Description

Note: many of the industry tailwinds and headwinds were discussed by rhubarb in his recent Dollar General write-up

Overview

• Dollar Tree is structurally well-positioned to grow same-store sales and new locations over the coming years.

• We expect Dollar Tree banners to grow at 4-5%, comps to grow at ~2%, and for margins to remain flat at ~12.5%.

• We forecast Family Dollar banners to also grow at 4-5%, comps to grow at ~2%, and for margins to expand from 3.5% to 7.0%.

• Given the company’s focus on lower income consumers (through the Family Dollar banner), who are a sizeable and growing portion of the U.S. population, we believe that Dollar Tree can compound earnings at a mid-teens rate over the next 3-5 years.

• The investment opportunity in the stock derives from the market’s short-term concern with the recent SSS growth that has been depressed by factors that we believe should normalize in the short-term (e.g. food deflation and reduction in SNAP benefits). Furthermore there is renewed concern in the market about competitive threats from players including Wal-Mart, Aldi, and Lidl. Finally, Family Dollar operates with much worse margins than its nearest competitor, Dollar General; however we find no structural reason why these margins can’t be improved significantly by Dollar Tree’s management.

• We believe that Dollar Tree can earn well over $6 in EPS in FY2019, and at a 16x multiple, we believe the stock could be worth ~$100.

Investment Thesis

• The small-format discount retail industry has consolidated to two meaningful players

• Dollar General: ~13,000 stores and a multi-price-point discount model

• Dollar Tree: ~14,000 stores, with the Dollar Tree concept selling everything for $1 while Family Dollar has multiple price points, similar to Dollar General.

• The discount retailers give customers more convenience than Wal-Mart or Kroger through a smaller sized store, but with similar or lower price points.

• Core Dollar Tree stores cater to a higher end customer ($50,000+ average household income), while the recent acquisition of Family Dollar ($30,000-40,000 average household income) creates a multi-price-point retailer with broad customer reach and a network of 13,000+ stores. This will help the company achieve size/scale opportunities over time.

• Family Dollar had the weakest operating margins of all the discount retailers, with sales per square foot 20% less than Dollar General, operating income per square foot less than half of DG, and overall operating margins about half of DG.

• Over the next three to five years, we believe that Family Dollar margins can double as Dollar Tree applies its industry leading practices to store operations, merchandising, and distribution, thereby bringing FDO results more in line with DG.

• Dollar Tree management is some of the best in the industry. Since Bob Sasser took over as CEO of Dollar Tree in 2004, the company has grown the store count from 2,500 to 14,000 and both revenue and FCF per share have compounded at over 15% per year.

• SSS growth at both DG and FDO have been weak over the past few quarters primarily due to food price deflation and food stamp cuts, both of which are cyclical and temporary.

• It appears that January 2017 may have marked the end of food deflation and food prices have rallied 0.75% off the January low (down less than 1% year-over-year).

• Given that we are likely late in the U.S. economic cycle, we believe that industry comps are likely at a trough and the risk is positively biased if the economy rolls over.

• Dollar Tree’s current tax rate is around 37%, and a cutting the corporate tax rate to 25% could add another $20 per share of upside.

• The company is an aggregate importer of about 1/3 of their merchandise. However, we don’t believe that the U.S. will enact a border adjustment tax, and if they do, management is likely to adapt over the long-term.

Risks

• Recent weak comps could persist amid continued food price deflation and food stamp cuts.

• A change in the competitive landscape as related to promotional activity or the ability to pass along price increases from other discount retailers and large-box competitors could negatively impact comps and overall profitability.

• Turn-arounds are hard.

• While the stock has de-rated recently, it is not “cheap” by historical standards. However, we feel the multiple is attractive relative to the rest of the market.

Catalyst

• Improvement of FDO margins
• Return of food inflation
• Square footage growth