Background: The retailer known as Dollar Tree (NASDAQ:DLTR) has as its theme that everything costs a dollar. Well, not really. Things may be packaged so shoppers must buy several dollar items. (That's probably the effect of inflation; does anyone remember the 5 and 10 cent stores?)
DLTR went public in 1995. Since then, its stock has appreciated about 21.5% annually, on average. Its returns have crushed not only that of the NASDAQ but of Berkshire Hathaway (BRK-A).
Dollar Tree announced yesterday that it is merging with another dollar store, Family Dollar (NYSE:FDO), which does not keep to the $1 price point. DLTR has been a stellar performer since its 1995 IPO, as shown versus the NASDAQ index and Berkshire Hathaway (BRK-A), both of which have paid few or no dividends, respectively:
The company being acquired, FDO, has a longer and also very successful history as a public company, and has paid dividends for years. Here is the comparison of its stock versus the S&P 500:
Thus the pressure from Carl Icahn for FDO's board to sell the company.
Dollar Tree is an experienced acquirer. I view this deal favorably and have initiated long positions in DLTR. This article explains why.
Introduction: As in most fields of business, better operators rise to the top. In its unglamourous field, Dollar Tree has managed to attain and then maintain superior operating and financial metrics. Its gross margin was 40% in 2004 and 38% now. In contrast, Family Dollar's GM was 36% both in 2004 and now, and Dollar Tree's direct peer Dollar General's (NYSE:DG) GM was only 33% last year.
Dollar Tree receives the following stellar ratings from Value Line:
Financial Strength: A++
Earnings predictability: 100th percentile
Dollar Tree has high quality earnings, as suggested by its high income tax rate of 38% and high free cash flow (see below for an independent view of these metrics). Except for some Canadian stores, all income is domestic. This may well be a plus, given problems in Europe and the BRICS countries, and the general state of affairs in several international venues.
The general observation that incomes and wealth levels in the U.S. have been having difficulty keeping up with inflation suggests that dollar stores and lower-end stores such as Dollar Tree and Family Dollar continue to be well-positioned (unfortunately) versus retailers that cater to middle-income and upper-middle class consumers.
As a consolidator that has acquired at least four chains since 2000, Dollar Tree could be a good vehicle for future capital appreciation. One of them, Deal$, is not a dollar store, meaning that Dollar Tree already has ongoing experience retailing at unrestricted (though discount) price points, as is the situation with Family Dollar.
While it has never paid a dividend, DLTR has shrunk shares outstanding at a significant rate. In 2003, there were 342 MM shares outstanding; last year there were only 208 MM. There is no defined benefit pension plan. Before the FDO takeover, total interest coverage was over 25X.
The following discussion will be in two parts. The first part will be further discussion of DLTR's merits, and the second will be of the FDO merger.
Dollar Tree: Over the years, I have done well investing in deep discount stores, including in DLTR. Other chains that I have done well with include Ross Stores (NASDAQ:ROST) and The TJX Companies (NYSE:TJX). I frequently highlighted these in 2009 and 2010 in my now-inactive blog as the best group of stocks to invest in, given my view at the time that the recovery would be weak. This has turned out to be correct. In other economic cycles, the deep discounters would stumble as consumers traded up as the effects of the recession faded, and excess merchandise was more difficult to buy on the cheap. This period post-Great Recession has been different, and the Dollar Trees and Ross Stores of the world have thrived.
Also different are the problems at the giant, Wal-Mart (NYSE:WMT), now replacing its U.S. CEO; and at Target (NYSE:TGT). These issues have allowed the smaller discounters more room to grow and higher margins.
Consensus EPS estimates for DLTR have managed to trend up lately, in contrast to those for WMT and TGT (and both FDO and DG).
DLTR has used its strong finances and good operational abilities to grow rapidly. Its last major acquisition was of Dollar Giant in November 2010. In 2012 it operated 4671 stores, Value Line's projections are for 5340 this year and 6900 by the 2017-9 period. Of this, Canadian expansion is a prominent part, potentially rising from 180 to 1000 stores in this period.
Some of the expansion has been fueled by an increase in long term debt. The recent $757 MM in LT debt is not due until the 2020-25 time frame.
Insiders own 3.4% of shares outstanding. NASDAQ reports that 90.45% of the stock is owned by institutions. About 2% of shares outstanding have been sold short.
On its own merits, I believe that DLTR is an attractive stock for investors who do not need current income from an equity investment.
Pre-merger, Street estimates are running $3.16 and $3.64 for fiscal years ending in Jan. 2015 and Jan. 2016, respectively. Net profit for FY 2015 (ending in Jan. 2016) is estimated to be around $700 MM. This number is important when looking at Dollar Tree's press release about the merger.
The Family Dollar deal: This is a very big deal. Family Dollar has more stores and more sales than does Dollar Tree, though its market value is less, even at the acquisition value. Dollar Tree has provided a summary of its reasons for wanting to make this acquisition. Here are its five bullet points:
- Will Operate More Than 13,000 Stores Across 48 States and Five Canadian Provinces, with Annual Sales Exceeding $18 Billion
- Will Continue to Operate and Grow Both the Dollar Tree and Family Dollar Brands, Offering Fixed- and Multi-Price Point Formats to Provide Consumers Greater Value, Convenience and Choice
- Expected to Achieve an Estimated $300 Million in Annual Run Rate Synergies by the End of the Third Year Post-Closing
- Estimated to be Accretive to Cash EPS within the First Year Post-Closing
- Strong Combined Financial Profile with Robust Free Cash Flow Generation
Potential DLTR (or FDO) investors will likely wish to read the entire document.
Will the deal work out as DLTR says? After all, most large acquisitions are reported to be bad for shareholders.
We will find out (assuming the deal goes through); I like it. One reason I'm bullish here is that, having owned DLTR on and off going back many years, and thus having followed it continuously, I agree with Value Line's observation that:
We note that the company has a history of underpromising and overdelivering.
Though there are no guarantees...
The third bullet point, about the $300 MM synergies, has more detail later in the press release:
Dollar Tree expects to generate significant efficiencies in sourcing and procurement, SG&A leverage, distribution and logistics efficiency, and through format optimization. Dollar Tree anticipates that the transaction will result in an estimated $300 million of annual run-rate synergies to be fully realized by the end of the third year post-closing.
This strikes me as realistic. Again, it could be low. And it is simply a guess at costs that can be wrung out of the combined entity, presumably at reasonable immediate expense, and it does not address enhanced growth opportunities from the combination.
$300 MM (presumably a pre-tax number) is significant given DLTR's current and projected profits and FDO's projected current-year projected net profits of $380 MM. This could well help EPS by at least $1 per share.
The press release goes on to say that:
The transaction is estimated to be accretive to cash EPS within the first year post-closing, excluding one-time costs to achieve synergies. Dollar Tree will be better positioned to invest in existing and new markets and channels and to grow its store base across multiple brands. The combined company expects to generate significant free cash flow, enabling it to pay down debt rapidly.
Of course, competitors will have their say. But given a lending market that favors borrowers right now, this deal looks especially well-timed by Dollar Tree.
DLTR could now emerge as a major consolidator in the lower-to-mid-range retail space.Perhaps this merger could be equivalent within its niches to the merger of CVS with Caremark last decade, creating the mega-company CVS Caremark (NYSE:CVS), about which I have written bullishly several times on Seeking Alpha.
The occasional very successful industry consolidators, aka roll-ups, in vital areas of the economy are the next best thing to the rare huge successes that are driven by internally-driven inventions and resources such as Apple (NASDAQ:AAPL), Starbucks (NASDAQ:SBUX), Whole Foods (WFM), etc. In some ways, roll-ups are safer, because we do not know when Apple's next disruptive innovation will occur and how major it will be in the context of its already immense size. We do know, however, that an uncountable number of underperforming retail chains exist for a consolidator such as Dollar Tree to consider acquiring.
Value Line has been projecting that in the 2017-9 period, DLTR will have $5.50 EPS. Given cost synergies and other positive benefits from the merger, and DLTR's general tendency to beat the numbers, I think it is reasonable to look at $7 EPS by then. So let's say that in calendar year 2019 (ending Jan. 2020), DLTR earns $7 per share, though I think it can do better. Its median P/E has been 16X, which as Value Line computes P/E is mid-way through the fiscal year. This would suggest that five years from now, DLTR could reasonably be expected to trade at 16 X 7, or $112. The stock is now less than than half that. This suggests a 15%, compound appreciation rate.
This in turn suggests that DLTR is too cheap right now.
Importantly, the above estimates look to be reasonably low-risk (though hardly no-risk). They could easily be exceeded, both on the EPS number and year $7 is achieved, and on the P/E. For all we know, DLTR will trade at 20X $7 EPS only four years from now, which is close to a triple.
There are other positives in this merger. One is that this bulks DLTR up and could make it attractive as an acquisition for one of the retail giants such as Wal-Mart or Target, or a foreign retailer that wants into the biggest and best large economy there is. Another is that with as a larger and more diverse company, DLTR will more easily be able expand both internally and by renewed acquisition both horizontally and vertically.
Also, store brands, which carry very attractive margins, can now be introduced, just as CVS stores have begun to do.
Finally, at a certain point, DLTR could follow WMT and move beyond the U.S. and Canada.
Technicals: I like the price chart of DLTR here, though the tremendous run since the Great Recession does give me pause. But (sigh) you can't have everything.
DLTR meets one of my most prized criteria for a new money stock purchase: the stock is below its 2012 high, but earnings are nicely higher. Thus its P/E has come down substantially from its peak.
Independent views of DLTR: Fidelity's weighted consensus of its indies is very bullish at 9.3. Jefferson Research, one of the firms it provides opinions by, has five criteria by which it makes recommendations. Of them, DLTR has the top rating in four of the five. These are earnings quality, cash flow quality, balance sheet and valuation. Of the fifth, operating efficiency, it is second to the highest in its system (of a five-scale set of possible ratings).
S&P Capital IQ carries a pre-merger 12-month price target of $65 and a fair value estimate of $67.
Risks: It is often prosperity that hurts dollar stores, so recession is much less of a risk for DLTR than for most companies. The risks therefore would appear to relate to the successful integration of such a large merger as well as worsening competition. Should the big gorillas of the retail industry such as WMT, TGT and Costco (NASDAQ:COST) decide to get serious on pricing, the little guys could get squashed.
Integration risks from the merger (assuming it is completed), and a general shrinkage of P/E's, are certain other notable risks from investing in DLTR now.
Conclusion: DLTR has been an extraordinary stock since its 1995 IPO. It is one of a modest number of discount retailers to see EPS estimates rising currently. I am optimistic about the operational aspect of the FDO deal. I also see the enlarged company being better positioned to grow as well as more attractive to a very large retailer looking to grow by acquisition.
While I favor biotech for long-term growth, biotech stocks are volatile, and that industry relies on very generous prices for its products to sustain its high gross margins. Dollar and deep discount stores are at the opposite end of the price and market perception spectrum, and provide good diversification. Within that field, I look at DLTR as a superior company, and look forward to the merger with FDO being completed and leading to strong, sustained profits growth for years to come.
Disclosure: The author is long DLTR, CVS. 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.
Additional disclosure: Not investment advice. I am not an investment adviser.