Description

Dollar Tree, Inc. ($90.79)

Summary:  Dollar Tree, Inc. (DLTR) is the largest discount retailer in the U.S. by store count, with 15,000 stores across its two banners, Dollar Tree (6,700) and Family Dollar (8,200).  The Dollar Tree banner has been one of the best-performing retail concepts for well over a decade (41 consecutive quarters of positive comps) and still has several years of door expansion. DLTR acquired Family Dollar (FDO) in mid-2015 for $9.8 billion; FDO more closely resembles the multi-pricepoint Dollar General (business mix at FDO/DG is ~75% consumable/non-discretionary vs ~50% at Dollar Tree).  While FDO and Dollar General (DG) have similar formats, FDO’s sales productivity and profitability have lagged DG’s over the past several years (sales/foot lower by 15%-20% at FDO). Investors have been optimistic that DLTR will narrow the sales gap and increase profits at FDO but the turnaround has been uneven to date; shares recently fell under pressure following a 1Q 2018 comp of -1.1% in the FDO segment. At current valuation, the market ascribes almost no value to FDO (~30% of consolidated EBIT) despite management having a credible long-term plan to improve and grow the segment, providing an attractive risk/reward opportunity.

Thesis:

1. Dollar Tree is a great retail concept – Dollar Tree is one of the most resilient and differentiated retail concepts (all merchandise sells at single pricepoint of $1.00; 50% of merchandise is discretionary/seasonal and refreshed frequently creating a treasure hunt atmosphere) with broad appeal (customer base extends well into middle class relative to DG/FDO) and a long track record of consistency (41 quarters of positive same-store sales, with comps driven entirely by traffic/increased units).  Segment profits stand at sector-leading 13%+. The unit economics are among the very best in retail (new store ROIC exceed 50% with payback periods less than two years), with several years of reinvestment opportunity (increase its current store base of ~6,700 by over 60% to long-term 11,000). The business performs well in good economic times (comps have averaged ~4%+ the last four quarters), and has historically outperformed significantly during times of economic hardship (DLTR was best-performing stock in S&P 500 in 2008).

2. Family Dollar turn taking longer than anticipated but should not be left for dead – While consistent comps have not materialized to date at FDO, there does not appear to be any structural reason why the segment cannot close a meaningful portion of its productivity gap with DG over the next several years.  Management has undertaken several initiatives – and while no single thing represents a silver bullet or quick fix – taken together, these initiatives represent a credible plan to drive improvement:

• “Table Stakes”/“Retail 101”: Ongoing focus on cleaner stores, better product assortments, greater value, more consistent in-stocks and better customer service.  Also investing more in store hours and wages (reinvesting $100mm of tax savings across both banners).

• Return to EDLP: Prior FDO management made the unfortunate decision to move away from Everyday Low Prices in favor of a promotional-driven/hi-lo model.  FDO is emphasizing ELDP through its “Smart Ways to Save” marketing message, targeted Price Drops, private brand offering and new mobile app that utilizes Smart Coupons.

• Private brands: FDO is in the process of rebranding/repackaging its private brands over the course of 2018 across several categories.  Private brands currently account for approximately 20% of consumable products so meaningful base from which to expand (private label drives higher margin and higher gross profit dollars).

• Store manager compensation: Restructured FDO store manager incentive compensation to match Dollar Tree structure (bonuses earned and paid based on monthly results; early response is positive).

• Store renovations:  Perhaps the biggest multi-year comp driver/ opportunity for FDO.  DLTR only began its FDO renovation program in earnest just over a year ago and the early results have been encouraging (renovated stores see a HSD lift in comps).  Renovated store layouts include better category adjacencies and more productive endcaps; expanded beverage and snack, including immediate consumption coolers near checkout; more coolers and freezers; shopper-friendly power alley for "$1.00 Wow Items" (draw upon Dollar Tree merchandise) and a faster checkout process.  DLTR completed 370 renovations in 2017 (increased number from original guidance of 250 following favorable early results) and plan to further accelerate renovations to 450 in 2018; see the opportunity to renovate over 2,000 stores over next few years.

3. Management has strong long-term track record; sticking to its guns on turning Family Dollar – DLTR is led by Executive Chairman Bob Sasser and CEO Gary Philbin; they have been partners for over 17 years and built up Dollar Tree organically and via several acquisitions during that time.  While the acquisition of Family Dollar has plainly not created discernible value to date, management has an excellent track record of long-term capital allocation and delivering on what they say they will do (have not missed full-year guidance in over seven years).  Management's current plan is credible, and moreover management is not backing off on the goal of driving sales improvements at FDO and returning segment margins to past peak of 7.5% (versus ~4.1% in 2018E) and beyond ("[7.5%] is not where we're going to stop, obviously." – CFO Kevin Wampler (Sep-17)).

4. Little value ascribed to Family Dollar at current price; stock cheap on consolidated basis – When valuing the Dollar Tree segment at 11-12x Ebitda (similar to DG, below Off-Price comps), it implies minimal residual value for the FDO segment ($1.7-$3.5 bn; 0.6x-4x Ebitda) on 2019E numbers versus the $9.8 bn that DLTR paid for the asset three years ago).  If DLTR begins to show steady traction in the FDO segment, sentiment will likely improve and the multiple will re-rate. Would also note that DLTR is cheap on a consolidated basis by most conventional metrics relative to other leading discount retailers/off-price retailers (TJX/ROST trade for 13.5x Ebitda; FIVE/OLLI trade for ~25x Ebitda):

• 14.5x 2019E consensus P/E

• 8.7x 2019E consensus EV/Ebitda

• 6.6% equity FCF yield on 2019E numbers

5. Underappreciated upside potential over several years – DLTR has been a solid compounder for many years and offers an attractive base case risk/reward through combination of continued execution and store growth at Dollar Tree banner and demonstrating traction on FDO turnaround.  However, worth highlighting two additional areas that could drive meaningful value in the future for DLTR beyond the continued expansion of Dollar Tree and Family Dollar banners in the U.S.:

• Dollar Tree Canada – DLTR entered Canada in 2010 with the acquisition of 86 Dollar Giant stores and has made steady progress after its initial integration/re-bannering to Dollar Tree Canada (last several conference calls have noted "continued momentum" and "exceeded plan for operating income" in the Canadian segment).  Currently 225 stores with minimal disclosure (filings report "revenue and assets in Canada are not material"). Management believes Canada can support 1,000 stores over the long haul, so long potential runway for growth. Dollarama is the leading dollar store in Canada with 1,200 stores and a market capitalization of C$16 bn.  If DLTR continues to grow in its Dollar Tree Canada banner over the next several years, it could increasingly drive value at the consolidated DLTR entity or as a possible stand-alone/spin entity.

• "Break the Buck" – Purely speculative at this point as management remains firmly committed to the single $1.00 pricepoint at Dollar Tree.  However, Dollar Tree arguably does have a great deal of latent pricing power and merchandising opportunity if it were to evolve away from the single $1.00 pricepoint in the future.  Dollarama in Canada provides an interesting case study: Bain Capital acquired the business in 2004, at which point it exclusively sold merchandise at the single C$1.00 pricepoint. In 2009, DOL.CN began to expand its pricepoints above C$1.00; comps accelerated and margins have expanded 1,000 bps to 23% in the decade following the move towards multi-pricepoints.  To reiterate, do not expect DLTR to move away from the single $1.00 pricepoint in near term, and expect the concept can continue to outperform based its current time-tested approach of selling at $1.00, but this idea is worth highlighting as DLTR is arguably uniquely positioned among retailers in terms of latent pricing power/merchandising opportunity. Expanding pricepoints someday could very well drive a multi-year next act of growth and margin expansion for DLTR.

Other Topics:

• Cash Flow / Capital Allocation – DLTR generates a lot of free cash flow.  The company has paid down $3.5 bn of debt over the past three years while undertaking the integration of FDO and investing in both banners.  Rent-adjusted net leverage recently fell below 4.00x and DLTR received an investment-grade rating in connection with a recent bond refinancing (will save ~$50mm in annual interest expense).  Expect net leverage will approach 3.50x by year end, allowing for significant share repurchases to resume in 2019E (share repurchases were suspended in connection with the FDO acquisition).

• E-Commerce/Mobile – Dollar stores in general are relatively more immune to online shift than other categories for several reasons: small average ticket ($10.50 at FDO; $8.30 at Dollar Tree); product offering and convenience (consumable/"need-it-now" dynamic at FDO; "need-it-now" combined with treasure hunt at Dollar Tree); and demographics (largely focused on bottom half of consumers; two-thirds of transactions at FDO are tendered in cash).  However, it is worth noting the following online/mobile initiatives at the respective banners:

• Dollar Tree operates an e-commerce site that is profitable and growing at a double-digit rate, but likely only ~1% of segment sales.  Business evolved from the prior Dollar Tree Direct 1-800 number which was more of a B2B model that allowed customers to purchase items by the case rather than individual units (e.g., cases of party supplies or classroom supplies).  Given the single $1.00 pricepoint, Dollar Tree requires minimum unit purchases on several items and also charges for shipping (free shipping to stores available). DLTR also uses how-to videos on dollartree.com and social media to engage customers ("We allow our customers to show [on Instagram] 'look at what I did for this party and I only spent $10 to put all this together for the party.'")

• Family Dollar does not yet operate e-commerce site, but expects to launch a direct business in the future.  Current focus is on recently introduced mobile app, which provides customer with easier access to Smart Coupons and allows FDO to know customers better/have better targeted customer-specific offers.  App has good interface and is intuitive to use (4.8/5.0-star rating on iOS based on 50,000 ratings); has been downloaded by 3mm customers as of last quarter (over 5mm customers already using Smart Coupons).

• SNAP/Food stamps – SNAP tender represent less than 5% of sales at FDO and even less at Dollar Tree banner (compares to 14% of population receiving some form of SNAP benefits).  The company is very mindful of the low-income consumer/SNAP beneficiary who often lives paycheck to paycheck, particularly at the FDO segment (has noted the importance of having shelves ready at the start of the month as “our customer thrive at the beginning of the month and then survive at the end of the month.”)

Target Price:

Target price of $123.00 per share (~36% upside) predicated on 17x 2020E EPS of $7.19.  Also worth noting that risk/reward is attractive given (i) DLTR is recession-resilient, and (ii) current market valuation ascribes minimal value to FDO.

Risks:

• China tariffs/trade war.  ("substantial majority" of imports from China; bigger factor for Dollar Tree segment given greater emphasis on discretionary/non-consumable)

• Unforeseen slowdown at Dollar Tree segment

• Complexity of FDO integration in fact too great for management turnaround initiatives

Catalyst

• Demonstrated progress at Family Dollar segment
• Continued executiion at Dollar Tree segment
• Buyback resumed