Dollar Tree: A Welcoming Destination During Recessions (Unlike Target)

May 20, 2022 12:35 PM ETDollar Tree, Inc. (DLTR)TGT, DG, WMT12 Comments7 Likes
Larry Cheung, CFA profile picture
Larry Cheung, CFA
1.24K Followers

Summary

  • Dollar Tree is a counter-cyclical name that has stronger appeal during recessions.
  • Target’s recent earnings where consumers are trading down on goods suggests strength in DLTR products.
  • Rising gas prices do serve to be a concern for certain customer demographics who are unable to visit discount retailers as often.
  • Dollar Tree can be positioned as a macro hedge against uncertainty as a reasonable priced defensive name.

Dollar Tree Announces 25% Raise In Prices

Mario Tama/Getty Images News

Introduction

Judging from the stock market's 2022 price action, we are clearly either in a growth scare or an outright recession. In either case, the current investment environment has become far more challenging for long-only investors since the Fed made a pivot in their monetary policy outlook in November 2021.

If we are indeed facing future economic turmoil, then placing Dollar Tree (NASDAQ:DLTR) on your watchlist to understand the spending behavior of consumers may prove to be a powerful way to understand near-term consumption patterns, which drive roughly 70% of the U.S. economy.

For me personally, while I am not as bullish on Dollar Tree as I am on Costco due to Costco's more stable business model, I do believe Dollar Tree's counter-cyclical qualities can potentially allow investors to reduce portfolio beta while still providing upside potential.

I believe Target's (TGT) recent earnings quarter has grouped all of retail stocks into one category, but investors should remember that DLTR is a discount retailer and has completely different customer bases compared to that of Target.

A quick company summary

To make sure our friends here on Seeking Alpha are on the same page with Dollar Tree, I'm going to provide a very brief summary of their business model in case you are not familiar with the company.

If you've ever seen stores named Dollar Tree or Family Dollar (and there are 16,000+ of them in the U.S.), these are the stores owned by the Dollar Tree family of brands. The company serves consumers from all income levels, but specifically competes as a discount retailer with most items sold being priced under $10.

The business model behind Dollar Tree

To understand Dollar Tree, we need to separately understand the business models behind Dollar Tree - the store - and also Family Dollar the store.

At Dollar Tree stores, most of the items in their stores are now priced at $1.25 per item. Dollar Tree has also partnered with Instacart where customers can get same-day delivery. In terms of where Dollar Tree sources their merchandise, according to their 10K, they buy roughly 60% of their items domestically and imports the remaining 40% from countries outside the U.S. such as China. The merchandise mix typically includes consumable, variable, and seasonal items.

In contrast to the Dollar Tree stores, Family Dollar sells items that range from $1 to $10 and have products ranging from consumables, home products, apparel & accessories, and seasonal/electronics items.

As discount retailers Dollar Tree and Family Dollar stores focus very heavily on consumable products at lower price points, and in my opinion, cannot be properly prepared to the consumer base that Target attracts.

What drives Dollar Tree's same-store-sales model and outlook

To understand what has been driving Dollar Tree's consumers in the past 18 months, I would objectively say that we should focus on the current gas prices at the pump, the job market outlook, as well as the forecast for inflation. I recently ran a poll on YouTube to understand my audience's biggest concern with the market, and the answer was high inflation. If high inflation is indeed the largest problem among market participants, Dollar Tree's defensive positioning in the market-place should serve as an effective hedge as consumers seek better deals to stretch their finances as much as possible. This poll had only been up for 3 hours.

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Given that Dollar Tree is a discount retailer, many of their consumer demographics would more acutely feel the pinch of higher transportation costs via higher gas prices. As a result, Dollar Tree Management has discussed in the past on their earnings calls back during the financial crisis that after a certain threshold of gas prices, their target consumers start to make fewer trips to the store due to the higher cost of transportation. The offset to higher transportation costs is that Dollar Tree has many of its stores located in local neighborhoods where consumers can more easily walk to. That said, higher energy prices are going to eat up any discretionary spending income that Dollar Tree's customer base most likely has left. So strategic locations in local neighborhoods may or may not offset the strong discomfort that consumers feel due to high gas prices.

In this current economic climate where gas prices are high and general inflation is also high, Dollar Tree's business model is likely to continue to attract more customers outside of their usual target market. We can surmise this because Target recently reported that many of their consumers were buying more low-margin items (also low priced items). However, Dollar Tree is not immune to a large-scale pullback in consumer spending where aggregate spending is lowered to account for job security anxiety or a person's job outlook. So while Dollar Tree will perform well when the economy is soft, it cannot be expected to still deliver strong same-store-sales if the economy is in a major crisis.

For this reason, it's appropriate to think about DLTR as a name that does perform relatively well when the economy goes through a temporary short-term growth scare, but if the economy enters a prolonged deep recession, then their target market customers will have even fewer resources to spend on goods and services. A prime example of this is that Dollar Tree was still hurt during the 2008 financial crisis.

The risks to consider

Dollar Tree's gross margins have historically ranged in near the 30% level. I believe the Street will be hyper focused in assessing whether shipping costs, wage increases, and other supply chain disruptions will impact DLTR's gross margins.

Given that China is a large source of Dollar Tree's imports, monitoring Biden's policy on reducing trade tariffs will also be important. I believe Dollar Tree will see stronger gross margins if Biden were to lift tariffs placed on China.

Dollar Tree currently trades at its 15Y average forward multiple of roughly 17.5X. DLTR's valuation multiple contracted sharply after Target's recent earnings report that sent the entire retail industry and the consumer discretionary ETF XLY down. In this environment, Dollar Tree's multiple is at a slight premium compared to the SPX, but that premium is most likely justified because of its counter-cyclical defensive positioning. Fundamentally speaking, we will definitely see more consumers shop at Dollar Tree due to high inflation and a weak economic outlook.

On a technical level, after the latest selloff inspired by Target, Dollar Tree's RSI is showing a reading of 26 (where 30 reads oversold) after the company fell 20% in sympathy with the retail sector. In the past, such an oversold reading on DLTR has historically resulted in longer-term objective entries.

Trading View (Dollar Tree)

Dollar Tree Charts (Trading View)

Dollar Tree reports earnings next week, and my research article is by no means suggesting that my readers take a position before earnings given that large swings will happen after they report. Walmart (WMT) and Target are reminders that the retail sector is experiencing headwinds due to the current environment we are in.

However, I do believe that unless DLTR's earnings report indicates sharply contracting margins, Dollar Tree's fundamental setup and its positioning in this macro backdrop as well as its technical positioning provide a reason to potentially explore a very light starting position in this name (earnings report aside).

I continue to believe that Dollar Tree is fundamentally different from Walmart and Target and even Costco. Therefore, although the industry-wide sentiment on retail is very fragile, it's unfair to group Dollar Tree (and Dollar General) in the same bucket as Walmart and Target given their different business models, customer bases, and unique growth opportunities.

TGT and WMT may have disappointed the Street, but that does not guarantee that DLTR meets the same fate post-earnings given the economic environment we are now in.

This article was written by

Larry Cheung, CFA profile picture
1.24K Followers
Dear SA Community, My name is Larry Cheung, CFA and I am an Investment Strategist who specializes in the following themes 1.) U.S. & China Technology 2.) Consumer Discretionary and 3.) Macro Strategy. I'm on Youtube (85K+ Subscribers), Substack (4K+ Public Subscribers), and Patreon (Fans of my work). Let's connect and win together.-Larry
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Disclosure: I/we have a beneficial long position in the shares of DLTR either through stock ownership, options, or other derivatives. 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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