A Good Operator In An Increasingly Competitive Market

| About: Dollar Tree, (DLTR)

Summary

Dollar Tree is seeing a slowdown in terms of sales on the back of increased competition.

The company´s performance remains relatively solid given the increase in competition and acquisition distractions.

While the valuation multiples look fair if we look at expected earnings, a positive earnings surprise or further retreat is necessary before I will become a buyer.

Dollar Tree (DLTR) saw a big sell-off following the release of its second quarter results. Slower growth was the key reason behind the sell-off as increased competition from Wal-Mart (among others) hurts the sales performance of the company and its major rival Dollar General (DG).

While an increase in competitive pressure results in slower sales growth, I must admit that I am impressed with the performance versus Dollar General as Dollar Tree probably faces continued distraction from the integration of the Family Dollar acquisition. If the company manages to successfully integrate this chain, I see potential earnings of at least $5 per share in the not too distant future. Given today´s share price, this does translate in a very fair valuation multiple.

To create real appeal I would like to see further dips in the share price before considering to initiate a position. That said, higher than anticipated synergies and continued growth could result in an upwards basis to that earnings estimate, making current levels almost attractive to consider.

Aggressive ¨Dollar¨ Growth

At the moment Dollar Tree is a major force in the dollar segment, competing with Dollar General. Traditionally this competitor has been the main force in this segment, having grown in an organic way to an annual sales base of $21 billion.

Dollar Tree is catching up to its competitor as its sales are expected to approach $21 billion as well this year, generated by a fleet of 14,000 stores.

For a long time Dollar Tree has been much smaller compared to its rival as it grew sales from $4 billion in 2006 to $8 billion in 2014. The company announced the $9.5 billion acquisition of Family Dollar that year in a deal that would double the company´s size, providing much needed scale.

While the deal resulted in a company which was similar in terms of sales compared to Dollar General, the company was left with a huge integration task while it needed to divest a couple of hundred stores as well for anti-competitive reasons. For these reasons Dollar General has taken a slight lead in terms of sales, although the difference is negligible.

What is furthermore worth noticing is the strong margin performance of Dollar Tree which actually posted margins of 12% of sales in recent years before the Family Dollar deal. This surpassed margins of Dollar General by 2-4% points despite the fact that the company has been much smaller. Also worth noticing, despite the nearly $10 billion deal with Family Dollar, the current outstanding share base has been cut by a quarter compared to a decade ago. This is despite the huge deal to acquire Family Dollar.

While the company still holds roughly $1.1 billion in cash, total debt stands at $7.3 billion, for a net debt load of $6.2 billion at the moment. With EBITDA running at little over $2 billion per annum, this is position is manageable by all means, although the company will look to deleverage the balance sheet.

Current Trends Are Concerning

Dollar Tree reported a 2.5% increase in comparable sales growth for 2015 in constant currency terms. This lagged the performance of Dollar General by 30 basis points, as this can easily be attributed to distraction following the Family Dollar deal.

Comparable growth came in at 1.7% in the fourth quarter of that year which was a bit worrying, although it followed a particularly strong quarter in the year before. The pace of growth rebounded to 2.3% in the first quarter of 2016, but it slowed down to 1.2% in the second quarter.

CEO Bob Sasser talked about a challenging environment although he is pleased with the integration of Family Dollar. Despite the challenges and integration work, the 1.2% growth number looks decent in comparison to Dollar General which posted a mere 0.7% increase in comparable sales. The difference might be explained by the lower reliance of Dollar Tree and Family Dollar on food stamps programs, making up less than 5% of sales.

Consumer spending is pressured according to executives despite lower gas prices. Key reasons behind tepid spending include higher healthcare costs as well as higher rent expenses. The company was however forced to lower the full year guidance a bit. Full year sales estimates are cut by roughly $200 million to $20.9 billion. The company did slightly increase its earnings guidance. This is in part the result of a tax benefit, with earnings projected to come in around $3.75 per share.

With shares trading at $83, the valuation looks very full at 22 times earnings, taking into account the usage leverage as well. Yet the potential to create an interesting investment case is certainly to be seen, as will be discussed next.

The Potential

Dollar Tree was traditionally a very good operator and it still is. The ¨original¨ company posted sales of $2.4 billion this quarter, accompanied by impressive margins of 11%. Family Dollar contributed $2.6 billion in sales but its margins come in just shy of 4%, for overall margins of around 7%.

The potential value to be created has to come from closing this margin gap. Note that Family Dollar typically posted margins of around 7% before it was acquired by Dollar Tree as integration costs weigh on its current performance. Given that both businesses are equal in terms of sales, typical margins of 7% for Family Dollar and 12% for Dollar Tree result in potential margins of 9-10% for the entire business.

Scale synergies and the implementation of best practices from Dollar Tree at Family Dollar should easily allow for a point leverage in terms of operating performance. As a matter of fact synergies resulting from the deal are expected to surpass $300 million per annum. For that reason I expect that total operating margins should improve to 11% over time.

These kind of margins on a $21 billion revenue base translate into operating profits of $2.3 billion. With interest costs coming in at $350 million per annum and assuming 35% tax rate, after-tax earnings could come in at $1.25 billion. With 235 million outstanding shares, that translates into potential earnings of $5.00-$5.50 per share down the road, realistically seen in one or two year´s time.

Based on these estimates, shares trade at 15-17 times earnings, a similar multiple at which Dollar General is trading today.

Final Conclusion

Dollar Tree and its rival Dollar General are both facing headwinds, and I do not expect that these headwinds alleviate anytime soon. Wal-Mart has made a serious push into pricing as online competition might become a more serious concern as well.

Both companies trade at similar valuation levels, but differ a great deal. Dollar Tree is actually a better operator than Dollar General, but it has still much work to do on the Family Dollar deal. A successful integration, through leveraging best practices to that business, is necessary to justify the top-notch price paid for the business.

I must say that I think that Dollar Tree is doing a good job. Not only are its margins better than Dollar General, comparable sales number show an outperformance as well. This is despite the distraction resulting from a huge deal, as the purchase of Family Dollar more than doubled the size of the business in an increasingly challenged external environment.

The reality is that a 6% earnings yield looks decent (based on the anticipated improvements in terms of margins) although investors do not see any dividends at the moment. Cash flow generation is used to deleverage the balance sheet for obvious reasons.

While investors hit the sell button following the slower increase in comparable sales numbers, a 10-15% correction has been fairly limited. Note that the stock remains up nearly 10% year to date. To find some real appeal I require a higher earnings yield to accommodate for the risks and leave upside on my $5.00-$5.50 per share number. A 7-8% earnings yield translates into a $65-$75 zone in which shares become appealing enough in my eyes, making me a very patient buyer given that shares still trade in the low eighties at the moment.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.