Description

DLTR's recent willingness (albeit almost out of necessity) to "break the buck" in a more serious way should prove to be a pivotal moment in the company's history as it finally gives investors what they have wanted for many years. Moving beyond a $1 price point to a multi-price point model ($1.25, $1.50 etc, along with higher $3/5 price points previously being tested) will not only give DLTR more flexibility at its Dollar Tree (DT) banner to maintain margins during inflationary periods, but should also structurally boost organic SSS and margins. DLTR's "normalized" earnings power is materially higher than F21/22 estimates imply as recent inflationary and supply chain headwinds have significantly lowered its near-term earnings. As those headwinds abate at the same time that re-opening and social gatherings return, and the DT multi-price point (MPP), DT/FDO combo store, FDO H2 stores, and other initiatives ramp, earnings should inflect over the coming years. The stock today provides the patient investor with the ability to buy a leading and defensive retail enterprise at just 12x normalized 2023E earnings of ~$8+. At an 18-20x multiple the stock could see near-term upside to $145-160 (50-65%). If management can execute and the multi-price point initiative is as accretive to the top and bottom line as I think it could be, DLTR could potentially earn $11/13 of EPS in F24/25 in a blue-sky scenario. At an 18-20x EPS multiple the stock could be worth $200-260 in 2-3 years.

Background:

DLTR has been written up a few times in the past and those provide good background on the core business if needed, but I will focus primarily on recent events over the last two years. At a very high level, DLTR is comprised of the Dollar Tree (DT) banner and the Family Dollar (FDO) banner. The DT banner skews more to the suburban middle income consumer looking for more discretionary items like seasonal, holiday, party, education, etc. All of its products historically were sold for $1. The FDO banner is a discount store that sells mostly consumables to the lower income consumer in urban areas. It's merchandise is not tied to the $1 price point even though it is known as a "dollar store" (more similar to DG than DT). Historically, the DT banner was considered a best-in-breed, consistently growing defensive retail banner where much of the value of DLTR lied. FDO was considered a self-help story in the 5+ years after the 2015 ill-advised purchase that left it over-levered with an aging store franchise. Most writeups on DLTR focus on the implicitly cheap hidden value of the FDO banner. I think that remains true and believe that management has finally improved the FDO banner (with a little help from covid), but I believe both banners are moving more towards being interdependent on the front (combo stores) and back-ends (purchasing and distribution centers), so FDO will not be spun out, and therefore its more appropriate to look at what will drive the overall DLTR enterprise rather than a SOTP story that has not played out over the years.

In 2019, management finally started limited testing on a multi-price point (MPP) initiative at the DT banner. While the ramping of the initiative was slow and not to the scale that investors were hoping, it was finally a sign that management was willing to innovate the business strategy. The move to MPP had been a key want from investors for many years, with activists and investors alike citing the significant gains when Dollarama in Canada "broke the buck". However, management had dragged its feet because of the belief that consumers loved DT because of its $1 price point and bringing other price points into the store would dilute the brand and treasure hunt experience. Integration and operational issues with FDO also took away management resources and focus, and an over-levered balance sheet left little room for bold strategic actions. 

Despite the $1 price point, DT had done a great job over many years purchasing product and managing to a tight 35-36% gross margin (higher than the FDO banner due to its higher discretionary mix). Then the Trump China tariffs, a helium shortage, and Covid hit, and DT became the risk to the DLTR story while FDO was showing steady progress. The Trump China tariffs were more detrimental to DT than most retailers because of the significant amount of product purchased from China and the inability to raise prices given its fixed $1 price point. DLTR managed reasonably well through this process by using its purchasing scale for vendor discounts and shifting some purchases away from China, but margins were still negatively impacted (down 60bps YoY in F19 to 34.72%, its lowest margin in many years at the time).

Margins would have likely normalized during F2020/21 if not for covid, which has had multiple negative impacts on the DT business. While other retailers saw significant SSS tailwinds from consumer stocking of consumables (including FDO), the DT banner was actually negatively impacted given its discretionary mix and focus on items that largely center around social gatherings (-0.9% SSS in 1Q20). Store traffic continues to be negatively impacted (-13.3% in F20 and just +1.1% off an easy comp in 2Q21) as consumers consolidate trips and purchase more of the discretionary items they would normally get from DT from other stores. Labor costs have also materially increased from the combination of enhanced unemployment benefits (and the resultant lack of minimum wage labor at stores and DC's) and state increases in minimum wage. For a while, the Federal minimum wage proposal negatively impacted sentiment as it would have adversely impacted DLTR stores in lower wage states. Again, DLTR historically has done a decent job in managing higher labor expenses through technological innovation, but the lack of actual available labor has proven to be too much to overcome in the near-term.

The number one issue today borne out of covid is supply chain disruption that has left the company low on inventory (in both banners) and short of in-store merchandise which has and will have both a top and bottom line impact. DLTR has tried to manage through this by prioritizing SKU procurement to the highest value mix and ordering key seasonal inventory ahead of time, but there is just limited import shipping capacity available for the company to actually work around. To partially mitigate these headwinds, the company has chartered a vessel for three years to ensure it can get product when it needs, and has selectively chartered other ships for a few round trips.

After warning of potential higher freight expenses on the 1Q21 call, DLTR significantly increased its freight expense forecast for F21 on the 2Q21 call. Specifically, the increase in freight expense is expected to have a negative impact to the tune of $1.50-1.60 in EPS (current guidance is now ~$5.50) across all of DLTR in F21 (relative to F20 freight expenses). Embedded in this outlook is the assumption that only 60-65% of DLTR's product will be shipped via its contractual carriers, with the rest via spot carriers. The bears believe DLTR will need to lower guidance again in the coming quarters due to persistently high freight rates and potential incremental negative impact to SSS from reduced inventory.

Post-2Q21, DLTR dropped to a low of ~$85 (from an April high of ~$120) before the company announced last week (Sept 28) that it was going to "break the buck" in an even more dramatic fashion, expanding the MPP initiative by adding other price points ($1.25, 1.50, etc vs just $3/5) to both DT Plus stores and legacy DT stores. It also announced an increase in the share repo authorization. The stock popped ~16.5% the next day and has since given a bit of that back. I believe the stock reaction is appropriate as the announcement is what investors have been clamoring for and should result in structurally higher SSS growth and margins for the DT banner and DLTR as an enterprise. Unfortunatly it took significant inflation headwinds to push management over the hump and get to this point, but here we finally are and now it is all about execution and framing the upside from this key initiative.

Breaking the Buck Should Mean Structurally Higher DT Growth/Margins:

Higher price points at DT should result in higher average basket sizes over time and structurally higher SSS growth versus the 2-3% historically (assuming store traffic returns to historical growth, which it should as re-opening continues and social gatherings/back-to-school/holidays normalize). And that higher basket size and higher sales per store will also apply to the 3-4% of new unit growth per year thereafter. 

Putting some numbers on the MPP opportunity using recently disclosed metrics for just the $3/5 DT Plus initiative:

• Management has noted a 6% sales lift and 6% gross profit increase for a ~13% contribution dollar increase versus legacy stores. Conversion to DT+ stores has less than a 1 year payback. 
• The $3/5 MPP initiative is already rolled out to 340 DT Plus stores, with 500 expected by the end of 2021, and another 1,500 by the end of F22. DLTR expects at least 5,000 DT Plus stores by the end of F24, or ~1,500 per year from F22-24. That is off a base of ~8,170 stores at the end of F21.

In order to back into a 6% year 1 sales uplift, and using some guesstimates as to what the mix of merchandise between the $3 and $5 items has been (75%/25%), implies about 2.5% of all merchandise sold in DT+ stores in year 1 is at a price point other than $1. However, with the acceleration of MPP, far more items will likely be above $1, especially if DLTR uses the initiative initially to recapture lost margin. Again using some rough guesstimates for illustrative purposes, it isnt hard to see how the Year 1 sales uplift under the expanded MPP could be 10% or more.

Under the current 6% Year 1 sales uplift guidance, I estimate F22-25E DT banner total annual revenue growth algorithm would be boosted by >90bps per year. That assumes 1,500 new DT+ stores per year and an historical 2.5% organic SSS growth after year 1. However, under the new expanded MPP regime at the 10% Year 1 sales uplift, total DT banner annual revenue growth algorithm would be boosted by >150bps.

A 13% increase to contribution cash profit implies roughly 50bps of gross margin expansion from the initiative. But that was just for a limited selection of merchandise. Going forward, DLTR will be better able to maximize gross margins across the entire portfolio (similar to best in breed like HD) and across a broader breadth of products. It will also be able to purchase a different merchandise mix that could skew to higher margin more discretionary products. If we assume 200bps of margin expansion (on top of the 10% sales uplift in year 1) to the ever expanding percentage of DT+ stores, you get significantly higher DT banner margins over time. I see normalized gross margins potentially expanding by 30bps+ per year and being >125bps higher by F25E, assuming freight/labor/etc normalize at the lower end of  legacy DT margins (versus the 35-36% historical). Even if freight/labor etc do not fully normalize, expanded MPP would enable the DT banner to get back to ~35% by F25, and even sooner if they are able to roll it out to stores quicker than the 2Q21 guidance. All of this should be put into context against the backdrop of a management team that has historically not been the best at executing operationally.

See below for my rough high level math:

Further Operational Opportunities:

DLTR usually has several initiatives ongoing at any one time (as does its competitor DG) that are intended to drive both top and/or bottom line growth through either operational performance improvement, new and/or expanded product offerings, or new store growth oppourtunities. I wont focus on all of the initiatives, but will point out two of the key ones.

DLTR recently began opening combination DT+FDO stores, expanding its TAM into more rural markets where it historically hadnt made sense to put a stand-alone DT banner. This is historically where DG has thrived. DLTR believes it has the potential to open 3,000 Combo stores in rural towns alone, while it is looking at also expanding to other geogrpahic areas. These stores will be under the FDO reporting segment and are larger than traditional FDO stores (12,500sq ft vs 9,500). DLTR recently disclosed that Combo stores deliver 23% more sales, 31% more gross profit dollars, and 120% more contribution dollars versus the traditional FDO stores, with a 30% reduced payback. They are also delivering a 17%+ sales increase versus similar sized FDO stores and >40% sales increase for renovated/relocated stores versus non-renovated ones. These larger more profitable stores have the potential to boost growth in the FDO business, continuing its improved performance from gains made during covid. Purchasing scale from more DT products in these stores should help DT's gross margins over time and a more unified distribution system able to serve both banners should improve distribution costs (further boosting gross/operating margins in both banners). Historically one of the key areas of focus and potential improvement from combining the DT and FDO businesses was to gain distribution scale which has yet to come to fruition and represents all upside.

DLTR continues to rollout its H2 renovated FDO stores. As of 2Q21, just 40% of the store base had been converted to the new and improved H2 stores (cleaner, better merchandise mix with more discretionary products, etc). Management continues to claim H2 stores give a >10% boost to revenue and with almost 60% of the FDO store base still not converted, there remains significant runway in the FDO business for further top and bottom line improvement.

Normalized Earnings Power Is Much Higher than Near-Term Estimates:

DT's gross margins in 2021/22E are expected to be close to ~33.2/32.7% (down from the 2017 highs of 35.81%). Almost 200bps of that has been from merchandise/freight/tariffs and the remainder from higher distribution costs. That 200bps of merch/freight headwind also includes the positive impact of a merchandise mix that has been skewing more to higher margin discretionary products (ie Crafters Square). The positive impact from a better merchandising mix should prove to be stickier than the freight and distribution headwinds that have hindered near-term margins. The same holds true at FDO, which is also going to see significant freight headwinds in 2021 even though it has improved the underlying operations of the business. Those improvements should also prove to be stickier than those headwinds over time.

DLTR has guided to 2021E EPS of $5.40-5.60 with $1.40-1.60 of freight headwinds relative to 2020. It has noted that it believes its earnings power is closer to $7 and is confident that the disruptions in the supply chain will prove to be transitory over time (however, will extend into 2022). When these disruptions will normalize is anyones guess, and it doesnt appear to be yet, but I do believe that DLTR is very adept at managing its supply chain and if/when the global supply chains normalize as covid passes, people go back to work, and new ship capacity comes online, that DLTR should be able to drive consistent margin improvement from current levels back to more normalized levels in 2-3 years. Just getting the $1.50 of EPS back would result in low-teens EPS growth over the next two years. Coupled with the benefits of breaking the buck, combo stores, H2 stores, and just organic growth in the business, normalized earnings power in a few years could be quite significant relative to current levels. And an argument could be made that DLTR will emerge with a much stronger supply chain after coming out of the current disruption resulting in structurally higher gross margins. We dont need that for the stock to work. And unlike in the past when DLTR did not have a repurchase program to take advatnage of a weak stock price because of its leverage (while DG did), DLTR now can repurchase 4-5% shares back each year while maintaining its ~1x leverage multiple.

Below is a high-level summary normalized earnings model. I see normalized 2023 EPS being $8+ (versus ~$7.50 consensus, and $5.50 in 2021) implying a mere 12x EPS multiple for potential 21% EPS CAGR. At its historical multiple of ~18x over the last few years, DLTR could be worth $144+ by the end of 2022 ($160 at the 20x S&P multiple) for 50-65% upside. If we look further down the road to 2024/25E when the benefits of the multi-price point program will be realized, it is possible that DLTR could earn $11 to $13 per share. Call that the blue-sky number and discount it as need be, but at an implied <9x and <7.5x EPS multiple, you are not paying much for that optionality. At an 18-20x multiple on $11-13 per share, DLTR could see $200-260 per share over the next 2-3 years.

Risks:

DLTR is no stranger to disappointment. It has done so many times over the last five years and every time it seems the company is poised to return to its normal algorithm of growth another black swan event prevents that. The big risk is that the DT banner's margins are structurally impaired and coming out of covid the allure of the banner is permanently diminished, reducing store traffic. The lack of inventory over the coming quarters could permanently dampen consumer sentiment on the DT banner. Management could also either mess up the MPP initiative, or not roll it out as aggressively as investors hope. Further supply chain disruptions and/or the lack of inventory negatively impacting 2H21 sales and margins could lead to another guidance cut. 

Catalyst

Multi-price point offering rolling out aggressively to all DT banner stores and management providing incremental color on metrics of the rollout.

Freight rates and global supply chain disruptions easing as the world re-emerges from covid.

Re-opening and the return of holidays, parties, and school benefitting DT banner stores in the coming quarters.