I wrote an article about Dollar Tree (DLTR) back in January that looked at the company’s historic financial results as well as its plans for the years ahead. The company reported financial results for the fourth quarter of fiscal 2018 on Wednesday, so I figured an update would be worthwhile.
The company ended the year on a strong note, with comparable store sales (comps) up 3.2% at Dollar Tree (banner) and 1.4% at Family Dollar. For the year, comps were up 3.3% at Dollar Tree and 0.1% at Family Dollar, with consolidated comps up 1.7%. While that metric is still well below what the company was reporting prior to the Family Dollar deal, you can see below that consolidated comps have stabilized at roughly 2.0% average growth over the past four years.
After a tough start to the year, Family Dollar comps were up 1.4% in the fourth quarter, which is one of the best quarters the banner has reported since the acquisition in 2015. Success for Family Dollar was attributable to Consumables, with comps up 2.5% in the quarter. This result explains why the company is making a sizable investment in freezers and coolers (which will be added to roughly 1,000 locations in 2019). On a two-year stack, Family Dollar comps were up 2.4%, an improvement of roughly 150 basis points from the second and third quarters. (It’s also worth noting that the Smart Coupon program now has more than 8.8 million customers, up roughly 70% over the past year.)
Dollar Tree impressed as well, but that’s come to be expected: Comps for the banner have now been positive every quarter for the past eleven years. As CEO Gary Philbin noted on the call, “I consider the Dollar Tree brand to be the most unique, differentiated and defensible business model in the U.S. value retail sector.” Given the consistently strong results for the banner, it’s hard to disagree. Dollar Tree definitely stands out in the world of brick-and-mortar retail.
For the year, the combined company reported $22.8 billion in revenues. Adjusted for the headwind for the 53rd week in the year-ago period. Revenues increased by 4.5% in 2018 (with comps and net new units both contributing a low-single digit percentage to growth).
2018 gross margins declined 50 basis points for Dollar Tree and 200 basis points for Family Dollar, with that margin compression rolling through to operating income (for the company, operating margins declined 100 basis points to 8.1%). This was offset by lower interest expense (the company paid off $1.4 billion of debt in fiscal 2018 and has repaid a total of $4.3 billion since the Family Dollar deal closed) and a lower effective tax rate. As a result, net income increased by 13% and non-GAAP earnings per share increased by 12% (with adjusted EPS climbing to $5.5).
As it relates to the company’s strategic focus in the years ahead, there were two noteworthy items discussed on the call: accelerated plans for the turnaround of the Family Dollar banner, and testing of multi-price points at select Dollar Tree locations.
As it relates to Family Dollar, the company plans more than 1,000 renovations in 2019 (compared to 522 in 2018). In addition, it will re-banner 200 locations to Dollar Tree and close nearly 400 stores. All-in, that means they will touch roughly 20% of the store base in 2019. In addition, CEO Gary Philbin noted on the call that he can “certainly see another 1,000” Family Dollar remodels in 2020 as well. Clearly management is optimistic with the results from recently remodeled stores (as noted on the call, they have been delivering average comp lifts in excess of 10% on the remodels).
But that is only half the story. The company took a $2.7 billion impairment charge in Q4 tied to the Family Dollar acquisition. These two sides of the coin nicely sum up the current situation: while the results are improving, there’s a lot of work to be done. As noted during the question-and-answer session, improvement at Family Dollar comes down to “changing the fleet … one store at a time.”
But even at 1,000 boxes annually, it will still take five-plus years to touch most of the base. In addition, investors shouldn’t overlook the fact that Family Dollar, as a standalone company, invested significant amounts of money on renovations in the five years prior to the acquisition by Dollar Tree. That is a long way of saying that this will probably take a long time, cost a lot of money and come with an uncertain payoff. As I noted in my last article, that doesn’t sound as good to me as the opportunity to continue adding additional Dollar Tree's (granted, they've expanded the Dollar Tree banner by roughly 40% over the past five years, so you can argue they're still marching ahead).
While many have discussed the idea of a sale if the Family Dollar turnaround falters, I think the reality is that outcome is increasingly unlikely. The company has consistently voiced its commitment to Family Dollar and has pushed forward with the integration of the two banners (the most recent example is the move to a shared headquarters in Chesapeake, Virginia, which is expected to generate roughly $15 million in annual savings). As noted on the call, “Nearly all systems, functions and departments at Family Dollar and Dollar Tree have been substantially integrated ... Real estate, supply chain, strategic planning, global sourcing, information technology, store development, finance, human resources, inventory management and legal have been integrated to a significant degree. These integrations have resulted in annual savings exceeding $50 million.” The idea that Dollar Tree and Family Dollar will be split is becoming more difficult (and unlikely) by the quarter.
On the multi-price points test, I’ll be blunt: It sounds to me like the company is doing little more than paying lip service to the idea (which was proposed by activist investor Starboard Value). They took time on the call to remind investors that the one-dollar fixed-price point has been “critical” to their success and that it has already completed similar tests in the past. We will see how this evolves over time, but I would be surprised if anything comes from this anytime soon.
The company plans to open 350 net Dollar Tree locations and close 200 net Family Dollar locations in 2019 (inclusive of the nearly 400 closed stores mentioned above). Given those assumptions, the store count will only increase by 1% or so in 2019. That’s quite a bit below the roughly 3.5% compounded annual growth rate (CAGR) it reported over the past five years. 2019 guidance calls for 3-4% sales growth and a mid-single digit decline in EPS. Adjusted for a higher effective tax rate (which is a roughly 20-cent headwind) and some one-time discrete costs (which is a roughly 30-cent headwind), EPS would increase by a low-single digit percentage.
Conclusion
In 2019, management expects the business to generate more than $5 per share in earnings (that compares to roughly $4.2 per share of free cash flow, with conversion declining to about 75% over the past two years due to outsized capital expenditures). Despite a relatively even split in revenues between the two banners, the vast majority of profitability will come from Dollar Tree.
By my math, the Dollar Tree banner should generate $1.5 billion to $1.6 billion in segment operating income in 2019. If we apply 100% of the company’s interest expense to the banner (roughly $150 million) and use a 23% tax rate (in line with guidance), that’s over $1.0 billion in after-tax profits for the Dollar Tree banner. If you’re willing to apply a multiple of 20x earnings, which I think is justified due to the attractive unit economics, a track record of solid comps and a differentiated value proposition for customers that will support continued unit growth over time, that’s $20 billion of value. On 239 million diluted shares, that’s worth roughly $85 per share.
If you accept that math, we’re effectively paying $15 per share – or roughly $3.5 billion – for Family Dollar. Considering that this business generated less than $300 million in adjusted operating profits in 2018, I would need some convincing to believe that it’s worth much more than that (the most obvious opportunity is a move in margins back towards the historic average). To argue DLTR is undervalued at current levels, I think you need to believe a Family Dollar turnaround is in the cards.
I’m not ready to make that argument. I have invested in a few retailers over the years, and I have come to believe that turnarounds in this business are often long and arduous. I wish management the best of luck, but I’m not convinced that success is right around that corner.
For that reason, I don’t plan on buying the stock near current levels. That would likely change if Mr. Market became more pessimistic and pushed Dollar Tree stock back towards a price where I felt I was wasn't paying much - or anything - for the Family Dollar business (call it under $90 per share).
Disclosure: None.
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