Description

Quick History

Dollar Tree closed on the acquisition of Family Dollar on July 6^th, 2015 for around $9 billion in cash and stock. Here is a comparison of the Family Dollar segment in the first two full years of ownership (Fiscal years 2016 and 2017) vs. the most recently completed year (Fiscal 2023):

• Fiscal 2016: $10.6b Sales, ~$500m EBIT (a 4.8% margin), ~$770m EBITDA, <$250m CapEx
• Fiscal 2017: $11.1b Sales, ~$650m EBIT (a 5.9% margin), $1b EBITDA, <$250m CapEx
• Fiscal 2023: $13.8b Sales, $(9)m EBIT, $432m EBITDA, $995m CapEx

Several efforts have been made to try turning around the banner. This includes the most recent attempt where an activist brought in Rick Dreiling to try implementing the playbook he famously used at Dollar General to great success. Dreiling joined the Dollar Tree board as Executive Chairman in March of 2022 and was further appointed as CEO in January of 2023.

It’s important to note, at the time Dreiling was appointed CEO of Dollar Tree, Dollar General was operating at a ~9% EBIT margin vs. Family Dollar at 1% - closing the gap was a big opportunity for Family Dollar.

In June of 2023, management held an Investor Day outlining ambitious targets for Fiscal 2026. The Family Dollar banner was meant to accelerate net-new store growth, grow same-store-comps at MSD and achieve a 5%+ EBIT margin. It was therefore surprising when management announced on March 13^th, 2024 as part of its fourth quarter earnings release a plan to close 970 stores over the next few years, including 600 in the first half of Fiscal 2024.

Finally, on June 5^th, less than a year after the Investor Day, Dollar Tree announced a review of strategic alternatives for the Family Dollar business.

Turnarounds in retail are notoriously difficult, and perhaps management realized the road to fixing Family Dollar would take longer than Dollar Tree investors would tolerate. Perhaps the board and management decided the way to create more per-share value would be via a separation of the businesses. Maybe Dollar General’s recent poor results (EBIT now ~6%) meant that “closing the gap” was not as lucrative as before. Whatever the case may be, this is finally the catalyst that will highlight the true gem of the company – the core Dollar Tree banner.

Dollar Tree Segment

Historically the Dollar Tree segment was known for its stores that sold everything for $1. Incredibly, management was able to drive positive comps year after year and maintain mid-30s gross margins without ever increasing the selling price of the products sold – in our opinion a stunning achievement. Over time, however, the cumulative impact of product inflation, elevated freight costs and the Trump tariffs made it ever more difficult to offer a compelling selection of products at the aforementioned margins.

In September of 2021, management made the decision to “break the buck” by raising the price of all items to $1.25. Comps in Fiscal 2022 went up to 9%, and importantly gross margins, which had deteriorated to 33% in 2021 are now back to the ~36% range. Management is further introducing multi-price points where items can be sold for $3, $4, and $5 – offering a wider selection of compelling products to consumers at a great price, while also giving its merchants much more flexibility to source merchandise that will meet the financial profile of the banner.

With that in mind, management has offered the following growth algorithm for the Dollar Tree banner:

• MSD+ new store growth
• MSD comps – driven both by multi-price as well as the better merchandising opportunities
• 14 – 15% EBIT margins

This should result in HSD / LDD growth in segment EBIT for the foreseeable future.

With multi-price still in the early innings, and with segment margins already near 14%, this plan does not strike us to be nearly as ambitious as the plan laid out for Family Dollar.

Consolidated Financials

Consensus estimates call for $7.85 of EPS in Fiscal 2025. Our sense is that Family Dollar contributes negative $0.35 to that figure when including its share of corporate costs, meaning core Dollar Tree might earn $8.20 in Fiscal 2025. Further, any value realized in a sale of FDO could be used towards more share buybacks and/or debt reduction, further increasing Dollar Tree’s EPS.

In other words, at today’s share price you are paying 13x forward earnings for the Dollar Tree banner and you get whatever optionality exists at the Family Dollar banner. We believe this is a very low price to pay for a business with the long-term success demonstrated by Dollar Tree in the past combined with the compelling growth opportunity looking forward – double digit EBIT growth combined with share buybacks should drive mid-teens+ EPS growth – most other banners we see with those characteristics trade at double-digit EBITDA multiple and EPS multiples of 20+.

At 12x 2026 EBITDA, you would arrive at a share price of $180 – not even 20x earnings – and that’s ascribing -0- value to Family Dollar. At 10x EBITDA you get a share price of $150 – a mid-teens P/E multiple – also not ascribing any value to Family Dollar. This seems like a conservative multiple to use if the Dollar Tree banner performs to management’s guidance.

Risks

Here are some risks we would highlight, as well as high-level thoughts on potential mitigants.

Tariffs – All else being equal, increasing tariffs on imported goods would hurt Dollar Tree’s margins. We believe multi-price gives Dollar Tree a way to help mitigate the impact – changing the assortment and package sizes combined with an ability to selectively raise price on certain items (as well as increasing price point to $6 and $7 over time) would go a long way to softening the impact of increased tariffs.

Economy – An important part of the growth algorithm is delivering mid-single digit comps at Dollar Tree – what happens in a weakening economy? We would offer several observations: As opposed to Five Below selling largely discretionary items, ~50% of Dollar Tree's sales are in the Consumable category. Additionally, Dollar Tree is in the early stages of rolling out multi-price – which should drive strong comps as it continues to be expanded over the next several years.

Final Thought - Incentives

The sum-of-the-parts story at Dollar Tree has been well known to investors for many years. We have followed it, but always felt that retail turnarounds are difficult to execute. What’s changed now is the announcement that management is now willing to wave the white flag on a difficult Family Dollar turnaround.

Part of this is undoubtedly driven by incentives: Mantle Ridge is in Year 3 of this investment with little to show for its effort in terms of share price performance. Further, the majority of Rick Dreiling’s compensation is tied to a one-time option grant he received in March of 2022: 2,252,587 shares with an exercise price of $157.17.

The first order of business and best case for shareholders would have been to create meaningful value at Family Dollar by turning around that banner. We believe if management is now pursuing a plan to separate the two businesses, it is likely their view that this is the best path forward to increasing the per-share value Dollar Tree.

Catalyst

Sale / Separation of the Family Dollar Banner