DLTR - Dollar Tree: Not Worth My Dollars Yet

2023-10-09 10:10:18 ET

Summary

• Dollar Tree continues to struggle with underperforming Family Dollar, facing inflationary pressures and shrinkage.
• The company's operating margins have fallen, and earnings per share growth has been modest.
• Dollar Tree expects continued shrink and recognizes the shift from a growth stock to a value stock. Activism may be a possibility in the future.

It has been a long time since I covered Dollar Tree ( DLTR ) ; in fact, it was January 2019 when I wondered if Starboard was the solution. At the time, the activist investor was pushing for a sale of Family Dollar (among other measures) as Dollar Tree actually bought the business in 2015 in a $9.5 billion deal.

Due to (inflationary) pressures, the company over time has engaged in multi-price strategies, but Family Dollar is still part of Dollar Tree and continues to underperform. These observations, with inflationary pressures and shrinkage hurting the business in a big and continued way, make it easy to avoid the shares here, even if they are on sale.

A Recap

Early in 2019, Dollar Tree was a $100 stock as it got involved with the dollar store M&A race in the year before after it bought Family Dollar. Part of the criticism of Starboard was the fact that Family Dollar stuck to the dollar strategy, while many peers employed price differentiation strategies.

Starboard had some valid points as operating margins of Dollar Tree fell from about 9% of sales in 2015 to 8% in 2019, while Family Dollar's margins fell a point to 3%, accompanied by negative same store sales growth. Amidst many moving targets, including a reasonable valuation from the get to and no easy value creating moves, I found it easy to stick on the sidelines, as I was only in part onboard with the Starboard thesis.

Stagnation

Since the cautious take in 2019, shares traded around the $100 mark until the start of the pandemic. Shares of Dollar Tree actually continued to trade around those levels during 2020 and 2021, to rally to a high of $170 in 2022, after which shares have largely traded around the $150 mark this summer, now selling off to $105 per share.

In the end, Dollar Tree and Family Dollar stuck together, although the company employed multi-price strategies, desperately needed in the high inflationary environment of course.

A combined $23 billion business pre-pandemic has seen growth amidst the pandemic and inflation. For the year ending January of this year, Dollar Tree generated $28.3 billion in sales, up two billion the year before, aided by inflation of course. Operating earnings rose a full point to 7.9% of sales, with operating profits reported at $2.2 billion.

Net earnings of $1.6 billion came in at $7.21 per share, as the company has seen earnings per share grow from a number around $5 per share a few years before amidst sales growth, flattish margins and a slight reduction in the share count.

Net debt was reported at $2.8 billion, virtually at par with EBITDA of around $3 billion. The company did announce that 2023 was to become an investment year, originally guiding for earnings between $6.30 and $6.80 per share which includes actually a $0.29 per share benefit from the 53rd working week. This means that earnings would be down by about a dollar, due to an estimated $1.45 per share operating expense investment in labor, wages and stores, with few benefits seen in the near term. This however was offset in part by lower freight expenses as the company guided for low- to mid-single digit sales growth.

The market clearly liked this, as the shares commanded a premium valuation around the $150 mark during spring and up to the summer, actually.

Tougher Times

Bad news arrived in May as the company posted first quarter results. Reported sales rose by 6% to $7.3 billion, but operating income fell to $420 million as operating margins were down a near five points. The company guided for full year sales at $30.0-$30.5 billion which is quite decent, as the issue is that earnings were now seen at just $5.73-$6.13 per share, a $0.57 per share cut from the original guidance. Specifically, shrink and unfavorable mix effects were seen as key drivers for this shortfall.

Another shortfall came in August. While second quarter sales rose by 8% to $7.3 billion and the company hiked the full year sales guidance to $30.6-$30.9 billion, consolidated operating margins essentially were cut in half to 3.9%. The company is hurt by the same factors as before as Dollar Tree saw operating margins fall some 5 points to still a respectable 10% on $3.9 billion in sales, while Family Dollar posted margins of just 0.3% on $3.4 billion in sales. The margin pressure meant that earnings per share fell seventy cents to $0.91 per share, although the company essentially maintained and narrowed the full year earnings guidance to $5.78-$6.08 per share.

Net debt was flat at $2.9 billion, but this definition comes ahead of another near $7 billion in lease liabilities, although that EBITDA is falling given the margin pressure, seen at $1.1 billion in the first half of the year. Even as the company maintained the full year earnings guidance, shares have fallen from $150 in the summer to $105 per share now, which does not surprise me as this works down to a market multiple.

And Now?

By now shares are trading flat for over 5 years, and while the company has initiated a multi-price strategy, it continues to struggle with Family Dollar. The business is hurt by inflationary pressures, and while investments into wages were priced in this year, it is the degree of stagnation and underperformance of Family Dollar which might invite renewed activism again.

The real issue is that the company expects continued shrink, or better said stealing, as a headwind to the business with some parts of the country battling with a real wave of crimes. This trend hurts dollar stores even more, with many stores often manned by just one or two workers. The word shrink was used no less than 25 times in the second quarter conference call as it has an estimated 75-80 basis point impact on margins.

Moreover, there is the recognition of the market that this former growth stock might no longer be a growth stock but has become a value stock, with focus on store openings coming down as the business has inherent profitability challenges, certainly at less desirable locations.

Inflationary pressures hurt these business as this applies to Dollar Tree as well, but ironically enough it is the pressure on household budgets which might drive more consumers to such stores. This is seen in the composition of sales, with notably consumable sales categories growing quicker, as discretionary sales growth is much slower.

Amidst all this, I am not naturally going to chase the shares here. Based on current earnings multiples, valuations look reasonable and while activism might be seen at some in time, this is not an easy slam dunk as Family Dollar is hard to turn around, and a sale in current times will not likely involve a desirable price tag. Given all this, I am still a bit cautious as lower earnings power increase leverage ratios, keeping me from not getting involved right now, at these levels.

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