressed results.

Briefly, DLTR is one of the largest discount merchandise operators in the US and Canada with 16,231 DL and FDO banner stores (as of July 2022) and over $26 billion in revenue in FY2021. DLTR stores sell a broad range of merchandise products including everyday consumables (household, food, personal care, health, frozen food), variety (toys, gifts, supplies, stationary) and seasonal (Christmas, Easter, Halloween, Valentine’s). In FY2021, the company increased the price point on the majority of its products from $1 to $1.25 (‘broke the buck’) and offers select items in the “$3-5 plus” range in DL stores as well as the combo and “H2/H2.5” renovation stores.  At a fundamental level, I view DLTR as a strong, defensive business with a differentiated value proposition, high repeat customer base (and therefore generally low customer acquisition costs), largely insulated from e-commerce competition (given the price point), solid unit economics given its large scale to leverage the supply chain and attractive returns on equity. In response to well-telegraphed inflationary pressures, the company successfully flexed its pricing structure and introduced multi-price point offerings above the historically sacrosanct $1/item threshold. The company has experienced some headwinds with freight costs, markdowns and shrink which have impacted recent quarterly results.

Family Dollar Acquisition

In 2015, DLTR acquired FDO for $9 billion and has struggled to integrate and grow the FDO banner. The acquisition has proved challenging because the two companies have different business models: FDO is mostly aimed at lower-income families looking to save money; the DT banner is aimed at both lower-income but also middle-income families looking for cut-price items to complement a shopping trip (‘treasure hunt’ experience). While the historical $1 (now $1.25) price point is enough to fend off other budget retailers, moving into the $1 to $10 range, as FDO has done, opened up DLTR to competition from outside of the dollar-store category (such as Amazon, Target and other mass merchandisers). In attempting to integrate a different concept, DLTR has mismanaged FDO which has resulted in supply chain issues, items consistently out-of-stock, lackluster growth and staff turnover/poor morale. FDO has been treated as a ‘turnaround story’ for many years with the underlying theme of closing underperforming stores, renovating others and rebranding. In early FY2022, the situation attracted an activist-type investor, Mantle Ridge, which successfully orchestrated the appointment of Rick Dreiling to the leadership suite; Dreiling is credited with significantly improving operations at Dollar General during his 2008-’16 tenure (with notable success in his first few years) and also tried to acquire FDO but was rebuffed despite offering a higher price than DLTR. He now sees FDO in a similar state to Dollar General in 2008 when he joined as CEO.

Taking Consensus Estimates as a Starting Point to Present Variant Thesis

Based on the numbers below, it seems clear that the market is expecting the majority of DLTR’s growth to come from the DL banner in the next few years and is ignoring the prospects of an FDO turnaround. Specifically, between FY2021 and FY2024E, consensus estimates are generally assuming the following:

• Sales growth: 24% for DL banner vs 10% for FDO.
• SG&A leverage: From 21.5% of revenue to 20.3% at DL banner vs from 20.8% to 22.1% at FDO.
• EBIT growth: 80% for DL banner vs 2% for FDO.

Thesis:

1. New management – incentives and credibility.
2. FDO turnaround – The Rick Dreiling Playbook.
3. Macro is a wild card but also an opportunity for share gains.

1. New Management - incentives and credibility:

Incentives:

• Rick Dreiling – new Executive Chairman, former CEO of Dollar General, former CEO of Duane Reade, several leadership positions at Safeway over 33 years; DLTR has a five-year employment agreement with Dreiling and granted him options to purchase 2,252,587 shares of DLTR stock at an exercise price of $157.17 (price on March 18, 2022). Assuming my thesis of higher normalized earnings power where the stock is worth ~$250/shr, his package is worth over $200MM. Dreiling also receives $1MM base salary so the overwhelming majority of his compensation is tied to the performance of the stock. He is clearly incentivized and aligned.

Several other leadership changes have been announced in the last few months (many of which worked with Dreiling at Dollar General) highlights the company’s focus on improving operational efficiency:

• John Davis – new Chief Financial Officer, ex-Walmart executive
• Mark Creedon – new Chief Operating Officer, ex-Advance Auto Parts and several leadership positions at Tyco
• Bobby Aflatooni – new Chief Information Officer, ex-Dollar General (worked with Dreiling)
• John Flanigan – new Chief Supply Chain Officer, ex-Dollar General (worked with Dreiling)
• Larry Gatta – new Chief Merchandising Officer, ex-Dollar General (worked with Dreiling)

Credibility:

What exactly did Dreiling accomplish at Dollar General in the first few years after he was hired as CEO in January 2008?

In the FY2010 10-K (filed 3/22/11), Dreiling outlined the playbook that improved performance at Dollar General: “At the beginning of 2008, we defined four operating priorities, which we remain keenly focused on executing: These priorities are: 1) drive productive sales growth, 2) increase our gross margins, 3) leverage process improvements and information technology to reduce costs, and 4) strengthen and expand Dollar General’s culture of serving others.”

Here are the results:

• Sales: grew 37.3% in the FY2008 to FY2010 three-year period, or 11.1% CAGR compared to 3.5% growth in FY2007.
• Gross Margin: improved 420bps during the same period to 32.0% in FY2010.
• SG&A: reduced SG&A as % of sales by 180bps from 24.1% to 22.3%.
• EBIT Margin: improved 600bps from 3.8% on FY2007 to 9.8% in FY2010 at a ~26% contribution/flow-through
• Net sales per sq. ft.: increased 21.5% from ~$166 in FY2007 to ~$201 in FY2010 or ~6.7% CAGR.

2. FDO Turnaround – Rick Dreiling is using the same 2008-’10 Dollar General playbook to turnaround FDO and conceivably drive an incremental ~$4 of EPS by FY2024E that isn’t included in sell-side estimates. The company has announced multiple strategies to drive sales growth, increase gross margins and reduce operating costs, including:

• Targeted price investments – “FDO is now in a better competitive position on price than it has been for over a decade”; that is quite a statement by the CEO on the FQ2-22 call, so let’s dig in: management implemented a $130-135MM price investment in July. This effectively means more competitive price points to regain/increase market share, most notably in consumables, frozen, beverages and cleaning supplies. Key value items are now ~40% below drug stores and ~20% below grocery stores. FDO has now effectively closed the pricing gap with Dollar General on these items. The new management team is focused on making the necessary changes and ‘price’ investments in lieu of managing earnings, so some short-term pain is likely before anticipated market share gains kick in but which could prove very sticky given the new price points. While the company doesn’t anticipate any additional price investments, the reality is that near-term consolidated gross margin performance could be a little messy as the company is effectively using DL banner’s expanding gross margins (37-38%) to fund the price investment at FDO where gross margins are still in the low 20s percent.
• SKU expansion opportunity – expand SKU count/assortment from ~8,000 SKUs currently to perhaps 12,000 (in line with Dollar General) and thereby grow TAM accordingly. Management is focused on increasing the shelf height capacity at FDO stores and expanding private label assortment in multiple verticals including health/beauty which is a growth category and carries a significantly higher gross margin than consumables. The expansion of private label is a logical strategic step given that private brands have outpaced national brands over the last two quarters, a pace that hasn’t been seen in five years and another indication that consumers are proactively managing their budget.
• In-Stock opportunity – vendor (supply chain) and execution (product flow/distribution processes) issues have resulted in many out-of-stock items. Management has rolled out a number of strategies (similar to what worked at Dollar General in reducing out-of-stock items by ~50% during the 2008-’10 period) to reduce out-of-stock, increase customer loyalty and enhance efficiency/reduce stock replenishment.

1. “Drive productive sales growth”: ~$2.03 incremental tax-effected EPS opportunity by FY2024E – during the FY2008-’10 period at Dollar General, Dreiling grew sales/sq.ft at 6.7% CAGR and at a ~26% contribution margin. I am assuming a 5.5% annual sales per sq.ft. growth and incremental 20% EBIT contribution margin from FY2022-'24 for FDO. Dreiling cited sales productivity in terms of sales/sq.ft. as FDO’s main focus, which currently stands at a ~30% gap to Dollar General vs ~20% in 2015:  

b. “Increase gross margins”: ~$1.01 incremental tax-effected EPS opportunity by FY2024E. I assume a 300bps improvement from FY2022-'24E, which is 200bps higher than consensus but 120bps lees than the 420bps improvement at Dollar General from FY2008-'10.

c. “Leverage process improvements and IT to reduce costs”: ~$0.66 incremental tax-effected EPS opportunity by FY2024E. I am assuming no leverage/flat SG&A as % of revenue from FY2022-'24E or -130bps relative to consensus; this compares to 180bps SG&A leverage at Dollar General in FY2008-'10. Company-wide basic IT was a negative surprise when Dreiling showed up at DLTR, he sees a lot of low hanging fruit to drive efficiencies and improvements.

3) Macro is a wild card but also an opportunity for share gains – concerns about the economy continue to rise with the Fed maintaining its rhetoric of tightening monetary policy in order to tame inflation. At a micro level, as higher interest rates begin to impact demand, create slack and cool the economy, consumer cohorts are “trading down”, according to Walmart US President and CEO, John Furner (Groceryshop conference, 9/19/22), and are looking for greater value as they have in prior recessionary periods; value and discount-oriented stores such as Target, Walmart, Dollar General and DLTR are well positioned to benefit and take share from other merchandise retailers as consumers look to stretch their dollars. Given DLTR’s sizable investment in price, Dreiling has demonstrated his commitment to future share gains. Since July DLTR is already seeing increased traffic from the +$80,000 per year income bracket at both banners illustrating the “trading down” effect from inflationary pressures and a greater move from cash to credit transactions, further substantiating the thesis that the consumer is under increasing stress.

Risks:

DLTR has been focused on the turnaround of FDO for many years without much success, so the main risk is execution where the new management ultimately fails to elevate FDO’s growth and margin trajectory.

Catalysts:

• The new management team is now largely in place and appropriately incentivized.
• Multiple strategic initiatives to turnaround FDO.
• Macro backdrop bodes well for discount retailers to take share.

Catalyst

• The new management team is now largely in place and appropriately incentivized.
• Multiple strategic initiatives to turnaround FDO.
• Macro backdrop bodes well for discount retailers to take share.