- Solid 2017 with growth in comps, revenue, and margin.
- The market didn't like management's 2018 forecast, but it was in line with my previous projections.
- Even with conservative assumptions, Dollar Tree is a great value at these prices.
On March 7, Dollar Tree (NASDAQ:DLTR) released its fourth-quarter 2017 earnings report. Sales increased 12.9% to $6.36 billion, with rising same-store sales in both Dollar Tree-branded stores ("DT") and Family Dollar-branded stores ("FDO"). DLTR earned $1.89/share in adjusted earnings per share, excluding some hearty tax benefits, up from $1.36 a year ago. Shares fell 14.5% on the news, from $104.36 to $89.25. Why? Analysts had forecast revenue of $6.4 billion and adjusted EPS of $1.90. Wall Street was also disappointed by Dollar Tree's outlook for 2018.
I don't share Wall Street's concern with analysts' estimates. DT stores have now demonstrated rising comps for a 40th consecutive quarter, while FDO stores posted their third consecutive quarter of rising comps. Regardless of the short-term price movement, DLTR posted a strong quarter to cap of a very strong year.
Expanding margins at FDO stores will be an important area for DLTR to grow in the coming years. Family Dollar was purchased in mid-2015 and is a much lower-margin operation. This year showed improvements in FDO margins - gross margins rose 60 bps compared to DT margins rising 40 bps - but there is still a lot of work to do in getting FDO up to speed. Management is focused on that work and intends to continue investing money into FDO stores and its employees.
I rate DLTR as a buy. It was made even more attractive by the declines on earnings day.
The Fourth Quarter
|Revenue||$6,360.6 million||$5,635.6 million||12.9%||4.8%|
|Gross Margin||33.0%||32.1%||90 bps|
|SG&A % of Sales||21.7%||21.0%||70 bps|
|Operating Margin||12.0%||10.4%||160 bps|
|Operating Profit||$691.5 million||$586.5 million||17.9%||9.5%|
Source: Dollar Tree earnings report
Dollar Tree had rising revenue (4.8% on a weekly basis), rising comps (2.4% excluding some positive currency fluctuations), rising gross margins (up 90 bps), falling SG&A costs (down 70 bps), and rising operating margins (up 160 bps).
Dollar Tree revenue in the fourth quarter rose 12.9% from $5.64 billion to $6.36 billion. However, the fourth quarter in 2017 was a 14-week quarter. Excluding the impact of the extra week, revenue rose 4.8% in the fourth quarter.
During the quarter, same-store sales rose 2.4% on a constant-currency basis, with FDO posting gains of 1.0% and DT posting gains of 3.8%. In both cases, comps were lower than last quarter (1.5% and 5.0%) but higher than a year ago (0.2% and 2.3%). Including Canadian currency fluctuations increases same-store sales 10 bps to 2.5%.
Gross margins also increased during the fourth quarter, due to lower merchandise costs, markdowns and occupancy costs as a percentage of sales, partially offset by increased freight costs. Gross margins increased 90 bps to 33.0%. Gross margins at DT stores were 38.0% (up 50 bps y/y) and gross margins at FDO stores were 27.6% (up 130 bps y/y).
Operating expenses fell, with SG&A dropping 70 bps to 21.0%. Excluding two special items (a settlement related to an impairment charge and an increase in workers' comp reserves), SG&A dropped 40 bps to 21.3%. This improvement was attributed to lower depreciation costs and lower repair and maintenance costs as a percentage of sales, partially offset by higher hourly payroll, incentive compensation, and advertising costs.
Operating margins rose 160 bps up to 12.0% in the fourth quarter. Operating margins at DT stores were 16.9%, up 40 bps y/y, while operating margins at FDO stores were 6.8%, up 280 bps y/y. As a result, operating income rose to $766 million from $587 million a year ago. Operating income was up 17.9%, or up 9.5% when accounting for the extra week in 2017.
Changes from the Tax Cuts and Jobs Act ("TCJA") will have the effect of reducing DLTR's taxes in the coming year. In 2016, DLTR paid 33% tax, and ~37% in the five years prior. That tax rate will fall, thanks to the tax cuts, down to perhaps 23%. In the fourth quarter, DLTR recognized a $583.7 million benefit from the TCJA, resulting in EPS of $4.37/share. Without this factor, adjusted EPS was $1.89/share.
|Revenue||$22,245.5 million||$20,719.2 million||7.4%||5.3%|
|Gross Margin||31.6%||30.8%||80 bps|
|SG&A % of Sales||22.6%||22.6%||unchanged|
|Operating Margin||9.0%||8.2%||80 bps|
|Operating Profit||$1,999.1 million||$1,704.8 million||17.3%||8.9%|
Source: Dollar Tree earnings report
On an annual basis, revenue rose 7.4% for the year, 5.3% excluding the impact of the 53rd week. Gross margins rose 80 bps while SG&A costs were flat. Operating profits rose 8.9% excluding the extra week while operating margins expanded 80 bps.
Overall, in my view, Dollar Tree had a fantastic year.
Next year, DLTR expects to save about $250 million through the TCJA. Of that money, management plans to invest about $100 million into longer store hours, higher wages, and improved employee benefits.
In the first quarter of 2018, DLTR's management projected revenue of $5.53 to $5.63 billion (up 5.5% at midpoint), with low-single-digit increases in comps. For the year, DLTR expects revenue of $22.7 to $23.12 billion (up 5.0% at midpoint excluding the impact of 2017's 53rd week, 3.0% on absolute terms). This expectation is based on a low-single-digit increase in same-store sales and 3.7% square footage growth.
Dollar Tree expects first-quarter diluted EPS of $1.18 to $1.25 and full-year diluted EPS of $5.25 to $5.60.
Provided that square footage grows 3.7% in 2018, this expectation implies ~1.1% expansion in revenue per square foot per week. In 2017, revenue per square foot per week rose 3.1% at DT stores and 0.2% at FDO stores.
In my view, Dollar Tree posted great results in 2017. The market clearly felt different about the earnings report than I did - shares dropped 14.5% on March 7th. This drop has been attributed to Dollar Tree's 2018 guidance:
"Dollar Tree said full-year profit would range between $5.25 a share and $5.60 a share, below analysts' expectations of more than $6 a share. The company's first-quarter earnings guidance also fell below analysts' estimates.
The disappointing profit forecast was fueled in part by elevated labor and transportation costs, the company said on a call with analysts. But it was also due to Dollar Tree's decision to plow a chunk of its expected tax-cut windfall back into its business, as other retailers like Walmart have done."
I don't share analysts' concerns on Dollar Tree's projections for 2018. Analysts' concerns appear to be based on more aggressive projections than mine.
On the earnings call, Karen Short of Barclays noted that operating margin in 2018 would be ~8.9% to 9.3% in 2018, excluding the $100 million reinvestment. That works out to ~8.7% at midpoint, after the $100 million reinvestment, on projected earnings at midpoint of $22.91 billion.
Back in December, I posted a DCF valuation of Dollar Tree (paywalled). In that valuation, I expected 2018 revenues of $22.87 billion (versus $22.91 billion midpoint now forecasted), and 2018 operating margins of 8.8%, resulting in EBIT of ~$2.005 billion. If we instead use $22.91 billion revenue and 8.7% operating margins, we derive an EBIT of $1.993 billion.
A $12 million drop in 2018 operating income expectations does not warrant a 14.5% decline in share prices. In my view, Dollar Tree is a much better value today than it was before earnings were released - while expectations may be marginally lower, share prices are much lower.
Valuation & IRR
I try to pay as little attention to day-to-day stock prices as possible. Dollar Tree remains a very solid business with forty consecutive quarters of same-store sales growth at Dollar Tree-branded stores. Bringing FDO stores up to the level of DT stores will take time, but management continues to invest money into the process. In the meantime, Dollar Tree continues to be a profitable and expanding company.
I don't expect miracles from the company, but it doesn't need miracles to show attractive returns. Over the next year, I would like to see margin expansion at FDO stores, perhaps adding another 60 bps to its margins, as it added in 2017. In five years, that might bring FDO gross margins up to ~30%n compared to 35.8% for DT stores in 2017. In my view, this is a very realistic expectation.
|Dollar Tree Internal Rate of Return (based on future unlevered FCFs)|
|Terminal Growth Rate||0%||0.5%||1%||1.5%||2%||2.5%||3%|
|IRR @ $91.50/share||5.6%||6.0%||6.5%||6.9%||7.3%||7.7%||8.1%|
Source: Author's calculations
The above calculations are based on a very conservative set of assumptions.
I assume revenue growth slows from 5% in 2018 (adjusted for the extra week in 2017) to 1% in five years. I further assume that FDO gross margins increase to 30% in five years, while DT margins contract slightly to their five-year average of 35.4% (from 35.8% in 2017). I further assume that SG&A costs increase to their five-year average of 23.0% of sales (up from 22.6% in 2017), and that future tax rates will be 24% (down 13% from taxes prior to 2016). All figures are further based on a net debt of $4.58 billion, ~237.1 million shares outstanding, and ~$220 million in stock options & RSUs outstanding.
Even with these conservative assumptions, a terminal growth rate of 2% gives DLTR shares (at $91.50) an IRR of 7.3%.
I don't expect this IRR to be attractive to growth-oriented investors hoping to find a 10-bagger. However, DLTR has a very low beta: its 10-year monthly beta is 0.31 according to Intrinio and its five-year monthly beta is 0.56. This is comparable to other discount retailers such as Dollar General (DG), Walmart (WMT), and Target (TGT). Dollar Tree also has an investment-grade rating of Baa3 from Moody's - upgraded March 2, 2018. Based on this, I calculate a cost of capital for Dollar Tree of 5.2% - lower than its IRR even with a terminal growth rate of 0%. With a terminal growth rate of 1%, I value DLTR shares at ~ $126/share.
Dollar Tree is a safe company, with low market risk. Dollar Tree sports an investment grade rating, with rising comps and increasing margins. Even with a very conservative set of assumptions, Dollar Tree is underpriced by the market.
Recent price movements have created an opportunity to invest in Dollar Tree at very attractive prices. Dollar Tree has outperformed both the S&P 500 (SPY) and the Vanguard Consumer Staples ETF (VDC) over the past year, and I expect continued strong performance.
Despite market turbulence, Dollar Tree is a solid company with great management.
Today's price is a bargain.
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Analyst’s Disclosure: I am/we are long 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.
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