Description

We believe that Dollar Tree (DLTR) shares offer an attractive entry point for long-term focused investors at current levels.   Since peaking at nearly $120 in October 2019, three consecutive EPS guidance reductions (7% total reduction to the midpoint of the initial 2019 EPS range) have pushed shares to below $90.  We believe that many of the issues pressuring margins in the near-term are transitory including the consolidation of store support centers, higher freight costs, a helium shortage and trade and tariffs headwinds.  While the Family Dollar continues to underperform, investors are not paying anything for this business at the current valuation. The company is taking action to address the Family Dollar issues including remodeling stores and changing management.  In addition, the company is testing price points at Dollar Tree beyond the $1 level and this should drive higher earnings power over time. DLTR shares are currently trading at an attractive 16.4x NTM P/E multiple, a large discount to DG at 20.7x NTM P/E and the valuation is very compelling on a sum of the parts basis relative to DG.  With the core Dollar Tree Stores business is likely to grow in all economic environments, we see limited downside risk for DLTR shareholders and significant upside potential if the Family Dollar business performance improves. DLTR is well positioned to deliver at least low single digit comparable store sales growth and double digit EPS growth over the long-term.     

The business operates through two segments, Dollar Tree Stores and Family Dollar with a total of more than 15,000 stores (Dollar Tree Stores account for just over half of total revenue).  In July 2015, DLTR acquired more than 8,200 Family Dollar stores for $9 bil. and the acquisition has not met expectations with competitive pressures and higher than expected investment needs.                                                                                                                                                            

Below is a brief overview of the business segments.  Prior VIC write-ups also do an excellent job describing the business and strategy.     

Dollar Tree Stores

·         7,447 discount variety stores operating under the Dollar Tree and Dollar Tree Canada brands with items primarily sold at the fixed price point of $1.00

·         Mix of exclusive, seasonal, basic, home and closeout merchandise with both domestic (60%) and imported (40%) products

·         8,000 - 10,000 selling square foot stores

·         Large variety with ~ 7,250 items carried in stores and ~39% of items automatically replenished

·         2018 same store sales of +3% and operating margin of ~14%

·         Primarily suburban locations 

Family Dollar

·         7,815 general merchandise discount retail stores with merchandise sold at price points from $1.00 to $10.00

·         6,000 - 8,000 selling square foot stores

·         7,000 basic items alongside items that change on a seasonal basis throughout the year

·         2018 same store sales of  ~flat and operating margin of ~4%

Urban and suburban locations 

We believe that the dollar store industry is well positioned over the long-term.   The core Dollar Tree Stores business has a long-term track record of growth through economic cycles including strong performance in recessions as consumers trade down.   DLTR’s 2008 to 2018 EPS CAGR is 21% and Dollar Tree Stores delivered positive same store sales in each year. The business is relatively insulated from e-commerce competition and should continue to perform in line with long term revenue growth trends in the low single digit range.  The small basket size, fill-in trip nature of purchases, large percentage of cash transactions (~50%) and low value merchandise that aren’t good candidates for shipping all help to mitigate e-commerce competition. In addition, the treasure hunt atmosphere at very low price points and strong sourcing capabilities create a shopping experience that is differentiated relative to other U.S. retailers. 

The key headwind for the company has been the poor performance of the 2015 Family Dollar acquisition with intense competition and higher than expected investments required.  There have been several initiatives launched at Family Dollar with store renovations a key focus. Management expects an additional 1,000 renovations in 2020 and 40% of Family Dollar stores will be less than 5 years old at the end of 2020.  These remodels are driving tangible improvement with a 10% year one comp and a 5% year two comp. Other areas of focus include improved store layout and customer experience, more private label products at higher margins, improved in stock merchandise levels, new marketing strategies (Smart Coupon program) and more high value products.  Recent management changes should also support more aggressive adjustments and improved long-term performance at Family Dollar. We believe there is no value for Family Dollar included in the current DLTR valuation and any Family Dollar improvement is a source of upside for investors. 

Breaking the "Buck" at the Dollar Tree Stores should also drive a meaningful EPS boost over the long-term.   The company is currently testing pricing in increments of $2, $3, $4 and $5 in 115 Dollar Tree stores. DLTR is over six months into the test at the initial stores and is still collecting and analyzing the data.  In 2020, management will introduce more discretionary products and unique products with the focus on delivering exceptional value to customers at different price points. With distinctive merchandise and a strong value proposition, we believe the Dollar Tree shopper will embrace multiple price points while the company continues to focus on the core $1 price point and treasure hunt aspect of the shopping experience.   This strategy should help to grow the basket and offset pressure from higher costs (including current and potential tariffs). We believe that a multiple price point strategy will drive a boost to comparable store sales at high incremental margins over time.

We view DLTR shares as an attractive risk/return opportunity with the business delivering ~double digit EPS growth in all economic environments.  Modest annual store growth in the LSD to MSD range should continue with management estimating a long-term opportunity for 25,000 locations. If limited improvement is made in the Family Dollar business, we expect the combined business to grow EPS in the low DD range over the next few years driven by consistent performance in the Dollar Tree Stores business.  Management will likely continue to use FCF primarily to pay down debt with net debt reduced by over $3 bil. since the closing of the Family Dollar acquisition.  

The current valuation suggests that the market is assigning zero or even negative value to the Family Dollar business.  Given similar comp growth, operating margins and returns, we believe that the Dollar Tree Stores segment should trade a similar multiple to DG’s ~16.5x forward EBITDA.  However, recent poor results and Family Dollar concerns have pushed DLTR’s EV/NTM EBITDA to just 12.6x. Assuming a conservative ~13x multiple on Dollar Tree Stores 2020 EBITDA, a sum of the parts valuation suggests that the market is assigning zero or negative value to the Family Dollar business.  We believe that a 13x multiple is too significant of a discount for the core Dollar Tree Stores business and that while Family Dollar has its issues, it has potential to significantly improve from current business trends over the long-term. We believe a reasonable multiple for Family Dollar is around 8x EBITDA and this is a valuation for which the business could potentially be sold (acquired for 12x EBITDA in 2015).  13x EBITDA for Dollar Tree Stores and 8x EBITDA for Family Dollar leads to a $105 current value for the business or over 20% upside from the current price although a higher valuation for Dollar Tree Stores is likely warranted.  

Overall, we believe that DLTR offers an attractive risk reward scenario for investors.  While the company has encountered a number of margin headwinds in 2019, we believe these are largely transitory in nature and can be mitigated over time.  With a solid core Dollar Tree Stores business and no value implied in the current valuation for Family Dollar, the current set up is favorable for investors.      

Risks

Consumables retail is an inherently competitive industry.

Cost inflation (merchandise/tariffs, freight and labor) could be a greater than expected headwind.

Strong economic growth could cause dollar stores to underperform other more cyclical retailers. 

Challenges at Family Dollar take longer than expected to drive improvement.

Catalyst

One time headwinds dissipating. 

New pricing strategy. 

Family Dollar improvement.