Dollar Tree: Future Performance Will Be Challenged

| About: Dollar Tree, (DLTR)

Summary

DLTR is operating in a challenging industry environment.

Company’s performance will be challenged due to intense competition.

Stock is trading at a forward P/E of 18x, in contrast to DG’s forward P/E of 14.5x.

The U.S discount retailers are facing challenges to grow their topline numbers due to macro challenges and intense competition in the industry. Dollar Tree (NASDAQ:DLTR) is one of the leading discount retailers in the U.S. The company's performance in the future will be adversely affected due to increase in promotional activities by its competitors and food deflation, which will weigh on its profit margins. Also, reduction in SNAP benefits will put pressure on its top line numbers. The recent acquisition of Family Dollar (NYSE:FDO) makes DLTR a multi-price point retailer in the U.S. with a broader customer reach. However, DLTR will face challenges to turnaround FDO business, which will weigh on the stock valuations; the stock is trading at forward P/E of 18x versus Dollar General's (NYSE:DG) forward P/E of 14.5x.

Financial Performance and Catalysts

The company reported mixed financial results for 2Q16. DLTR reported adjusted EPS of $0.72 for the quarter, missing the consensus of $0.73. The company's comparable sales for 2Q16 grew by 1.1%, as compared to consensus of 2.4%. The performance for the quarter was adversely affected by intense competition, slowing demand, and weak FDO business results. Due to the challenging macro environment and competition, DLTR lowered its net sales guidance for 2016. The company expects net sales for 2016 to be in a range of $20.69 billion to $20.87 billion, as compared to its previous forecast of $20.79 billion to $21.08 billion. EPS for the year is expected to be in a range of $3.67 to $3.82.

The recent acquisition of FDO makes DLTR a multi-price point retailer. The company is projected to benefit from $300 million synergies from the integration of FDO business. Moreover, the company is expanding its store base, which will increase its customer base. The company's management plans to complete 800 store projects in the ongoing fiscal year 2016, consisting of 200 new FDO stores, 350 new DLTR stores and 258 re-banner. Also, the recent acquisition of FDO will allow DLTR to expand its customer base and market reach. However, DLTR is facing challenges to improve sales productivity of Family Dollar. Family Dollar is a large grocery store chain with a large number of stores and distribution centers. Therefore, it will take some time for DLTR to improve sales productivity and integrate Family Dollar business. Family Dollar has almost 100 bps to 150 bps higher fixed costs as compared to Dollar Tree. Also, Family Dollar has a lower EBIT margin of approximately 6.5% versus DLTR's EBIT margin of 9%. To improve its long-term performance, DLTR should rationalize Family Dollar stores by closing underperforming stores and accelerating its efforts to re-banner stores. In the long term, once DLTR integrates Family Dollar business and improves sales productivity of stores, its performance will be positively affected.

The company's topline numbers will be negatively affected due to food deflation in the U.S. Also, cut in SNAP benefits will weigh on its performance in the upcoming quarters. The reduction in SNAP benefits means that fewer customers will be shopping at discount retailers like DLTR and DG, which will weigh on their top line growth; people who receive SNAP benefits often do not have excess income to make up for the reduction in SNAP benefits. In the U.S., almost 500,000 people are anticipated to lose SNAP benefits in 2016. The following chart shows food price deflation in the U.S.

Source: Bloomberg

Also, the competition in the industry is growing. DLTR's competitors are cutting prices to strengthen their customer base and support topline numbers. Wal-Mart (NYSE:WMT) recently increased its competitive activities in efforts to address competition from discount retailers like DLTR and Dollar General. Also, Kroger (NYSE:KR) and DG has announced to reduce prices in efforts to increase sales volume; KR is cutting prices for almost 1,000 products. As the promotional activities in the industry are increasing, DLTR should also reduce prices to address competition and improve sales volume.

Also, expansion of small-format grocery stores in the U.S. will challenge DLTR's future performance. WMT, DG, Aldi and Lidl are all expanding their store networks, which will make industry environment even more competitive. Moreover, WMT's e-commerce expansion will negatively affect the performance of the discount retailers like DLTR and DG. To remain competitive, DLTR should also reduce prices. However, its profit margins will contract as a result of an increase in the promotional activities, which will put pressure on the stock valuations.

Summation

The acquisition of FDO has allowed the company to expand its target market and customer reach. However, the company's performance will be challenged due to macro challenges and intense competition. DLTR is operating in a challenging industry environment, and the increase in promotional activities in the industry will adversely affect its performance. The company should also cut prices to support its sales volume and attract customers. The company's profit margins will contract as a result of the price war in the industry, which will adversely affect the stock valuations; the stock is trading at a forward P/E of 18x, in contrast to DG's forward P/E of 14.5x.

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.

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