Dollar Tree: Highly Undervalued Discount Retail Opportunity
Summary
- Despite the ~60% rally since June, Dollar Tree remains an attractive brick & mortar retail play that is largely insulated from online competition.
- The Dollar Tree banner leads the industry in operating margins, and the Family Dollar turnaround is picking up steam, which will drive higher ROIC for the enterprise.
- Dollar Tree has grown FCF per share at a 20% CAGR over the last decade and should continue to generate strong FCF, pay down debt, and will initiate share repurchases.
- Valuation is attractive at 10.6x consensus EBITDA and I see strong upside from here.
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Dollar Tree (NASDAQ:DLTR) is one of the leading discount retailers in the U.S. and Canada and the largest by store count, with close to 15,000 stores. In 2015, Dollar Tree completed the transformational acquisition of Family Dollar. While the improvement of Family Dollar has taken longer than many expected, it appears that things are moving in the right direction.
Industry Overview
Participants in the dollar store industry generally compete on price and convenience. Price competition is more important (and more fierce) for banners like Family Dollar and Dollar General (DG), as they sell more consumable products directly comparable to grocery stores or big box stores like Wal-Mart (WMT). Given that their target customer is low income and constantly under financial pressure, pricing on key items can drive traffic. In addition to price, the value proposition of shopping at a dollar store as opposed to a Wal-Mart is based on convenience, as it's much less of a hassle to get in and out of a 7,200 square foot Family Dollar vs. a 177,000 square foot Supercenter. And in many rural locations, the local Family Dollar or Dollar General may be the only close option.
Source: Company reports, Author estimates, IBISWorld
According to Dollar General, their stores are priced on average 40% lower than drugstores, 20% lower than grocery, and at parity with mass retailers like Wal-Mart. Previous sell-side pricing surveys have indicated that Family Dollar is priced reasonably close with Dollar General, but competitive pricing often varies by region.
Given the low average ticket, dollar stores are somewhat insulated from online competition, as it can be cost prohibitive to ship at such a low price point. Further, if someone needs to pick something up in a hurry, they aren't likely to order online and wait days for it to arrive (while potentially paying shipping costs). In general, the core low-income dollar store customer (particularly at Dollar General and Family Dollar) does not shop as much online.
Opening new dollar stores offers highly attractive cash returns, as Dollar General and Dollar Tree have both indicated cash payback periods of ~1.7 years. Given the compelling store-level economics, Dollar General, Dollar Tree, and Family Dollar have cumulatively grown the store base ~60% over the last decade. While new store productivity has waned over the last few years, it has improved at Dollar Tree and Family Dollar recently.
Source: Author estimates, company reports
During previous periods of weakness in the economy, dollar store same-store sales have tended to be inversely correlated with GDP growth, as there is a trade down effect. This was particularly pronounced during 2008-2009, but in recent years this correlation has turned positive. Over the last 50 quarters, Dollar General has the strongest inverse correlation at -0.67, Dollar Tree at -0.35, and Family Dollar at -0.15.
Source: Author estimates, Company reports, St. Louis Fed
Dollar Tree Banner
The Dollar Tree banner (~6,600 stores) is strictly a $1 price point on every item and maintains a balanced mix of consumables and discretionary variety items. The Dollar Tree banner tends to focus on more suburban markets and targets a middle-income customer. The shopping experience more of a treasure hunt, with customers often making impulse buys given the great value. The average ticket is $8.30 (as of mid-2017) and store typically carry ~7,200 SKUs. 3.4% of the Dollar Tree banner store base is located in Canada (226 stores).
Consumables sales mix at Dollar Tree increased from ~40% in 2003 to ~50% in 2009, where it has consistently stayed ever since. Higher consumables mix means lower product margins, but it also serves as a traffic driver, and the new traffic tends to add non-consumable items to their basket as well. In conjunction with the increase in consumables, the company has added coolers and freezers, which, once added to a store, tend to lift comp sales 5-10% and increases customers' trip frequency. As a percentage of the Dollar Tree store base, stores with coolers and freezers have increased from ~9% in 2005 to 75% in 2016. Additionally, stores that accept SNAP benefits (food stamps) have increased from ~9% of stores to 95%+ over the same period. Importantly however, the banner isn't overly reliant on the SNAP customer, which accounts for less than 5% of sales.
Despite the increased consumable mix, Dollar Tree banner gross margins have remained remarkably consistent over the last decade, which is really the beauty of their model. As former CEO and current Executive Chairman Bob Sasser has often said, Dollar Tree isn't required to carry any specific items at all. Their merchandising goal is to provide the best value for $1 while meeting their strict margin requirements. So, if specific items happen to be experiencing cost inflation which could have a negative impact on margins, Dollar Tree could either not carry the item at all or work with vendors to alter the pack size (many items are non-standard pack sizes given the $1 price point). If they're experiencing cost deflation, they can increase pack sizes to offer more value to the customer. But the key here is that merch margins are largely within the company's control and gross margins have remained within a range of a few hundred basis points over the last 10+ years. Roughly 40% of Dollar Tree's product is imported, which has stayed relatively consistent over time.
Private label as a % of sales is fairly high at 35-40%, and increased private label is generally margin accretive (depending on the item, it can be hundreds or thousands of basis points higher gross margin).
Source: Company reports, Author estimates
The Dollar Tree banner's operating margins are higher than Dollar General and Family Dollar largely due to the smaller consumables product mix (other discount stores like Five Below see a similar benefit). Further, the near doubling of operating margins over the last decade (despite a mix shift to lower margin consumables) is truly a reflection of management's strong execution.
Source: Company reports, Author estimates
I think that Dollar Tree continues to be an extremely well-run retail chain and the bulk of this article will focus on the improvements to the Family Dollar banner.
Family Dollar Banner
The Family Dollar banner (~8,200 stores) is multi-price point and has more of a focus on the low-income segment of the population. As opposed to Dollar Tree's suburban focus, Family Dollar stores tend to be located in urban or rural locations. The shopping experience at a Family Dollar store is more focused on convenience and is more of a neighborhood market near where people live. The first 10 days of each month are very important and typically see higher sales volume given their lower income customer is often living paycheck to paycheck. However, SNAP benefits are still less than 5% of sales. The average ticket is $10.50 (as of mid-2017) and most items are priced at $10 or less.
Their mix skews much more heavily towards food/consumables (75% of sales) and has more traditional CPG products that you might find in a grocery store. Direct import penetration is much lower (~15%) given that Family Dollar's focus on consumables, though increasing this penetration is a margin opportunity. Prior to the acquisition, Family Dollar grew consumables from 57% to 73% of mix from FY04 to FY14, driving 89% of total sales growth over this period. Private label on the consumables side of the business is at 20% penetration and could serve as an important margin driver going forward. Stores generally carry ~7,100 basic SKUs along with many seasonal items throughout the year.
Though the shift to consumables was a strong comp sales driver from 2009-2012, Family Dollar management made a number of missteps in 2013-2014. They changed their pricing strategy from an everyday low price (EDLP) to a high-low strategy, which didn't work well with their low-income customer base. Management added many new SKUs that didn't perform well. Their real estate strategy began expanding into suburban markets and they got away from their core low-income customer. As a result, comps and margins suffered for years. Since acquiring Family Dollar in 2015, Dollar Tree management is taking a number of steps to turn around the banner which I address below.
Source: Company reports, Author estimates
Source: Company reports, Author estimates
Family Dollar Acquisition
Dollar Tree acquired Family Dollar for $9.1bn in July 2015, and Dollar Tree ultimately had to divest 325 stores to allay concerns from the FTC. Management identified $300 million in run rate synergies by the end of the third full year ($75m by FY16, $225m by FY17, and $300m by FY18) and has been quite confident that they can exceed the $300m. The synergies fall into the following buckets:
- Sourcing/procurement
- Lowering the cost of goods by leveraging larger purchasing power, rationalizing the vendor base, better buying on supplies, etc.
- While many of the changes were made early on, management has indicated that work is still being done here.
- This is the largest bucket and ~60% of the $300mm
- Store rebanners
- Management analyzed all Family Dollar stores through the lens of Dollar Tree's proven real estate model to identify Family Dollar stores to be rebannered into Dollar Tree stores, as well as to identify underperforming Family Dollar stores to close.
- Ultimately, ~300 Family Dollar stores were rebannered to Dollar Tree from 2Q15 to 4Q16. These conversions typically result in a substantial margin increase at the store level.
- The ~200 Deals bannered stores (a discount chain acquired in 2006) were also all rebannered to Dollar Tree (though any benefit from the Deals rebanners wasn't contemplated in the original synergy number).
- This is the second largest synergy bucket.
- Reduced SG&A/shared services
- The company has eliminated redundant positions and other public company costs, largely by centralizing shared services (HR, IT, finance, etc.) in Chesapeake, Va., where Dollar Tree is located.
- These synergies have mostly been achieved already.
- Distribution/logistics/supply chain
- Management has long said that this category is more of a long-term opportunity.
- The synergies here are based on rationalizing and improving the distribution network to more efficiently serve all stores.
- Last year, the company turned a Family Dollar distribution center into a co-branded distribution center servicing both banners, which has yielded positive progress so far. The idea is to reduce stem miles for delivering products to stores which will ultimately benefit margins.
Importantly, management is taking on the turnaround of Family Dollar by refocusing on some of the basics like having cleaner stores, keeping relevant products on endcaps, getting rid of older inventory, focusing on in-stocks, catching up on repairs/maintenance, and incentivizing store managers with monthly, performance-based bonuses to reduce employee turnover (lower turnover leads to better sales and lower shrink). Early on, management slowed Family Dollar store growth to ensure that these improvements were taking place before being rolled out in new stores.
More recently, management has begun substantial renovations to current Family Dollar stores to further improve sales productivity. The renovations focus on a number of areas including expanding immediate consumption coolers near checkout, improving checkout speeds, improved assortment for the coolers/freezer, expanded adult beverages, updated hair care assortments, and higher promotions of $1 items. Management targeted 250 renovations in FY17, which started in 2Q, but soon upped that to 350 based on the positive results thus far. They've also indicated that could ramp to 500 stores next year.
Another important aspect of the turnaround is the revamp of Family Dollar's private label brands. They're moving away from older Family Dollar brands and transitioning to more refreshed packaging and quality that is more comparable to national brands. This private brand refresh should driver higher private label penetration on the consumables side (currently ~20%) which will benefit merch margins.
While the turnaround got off to a slower start than many expected, it appears that these initiatives are having some impact. In the last couple quarters, comps have been positive and sequentially improving and TTM sales per square foot was up 1.8% y/y. Additionally, TTM adjusted (and GAAP) operating margins at Family Dollar have seen recent improvement as well.
I think that sustained comp growth and increased sales per square foot should result as many of these sales-driving initiatives start to kick in over the next several quarters (and easy comparisons on a two-year stack basis helps as well). Stronger comp growth should in turn accelerate margin improvement as more fixed costs are leveraged.
Below, I've compiled a table with various callouts from management of items impacting Family Dollar margins in each quarter since the acquisition. As you can see, merch costs have largely benefited gross margins, but occupancy has been a consistent drag. Positive comps should help leverage occupancy costs. Additionally, shrink should become less of an issue over time as employee turnover is reduced. Repairs and maintenance have been a consistent drag as well, as much-needed repairs had long been deferred by the old management. These should dissipate over time.
Source: Company reports and transcripts
The Opportunity
As I mentioned, I think that there is substantial room for margin expansion in the Family Dollar banner over the next several years. Historically, TTM operating margins at Family Dollar peaked around 7.4% in 2011 and surpassed 8% in a few quarters. They currently sit at 4.4%. Management has said on multiple occasions that they don't see any reason why operating margins couldn't get back to 7-8% over time. And given their track record with the Dollar Tree banner over the last decade, I'm inclined to find them pretty credible.
It's unfortunate that the CEO during this progress, Bob Sasser, stepped down in September 2017 (currently serving as executive chairman), but Gary Philbin filled his spot and has worked closely with Bob Sasser throughout this period. Gary originally joined Dollar Tree as senior VP of Stores in 2001, was promoted to COO, served as president/COO of Family Dollar after the deal, and then enterprise president since January 2017. Under their tenure over the last decade, the company has grown the store base 350%, increased sales at an 18% CAGR, operating income at a 19% CAGR, and FCF per share at a 20% CAGR while reducing the diluted share count 25% (including shares issued for the deal). Annual performance-based bonuses for management are based on operating income targets, which is encouraging.
As of the most recent proxy, directors and executive officers owned ~3% of shares outstanding.
In addition to the Family Dollar margin opportunity, management has even indicated recently that the already industry-leading operating margins at the Dollar Tree banner could get to 14% or even 15% longer term. Given this team's track record, I think it's certainly possible.
In the near term, the comp sales outlook for both banners is positive given improving retail sales data. As you can see below, I have compared historical comps for Dollar Tree and Family Dollar vs. Retail and Food Services sales, Grocery sales, and Food at Home inflation. Each of these are reported monthly, so I've aligned the data with Dollar Tree's reporting schedule and taken the 3-month average for each quarter. Over the last several years, comps at both banners have generally been positively correlated with this data.
Source: Company reports, Bureau of Labor Statistics, U.S. Census Bureau, Author estimates
Importantly for Family Dollar given the 70%+ consumables mix, grocery sales and food at home inflation are in an upswing which should bode well for comps. The United States is coming out of a period of historic food deflation and this rebound will be a positive for grocery sales, and Family Dollar should be a natural beneficiary of that.
Source: Bureau of Labor Statistics
Driving sales per square foot is a huge opportunity for this management team, as Family Dollar has historically lagged Dollar General by a wide margin. Sales per square foot is currently almost 25% higher at Dollar General, a gap that has continued to widen in recent years. I think that the ongoing store productivity initiatives at Family Dollar should help narrow this gap. Encouragingly, the company recently hired Duncan Mac Naughton as President of Family Dollar, as he has over 30 years of relevant retail experience including a stint as Chief Merchandising and Marketing Officer of Wal-Mart U.S.
Source: Company reports, Author estimates
In terms of the store growth opportunity, management recently updated their analysis which indicates more than 10,000 Dollar Tree stores (currently ~6,600) and more than 15,000 Family Dollar stores (currently ~8,100), so there is ample room for store growth.
Ultimately, I think that these improvements should lead to higher returns on invested capital (ROIC), which have been waning since the acquisition. I look at ROIC as the product of its two components, NOPAT margin (NOPAT/sales) and invested capital turnover (sales/avg. invested capital). Dollar Tree has historically lagged Dollar General in invested capital turnover given that Dollar General sells a much higher portion of higher turning consumables. Invested capital turnover should increase for Dollar Tree as Family Dollar sees improvements in sales productivity from new initiatives. Additionally, NOPAT margin should benefit going forward given the margin expansion opportunities laid out above, as well as a lower effective tax rate (of course, tax reform benefits all other competitors as well).
Source: Company reports, Author estimates
Capital Allocation
Another important point is that shareholders will continue to benefit as the company continues to pay down debt. Leverage (which I define as total debt + capitalized operating leases less cash divided by adjusted EBITDAR) has come down nicely since the deal, and management indicated in 2017 that they're looking to return to the 3-3.5x range to get back to investment grade status. This will lower their cost of capital and free up cash flow that will likely be allocated to share repurchases.
Source: Company reports, Author estimates
Valuation
Since any company is worth the present value of its future cash flows, I think that discounted cash flow analysis is useful, despite the inherent uncertainty about the future. On a discounted cash flow basis, I'm estimating an intrinsic value range from roughly $133 to $156, or $144 on average, which leads to 38% upside. Over the next 10 years, I assume that comps for both banners are steady at 2%. I assume 200 new Dollar Tree banners per year and 300 new Family Dollar banners per year (final year store counts are still well below management's long-term targets). I assume that Dollar tree operating margins gradually expand to 15% and Family Dollar operating margins expand to 8% by 2027 (I think this is sufficiently conservative as I expect Family Dollar to achieve 7-8% margins faster than I've modeled here). I assume tax rates of 21% from 2018 on (the benefit of the tax rate going from 37% to 21% due to tax reform adds ~$14-$40 to my valuation alone).
Using the perpetual growth rate method with a 3% long-term growth rate and 8% discount rate, I estimate ~$156, or 49% upside. Using the terminal multiple method with a 10x EV/EBITDA multiple and 8% discount rate, I estimate a per share value of $133, or 27% upside.
Assuming a 10% discount rate and a long-term growth rate of 1% (or 10% discount rate and a terminal multiple of 7x EBITDA) yields a downside value of $87-$88 per share or ~16% downside. Please see the sensitivity tables below as well.
Source: Company reports, Author estimates
On a forward P/E basis, the multiple has contracted 29% from the recent 1/29/18 high of 23.9x to 16.9x currently. On an EV/EBITDA basis, the multiple has contracted 14% from 12.3x to 10.6x over the same period. DLTR's multiple has recently moved in lockstep with DG. However, I think that DLTR deserves a higher multiple relative to DG given the superior margin expansion potential over the next several years. DG is certainly a quality company (disclosure: I am long DG as well), and DG currently has higher returns on invested capital and higher profitability on a per square foot basis, but DLTR has more potential to improve these metrics over the next few years. I don't know what the right multiple should be, but I believe it to be higher than where the stock currently trades.
DG EV to EBITDA (Forward) data by YCharts
DG PE Ratio (Forward) data by YCharts
Risks
The biggest risk to my thesis is that the turnaround of Family Dollar takes longer than expected or does not materialize. While Dollar Tree is a best in class discount retailer, there must be improvement at Family Dollar to continue driving the stock price higher. However, I have confidence in the management team that the turnaround will continue to improve.
There's also a risk of how realistic management's long-term store growth potential is. If new store productivity at dollar stores weaken over the next few years, this could lead management to revise the targets lower or at least cause the market to have less confidence in them.
Competitive threats from other market participants like Dollar General, Wal-Mart, and grocery stores could lead to a price war. I think that Dollar Tree is more insulated from this risk, but Family Dollar is certainly at risk here. Specifically, the expansion of German hard discounters Aldi and Lidl in the U.S. exacerbate this threat. However, Family Dollar also competes on convenience given the much smaller store size, and in many rural areas, it's the only game in town. Additionally, the industry is just starting to recover from a historically difficult period of food deflation, so it's likely that many players in the market will gradually pass these higher costs through rather than holding them down and taking the margin hit.
SNAP benefit cuts have also been a cause for concern recently. However, in the grand scheme of things, SNAP is <5% of the business at Family Dollar and even lower at Dollar Tree. So, while reductions in SNAP could certainly have a negative impact, I'm not overly concerned.
Despite the positive correlation with GDP over the last few years, sales at dollar stores could actually see a benefit if we were to enter a recession. As I indicated earlier, dollar store comps increased substantially during the financial crisis as consumers trade down looking for better values. Dollar General and Family Dollar would likely benefit the most in this situation given their larger offering of consumables.
Conclusion
I think that Dollar Tree is undervalued at these levels and that the market is not giving the company full credit for improvements to the Family Dollar banner over the next several years. Sales initiatives will benefit comp sales and sales per square foot (narrowing the gap with DG), and margins should also improve as synergies continue to have an impact. This will drive higher profitability per square foot and improved ROIC. As the company continues to pay down debt, I believe that management will continue to allocate capital well and will eventually use the company's strong free cash flow for share repurchases.
This article was written by
Analyst’s Disclosure: I am/we are long DLTR, DG. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (16)
I especially liked your survey of past earnings reports to map out the cost concerns.
I have never seen this done befoe - pretty original.
