Discount Retail Stores: The Family Dollar Deal Makes Dollar Tree An Excellent Short Candidate

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About: Dollar Tree, Inc. (DLTR), Includes: BIG, DG, DLMAF, FIVE, FRED, NWTUF, OLLI, ROST, TJX, TUES, WMT
by: Value Digger
Summary

From a fundamental standpoint, the post-merger Dollar Tree has absolutely nothing to do with the pre-merger Dollar Tree.

Pro-forma the deal, the company's financial health has significantly deteriorated amid increasing competition as new players enter the discount retail industry.

Nevertheless, at the current price of $82.54/share, DLTR's post-merger key metrics are much higher than its pre-merger ones.

In other words, by buying Dollar Tree now is like you are paying for a flawed product more than you were paying for the same product when it was flawless.

Don't bury the head in the sand, because no grossly overvalued company is immune to the fundamental approach.

When it comes to the business deals, 1+1 doesn't always equal 2. Often, it equals 1.5 or even less than that. And, this is the case with Dollar Tree, Inc. (NASDAQ:DLTR), whose deal with Family Dollar (NYSE:FDO) came at a very high cost.

In this factual and bearish article, I will try to present the big picture to those investors who are willing to see it. I will try to help them be proactive and make decisions, because investors who are in denial and do nothing will get hurt the worst. "Sheep get slaughtered," never forget this.

The Deal

In January 2015, Dollar Tree won the battle for Family Dollar, a multi-price discounter focused on urban and rural areas. Family Dollar accepted Dollar Tree's offer of 74.50/share while rejecting Dollar General's (NYSE:DG) offer of 78.50/share. Family Dollar's shareholders chose to merge with Dollar Tree over much larger competitor Dollar General primarily due to antitrust fears. Family Dollar had estimated regulators would force 3,500 to 4,000 store closings under a Dollar General merger versus the 500 closings that Dollar Tree projected for the completion of the deal. Finally, Dollar Tree needed to sell 330 stores to Sycamore Partners to avoid monopolizing the markets.

On July 6, 2015, Dollar Tree completed its acquisition of Family Dollar Stores, Inc. Since that date, the company has been executing its integration plan.

However, the deal impacted negatively Dollar Tree's financial health, given that the net debt skyrocketed from approximately (-$100 million) in January 2015 to $6.6 billion in January 2016. And according to the company's projections, the recovery of its financial health will take approximately five years, as presented in detail in the next paragraphs.

Key Fundamental Details

For FY 2015, consolidated net sales increased $6.90 billion, or 80.2%, to $15.50 billion from $8.60 billion in the prior year, and Family Dollar's sales represented $6.16 billion of the increase. In Q4 FY 2015, consolidated net sales increased 116.7% to $5.37 billion from $2.48 billion in the prior year's fourth quarter. The increase was the result of $2.68 billion in sales from the Family Dollar segment.

And as expected, the company was profitable for another consecutive year. However, investors have to take into account the following three key points:

1) SSS significant slowdown is here and will continue in FY 2016: Dollar Tree's same-store sales growth has slowed significantly since 2015. Specifically, same-store sales increased 1.7% on a constant-currency basis for the Dollar Tree segment in Q4 FY 2015. In comparison, same-store sales on a constant-currency basis increased 5.6% in the prior-year period for the Dollar Tree segment. Adjusted for the impact of Canadian currency fluctuations, the same-store sales increase was 1.3%.

Obviously, a significant slowdown on a YoY basis is here. And according to the company's guidance linked above, the SSS will remain in the low-single-digit territory in FY 2016. However, this doesn't surprise me because Family Dollar's SSS was just 0.7% in Q3 FY 2015.

2) CF and Free CF in Q4 FY 2015: Given that the deal with Family Dollar closed in July 2015, I am not going to dig into Q2 FY 2015, but I will focus on some key details from Q3 and Q4 FY 2015 instead.

In Q4 FY 2015, the company generated $830 million CF from operating activities while CF from investing activities was $101 million. In other words, the company's free CF in Q4 FY 2015 was $730 million, which helped it reduce its net debt significantly compared to Q3 FY 2015.

However, if investors extrapolate these figures and assume that Dollar Tree will continue to generate this amount of free CF during the next four quarters, they will make a huge mistake given that:

A) In Q3 FY 2015, the first quarter post-integration, Dollar Tree burned almost $180 million.

B) The fourth quarter has traditionally been DLTR's strongest quarter over the last three years. During the fourth quarter, the company traditionally generates more than 50% of its annual operating CF. Specifically, it generated $538 million operating CF in Q4 FY 2014 and $927 million for the entire FY 2014. It generated $427 million operating CF in Q4 FY 2013 and $794 million for the entire FY 2013. And it generated $365 million operating CF in Q4 FY 2012 and $678 million for the entire FY 2012.

3) Net Debt and FY 2016 EBITDA: As linked above, the company estimates consolidated net sales for the first quarter of 2016 to range from $5.05 billion to $5.12 billion. For FY 2016, the company estimates consolidated net sales to range from $20.76 billion to $21.11 billion. Both estimates are based on a low-single-digit increase in same-store sales.

Based on this guidance, I will guesstimate the company's EBITDA in FY 2016 while keeping in mind that Family Dollar's EBITDA margin was 6% in FY 2015. As such, and after taking into consideration several key factors in an increasingly uncertain and volatile macroeconomic and retail environment, I project that the company's EBITDA margin will be about 8%, resulting in EBITDA that will be about $1.7 billion. And therefore, the company's net debt of $6.6 billion (as of Jan 2016) is almost four times its FY 2016 EBITDA.

The Big Picture

Let's take now a close look at Dollar Tree's key metrics compared to the peer group. In this fundamental analysis, I have also included specific discount retailers from the home furnishing and the apparel sectors, for two reasons.

First, pro-forma the Family Dollar deal, Dollar Tree has significantly expanded its product offerings that include home products, apparel and accessories. And second, the discount retailers below have the same target group, which covers the low-income working families, the bargain hunters and the price-conscious shoppers.

1) EV/EBITDA (Based on the closing prices on 04/01/2016): This is what investors currently pay for Dollar Tree and its North American peers:

Company

EV

($ million)

EBITDA

FY 016 (*)

($ million)

EV

----------

EBITDA

FY 016 (*)

Dollarama,

Inc. (OTC:DLMAF)

12,120 (C$)

700 (C$)

17.31

Dollar Tree, Inc.

26,250

1,700

15.44

Five Below,

Inc. (NASDAQ:FIVE)

2,200

145

15.17

Ollie's Bargain

Outle Holdings

(NASDAQ:OLLI)

1,660

115

14.43

Ross Stores, Inc. (NASDAQ:ROST)

23,230

2,200

10.56

Dollar General

Corporation

27,810

2,640

10.53

The TJX Companies,

Inc. (NYSE:TJX)

51,580

4,950

10.42

North West

Company (OTC:NWTUF)

1,590

170

9.35

Fred's, Inc. (NASDAQ:FRED)

614

76

8.08

Wal-Mart Stores,

Inc. (NYSE:WMT)

255,000

34,000

7.5

Tuesday Morning

Corp. (NASDAQ:TUES)

330

49

6.73

Big Lots,

Inc. (NYSE:BIG)

2,250

385

5.84

(*): Estimate for FY 2016 ending on 01/31/2017, based on the company's guidance and FY 2015 results.

2) Net Debt/EBITDA: And now let's see the following four tables with some key metrics to realize why Dollar Tree doesn't deserve its sky-high valuation presented above:

Company

Net Debt

(Jan. 2016)

($ million) (**)

EBITDA

FY 016 (*)

($ million)

Net Debt

----------

EBITDA

FY 2016 (*)

Dollar Tree, Inc.

6,600

1,700

3.88

Ollie's Bargain

Outlet Holdings

170

115

1.47

Dollarama, Inc.

869 (C$)

700 (C$)

1.24

North West

Company, Inc.

188 (C$)

170 (C$)

1.11

Dollar General

Corporation

2,812

2,640

1.07

Wal-Mart Stores, Inc.

34,962

34,000

1.03

Fred's, Inc.

47

76

0.62

Big Lots, Inc.

8

385

0.02

Ross Stores, Inc.

-367

2,200

-0.17

TJX

Companies, Inc.

-823

4,950

-0.17

Five Below, Inc.

-99

145

-0.68

Tuesday Morning

Corp.

-35 (***)

49

-0.71

(*): Estimate for FY 2016 ending on 01/31/2017, based on the company's guidance and FY 2015 results.

(**): Net Debt: Interest Bearing Debt minus Cash/Cash equivalents/Short Term investments.

(***): As of December 2015.

3) EBITDA Margin:

Company

EBITDA Margin

FY 2016 (%) (*)

Dollarama, Inc.

23

Ross Stores, Inc.

16.5

The TJX Companies, Inc.

15

Five Below, Inc.

14

Ollie's Bargain Outlet Holdings

12.5

Dollar General Corporation

12

North West Company, Inc.

8.5

Dollar Tree, Inc.

8 (**)

Wal-Mart Stores, Inc.

7

Big Lots, Inc.

7

Tuesday Morning Corp.

5

Fred's, Inc.

2.5

(*): Estimate for FY 2016 ending on 01/31/2017, based on the company's guidance and FY 2015 results.

(**): For reference, Family Dollar's EBITDA margin was 6% in FY 2015.

4) Total Cash Returned To Shareholders: The companies return cash to their shareholders in the form of dividend payments and share repurchases. Dollar Tree is far from both and will remain far from both until 2020 due to its high financial leverage:

Company

Dividend (%)

Buybacks

North West Company, Inc.

4.28

-

Wal-Mart Stores, Inc.

2.9

Yes

Big Lots, Inc.

1.86

Yes

Fred's, Inc.

1.58

-

The TJX Companies, Inc.

1.32

Yes

Dollar General Corporation

1.15

Yes

Ross Stores, Inc.

0.92

Yes

Dollarama, Inc.

0.43

Yes

Tuesday Morning Corp.

-

-

Ollie's Bargain Outlet Holdings

-

-

Five Below, Inc.

-

-

Dollar Tree

-

-

5) Same Store Sales Growth:

Company

SSS Growth FY 2016 (*) (%)

Dollarama, Inc.

7.3

Tuesday Morning Corp.

6.5

Ollie's Bargain Outlet Holdings

5.5

Wal-Mart Stores, Inc.

3.8 (***)

Fred's, Inc.

3.5

Dollar General Corporation

3

Five Below, Inc.

3

North West Company, Inc.

2.3

Big Lots, Inc.

2

The TJX Companies, Inc.

1.5

Ross Stores, Inc.

1.5

Dollar Tree

1.5 (**)

(*): For FY 2016 ending on 01/31/2017, based on the company's guidance and FY 2015 results.

(**): For reference, Family Dollar's SSS was 0.7% in Q3 FY 2015.

(***): Average from Wal-Mart U.S. and Wal-Mart Neighborhood Market.

Conclusions From The Big Picture

Many investors do it very often. But believe me, I have been in the stock markets for 30 years, and I can assure you that when it comes to stock investing, the burying-the-head-in-the-sand approach never works.

In brief, Dollar Tree has the second highest EV/EBITDA ratio in the industry, which is also much higher than the industry's average EV/EBITDA, although:

1) It has by far the highest financial leverage among its peers, including the debt-free ones.

2) Its EBITDA margin and SSS growth for FY 2016 are lagging its peers' ones.

3) It doesn't return cash to its shareholders in the form of dividend payments and share repurchases.

Additional Key Factors

Dollar Tree's existing shareholders and the potential new buyers must not also overlook these additional key parameters:

1) The EBITDA multiple for the Family Dollar deal: I quote from Dollar Tree's press release:

"Transaction Details: Under the terms of the transaction, Family Dollar shareholders will receive $74.50 for each share they own, comprised of $59.60 in cash and $14.90 in Dollar Tree stock. The transaction values Family Dollar at an enterprise value of approximately $9.2 billion, and it represents an enterprise value to last twelve months May 31, 2014 EBITDA multiple of 11.3x."

2) The repercussions of the FDO deal: If you missed the repercussions of this buyout on Dollar Tree's financial health, you shouldn't definitely be more attentive. Dollar Tree's management has indicated that some of the repercussions of this buyout could be:

A) Limiting our ability to obtain additional financing in the future for working capital, capital expenditures, acquisitions or other general corporate purposes.

B) Requiring a substantial portion of our cash flows to be dedicated to debt service payments, instead of other purposes, thereby reducing the amount of cash flows available for working capital, capital expenditures, acquisitions and other general corporate purposes.

C) Limiting our ability to refinance our indebtedness on terms acceptable to us or at all.

D) Imposing restrictive covenants on our operations.

E) Placing us at a competitive disadvantage to competitors carrying less debt.

F) Making us more vulnerable to economic downturns and limiting our ability to withstand competitive pressures.

G) We believe we will be able to share our best practices in capital deployment and store development across our combined platform to generate significant excess cash flow going forward and enable rapid debt repayment with the goal of returning to an investment-grade rating profile within approximately five years.

3) The ripple effects of the energy downturn: It's an axiom that the discount retailers, including Dollar Tree, mainly target economically-sensitive households whose rising healthcare and rent costs have largely wiped out gas savings over the last 12 months.

In addition, the low-to-middle-income consumers who are living in the oil-producing states like Texas have been hit hard by this unprecedented energy downturn. And Texas is Dollar Tree's third-largest market behind California and Florida, with over 350 stores. As for the Family Dollar banner, Texas is by far its largest market with over 1,000 stores.

4) Fierce competition: The competition in the industry will not abate any time soon. In contrast, the competition will increase in the next years while Dollar Tree will be trying to digest the merger and tame its whopping debt. And, this competition will be coming from the aforementioned publicly-traded discount retailers and the privately-held ones like Sycamore Partners' Dollar Express LLC and Ares Management's (NYSE:ARES) 99 Cents Only Stores.

However, it must also be noted that:

A) The dollar stores face increasing competition from drugstores such as CVS Health Corporation (NYSE:CVS), Rite Aid Corporation (NYSE:RAD) and Walgreens Boots Alliance, Inc. (NASDAQ:WBA). And, this isn't going to change in the coming years.

B) New players enter the discount retail industry. Specifically, in June 2015, European discount grocer Aldi detailed plans to grow in the U.S., saying it would invest billions of dollars and create thousands of jobs. The German company plans to employ 1,100 people across its stores and at its regional headquarters and warehouse in Moreno Valley, Calif. Aldi also noted that it will invest more than $3 billion to implement its five-year plan and open 650 new stores across the U.S. By the end of 2018, Aldi expects to operate nearly 2,000 stores, or about 44% of Wal-Mart Stores Inc.'s current U.S. store count.

But Aldi is not alone. Whole Foods Market's (WFM) new chain of lower-price grocery stores called "365" and the highly competitive German player LIDL enter the discount retail in the U.S., creating a very competitive environment for companies like Dollar Tree.

Takeaway

Back in January 2015 (before the Family Dollar deal), Dollar Tree had a pristine balance sheet with negative net debt at about $100 million, Enterprise Value at about $14.3 billion ($70/share, 206 million shares) and traded 11.4 times its FY 2014 EBITDA.

Post-merger Dollar Tree's key metrics are much higher than the pre-merger Dollar Tree's ones, although the company's financial health has significantly deteriorated since the completion of the deal. Simply put, you pay for a flawed product more than you were paying for the same product a few months ago when it was flawless.

Specifically, Dollar Tree currently has the second highest EV/EBITDA ratio in the industry, which is also significantly higher than the industry's average EV/EBITDA, although:

1) It has by far the highest financial leverage among its peers, including the debt-free ones.

2) Its EBITDA margin and SSS growth for FY 2016 are lagging its peers' ones.

3) It doesn't return cash to its shareholders in the form of dividend payments and share repurchases. And this isn't going to change until 2020 due to its high financial leverage. The recovery and return to investment grade isn't going to happen overnight, but it will take Dollar Tree several years to bring its leverage in line with the industry.

On top of that, Dollar Tree is currently irrationally overvalued based also on the key metrics of the recent deal with Family Dollar. And it must be noted here that neither Dollar Tree nor Dollar General were willing to pay more than 12 times Family Dollar's EBITDA, although FDO's balance sheet in 2015 was much healthier than DLTR's highly-leveraged balance sheet in 2016.

These key reasons coupled with other ones (i.e. fierce competition, energy downturn's impact on the company's core areas) don't support the bull case at the current price of $82.54/share. And, if you bought the story and ignored the fundamentals, bear in mind that the fundamentals always prevail and always take their revenge. When you buy a stock, you don't buy the story alone, you buy its fundamentals too.

I know that investors are often in denial. They are rarely proactive. They are usually reactive. And thanks to these reactive investors, the subscribers to my Premium Research have benefited a lot from my previous, fundamentally-driven, bearish ideas, such as Restoration Hardware (NYSE:RH), Cheniere Energy (NYSEMKT:LNG), Birks Group (NYSEMKT:BGI), Sears Holdings Corporation (SHLD) and Key Energy Services (NYSE:KEG), as shown here, here and here.

Nevertheless, you are free to remain in denial. You are free to live your personal myth. It's your money. But, when it comes to the discount retail industry, Dollar Tree isn't the only girl in town. Thankfully, the canny investors have a large number of much cheaper and financially healthy firms to choose from.

To generate unrivaled returns while carrying low risk, please consider subscribing to the "Fundamental Investor's Stock Club" (2-week free trial) where you will discover unknown and/or underfollowed companies with pristine balance sheets and strong catalysts.

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Disclaimer: The opinions expressed here are solely my opinion and should not be construed in any way, shape, or form as a formal investment recommendation. Investors are reminded that before making any securities and/or derivatives transaction, you should perform your own due diligence. Investors should also consider consulting with their broker and/or a financial adviser before making any investment decisions.

Disclosure: I am/we are short DLTR. 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.

Additional disclosure: I recommended the subscribers to my Premium Research short DLTR when DLTR was above $82.45/share.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.