Dollar Tree Is Shining Brighter After Its Latest Deal

| About: Dollar Tree, (DLTR)

Summary

Dollar Tree has continued to post growth in 2014.

Dollar Tree swung for the fences with its deal to acquire the larger Family Dollar Stores.

The deal improves Dollar Tree's industry position and provides a runway for future profit growth.

Deep discount retailer Dollar Tree (NASDAQ:DLTR) has had a respectable start to 2014, reporting increases in revenues and operating profit in its fiscal first quarter. However, the company's share price appreciation has been limited, anecdotally due to worries over the trajectory of its future profit growth, as it faces ever-rising competition from larger competitors, like Dollar General (NYSE:DG) and Wal-Mart Stores (NYSE:WMT).

Against this backdrop management saw an opportunity to create shareholder value, recently agreeing to buy competitor Family Dollar Stores -- a company that was under the gun to find a dance partner after being hounded by billionaire investor Carl Icahn over its poor operating performance. The deal gives Dollar Tree the largest footprint in the deep discount sector, with more than 13,000 total stores, and it provides a path toward improved profit growth. So, is Dollar Tree a good bet after its latest deal?

What's the Value?

Dollar Tree is one of the largest chains of deep discount retail stores, operating a current network of more than 5,000 locations across the U.S. and Canada. The company has taken advantage of the scale efficiencies of its large size and corresponding buying power to create a consistently profitable operating model, which has produced a double-digit operating margin in recent years, including 12.4% in FY 2013. The profits have led to strong cash flow for Dollar Tree, helping to power a more than 30% expansion of its overall store base since FY 2009.

In its latest fiscal year, it was the same story for Dollar Tree, highlighted by a 5.5% increase in its operating income. While the company's gross margin took a slight hit during the period, due in part to a greater focus on low-margin food consumables products, a 2.4% increase in comparable store sales allowed Dollar Tree to maintain its operating margin at a relatively high level. The net result for Dollar Tree was solid cash flow generation, fueling further investments in its business, including a continued rollout of coolers to a majority of its store base.

Looking Into the Crystal Ball

The question for investors is whether Dollar Tree can continue to post profit growth going forward, thereby providing a solid foundation for a higher stock price. Based on its most recent fiscal quarter, the answer seems to be yes, evidenced by a 7.1% increase in operating income that was aided by a 2.0% comparable store sales gain, the result of higher customer traffic and higher average prices.

In addition, Dollar Tree looks set to reap a potential profit windfall from its purchase of Family Dollar. As illustrated in the table below, the math looks like this: Dollar Tree is getting a company that earned $988 million in adjusted operating income during its latest fiscal year, including $300 million in cost savings that Dollar Tree management says is feasible. After further adjusting for interest on the debt portion of the deal's purchase price and taxes, Dollar Tree could be expected to receive an incremental $447 million in net income from Family Dollar's operations, or $13.49 in earnings for each of the 31.2 million shares that it is expected to issue in the transaction. Given that Dollar Tree is currently expecting to only earn between $2.94 and $3.12 in earnings per share as a standalone company, the deal certainly appears to be accretive.

Incremental EPS

Family Dollar 2013 Adjusted Operating Income $688 M
Expected Cost Savings $300 M
Incremental Operating Income to Dollar Tree $988 M
Annual Incremental Interest - $6.8 B @ 5% ($340 M)
Taxes @ 35% ($227 M)
Incremental Net Income to Dollar Tree $421 M
New Dollar Tree Shares Issued 31.2 M
Incremental Earnings Per Share to Dollar Tree $13.49
Click to enlarge

Source: Family Dollar Stores 2013 10-K Report, my estimates.

Of course, the above discussion assumes that the combination of the two companies goes off without a hitch, which is unlikely in the real world. While Dollar Tree's management has indicated that it has respect for the Family Dollar culture and overall operation, it undoubtedly has plans for some changes. That could lead to higher-than-expected costs if not received well by the incoming employee base.

Plenty of Competition to Go Around

Also creating a potential roadblock to future profit growth for Dollar Tree is the competition in the deep discount retail sector, including Dollar General. Like Dollar Tree, Dollar General has been investing heavily in the food consumables product area, which accounted for the lion's share of its comparable store sales gain in its latest fiscal year. While the move negatively impacted Dollar General's gross margin, it brought higher customer traffic through the company's doors, providing opportunities to up sell higher-margin products. More importantly, Dollar General continued to generate solid operating cash flow, providing it with the flexibility to continue making investments in its everyday low price strategy.

Wal-Mart Stores, one of the world's largest retailers with an international footprint of roughly 11,000 stores including over 4,800 in the U.S., is an even bigger threat to Dollar Tree's story. Despite a below-expectations performance in its latest fiscal year, highlighted by its first comparable store sales decline since FY 2011, the company is pushing forward with a sizable expansion of its small-format Neighborhood Markets unit. Wal-Mart Stores also has the advantage of having one of the world's largest supply chain operations, which generally allows it to meet its goal of being the lowest cost provider in most of its markets.

The Bottom Line

Dollar Tree swung for the fences with its latest deal, which when completed will give it the largest operating footprint in the industry. The good news is that Dollar Tree seems to have locked up Family Dollar without engaging in an expensive bidding war, much to the likely chagrin of some of Family Dollar's investors. While competitors abound in the deep discount sector, Dollar Tree improved its position with the deal and is a good long-term bet for investors.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.