Dollar Tree Inc. (DLTR, Financial) is a leading operator of discount variety stores, primarily in the United States. The company’s namesake banner sells products at a fixed $1 price point. A quick look at the financials shows the concept has clearly resonated with consumers: the banner has generated positive same-store sales growth for 43 consecutive quarters. In fiscal 2017, the Dollar Tree banner reported $11.1 billion in revenue and $1.5 billion in operating income (13.4% EBIT margin). That works out to $1.7 million in sales and $220,000 in operating income, on average, for each of its 6,650 stores. While I haven’t seen comparable numbers from Dollar Tree, Dollar General (DG, Financial) has disclosed its initial outlays to add a new store is roughly $250,000. Using that as a guide, it’s clear that Dollar Tree is generating attractive returns on investment by adding new boxes (which explains why this has been its primary use of cash flow for years).
But the story changed in 2015 when Dollar Tree acquired Family Dollar for $9.1 billion (80% cash and 20% equity). Family Dollar has consistently reported lower margins than Dollar Tree, which has not changed under Dollar Tree's management: through the first nine months of fiscal 2018, Family Dollar reported 3.0% EBIT margins, compared to 11.4% EBIT margins for the Dollar Tree banner. In addition, Family Dollar has reported lackluster comps for years (well below both Dollar Tree and Dollar General, with the latter being a more direct comparison).
That has continued in the current year: through the first nine months of fiscal 2018, Dollar Tree and Family Dollar comps were +3.3% and -0.4%, respectively (Dollar General’s comps were +2.9% for the same period). Despite these persistently weak results, management has publicly voiced a steadfast commitment to the banner. At this point, I think any ambitious definition of “success” for the Family Dollar turnaround must assume many years of investment (that’s partly because the business started form such a poor position, something I think Dollar Tree management recognized over time).
Looking at the two banners independently, I think you can argue Dollar Tree is one of the best businesses in brick-and-mortar retail (supported by the long-term financials). The banner is on pace to generate roughly $1.5 billion in run rate EBIT in fiscal 2018. After backing out $190 million in net interest expense (annualized on last quarter’s results), that leaves approximately $1.3 billion in pretax income. At a 20% tax rate (in line with guidance), we’re left with a business earnings just over $1 billion in after-tax profits. If that’s worth 20x earnings (around where Dollar Tree traded prior to the Family Dollar deal), which I think is reasonable based on the unit economics, a track record of solid comps and forward unit growth prospects, the Dollar Tree banner alone is worth approximately $20 billion. To put that in context, the company’s entire market cap was $20 billion a few weeks ago (when the stock was in the mid-$80's per share). That’s a long way of saying Mr. Market was not placing much, if any, value on the Family Dollar business.
That changed over the past few weeks, and particularly last Monday, when activist investor Starboard Value LP disclosed a 1.7% stake in Dollar Tree (in addition to nominating seven directors to the company’s board). Starboard has two things they would like to see at Dollar Tree: first, consider selling the Family Dollar business; and second, consider changing the business model at Dollar Tree to offer a selection of products beyond the $1 price point.
I’ll focus on the first suggestion. Personally, I think Starboard is right (from what I’ve heard and read, it seems many analysts and other investors agree as well). Here’s one way to think about it that, for me, shows the fight to turn Family Dollar probably isn’t the best use of Dollar Tree’s resources (time or capital). Here’s what management said about renovations on the third-quarter call:
“From a cost perspective, they range from $100,000 to $150,000 [dependent upon the number of coolers and freezers added to the store] and the typical renovation takes two weeks… There are some significant changes in moving layout, changing the storefront, and adding immediate consumption coolers to the front of the stores… we feel good about the work we've done to get that down to a nimble timeline. And to your question, we haven’t said how much higher, but it is definitely higher than a mid-single digit [sales lift].”
Let’s think about that last part. I’ll assume the sales lift is ~10% (above mid-single digits). The average Family Dollar in 2017 generated $1.35 million in revenues at 5% EBIT margins, or roughly $68,000 in operating profit. Assuming a 10% sales lift and 10% incremental margins, which may be optimistic (mix shift toward consumables at lower gross margins likely offsets the SG&A leverage), a renovation adds ~$140,000 in sales and ~$14,000 in EBIT. That’s a $125,000 investment to add $14,000 in incremental EBIT. If those are the only variables, the IRR is 11%.
Now compare that to the Dollar Tree numbers I referenced above: on an initial outlay of $250,000 to add a new store, the average Dollar Tree generates over $200,000 in run rate operating income (13% EBIT margins on $1.7 million in revenue per box). Even if that outlay estimate is low (say it’s actually $300,000 or $400,000), that’s clearly a highly attractive return on investment. Given those numbers, why would we want to spend $125 million a year to renovate 1,000 Family Dollar stores? Wouldn’t you rather add 400 to 500 Dollar Tree locations? Even if the investments to improve Family Dollar turn out to be attractive (again, far from assured), I’m not sure they can ever compete with the ROI that Dollar Tree can generate by adding additional units for its namesake banner.
Just to be clear, I’m not saying these choices are mutually exclusive. What I am saying is that committing billions in cash and exchanging ownership in Dollar Tree for Family Dollar appears to have been unwise. I view the decision to keep focusing on Family Dollar as questionable as well.
One thing I’m unsure about is whether there’s a logical buyer for Family Dollar at this point. I would guess past success by private equity (KKR & Co. Inc. (KKR, Financial)) with Dollar General in the mid-2000s would whet some appetites. In addition, there’s a possibility Dollar General itself would consider making a bid (remember the company tried to buy Family Dollar previously, but the board rejected its higher offer in favor of the Dollar Tree bid because of antitrust concerns). Assuming it could find a buyer, even if it meant at a price tag a few billion dollars before the $9.1 billion Dollar Tree paid back in 2015, I’m of the opinion that it would not be a bad option to consider. (For context on valuation, Family Dollar is on pace for roughly $340 million in operating income this fiscal year.)
Conclusion
Based on what management has recently said, particularly on the third-quarter conference call, they clearly remain committed to trying to turn around Family Dollar. Considering the optimism expressed on that call, they probably have support from some investors and analysts. But if they cannot deliver results, I think that support will quickly fade. In that scenario, selling Family Dollar – even at a meaningful discount to the 2015 price tag – seems likely to me.
If that happened, I think Dollar Tree would have a few billion dollars of excess capital at its disposal. If the company commits $4 billion to repurchase shares near current levels (a dollar figure that is probably on the low end), it could reduce the share count by 15% or so. On the $1 billion in after-tax profits for the Dollar Tree banner I laid out earlier, that puts earnings per share north of $5. In that scenario, I do not think $100 per share is an unreasonable valuation for this business.
Based on that math, I would personally be interested in Dollar Tree if the stock price retreated back to the low-$80's. I plan to keep a close eye on how this story develops.
Disclosure: None.
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