If you listened closely to the conference call, you could tell a notable change in tone from prepared remarks (before the stock opened) vs the Q&A when the stock rallied by 5%. Management felt that the market was telling them that this print was a victory. But it wasn’t. It was an extremely low-quality beat that was entirely driven by SG&A – and likely a cut to management incentive compensation at BOTH banners. In the press release, management dedicated almost a page to all of its integration accomplishments -- it kinda read like a 'I shouldn't be fired for the following reasons' plea. But in actuality, both concepts weakened on the margin, and if not for the likelihood of a major change agent, I’d probably be short this stock. Cheap can always get cheaper when fundamentals are going the wrong way, and there’s no believable plan in place to right this ship. Yet.
The only strategic announcement that came from this quarter is that management is stepping up on store remodels. I cannot underscore how much of a mistake that is. You don’t pony up more capital to make stores look prettier when 60-75% of the problem lies in the buying and merchandising part of the organization, and another 25% is in misaligned incentives and the inability to attract and retain qualified store managers to run the 8,264 Family Dollar stores. The appearance of the stores is NOT the problem here. It is what the stores are selling and who is empowered to sell it. This decision represents good capital going after bad opportunity. That’s unacceptable.
If I was an activist (which management considers me to be since they cut us off after reading our slide deck and investment thesis) I’d consider this event to be pivotal in my decision to move forward with an activist campaign. The shareholder director nomination period starts next week. There is nothing anyone on my team can find anywhere in the global retail supply chain that is as cheap as the implied valuation of Family Dollar ($5 per share best case) within DLTR. Fixing Family Dollar would result in $8 of EPS power. A flat out disposal – even at a bargain price (ie a loss) – would still wipe out the debt. There is also nothing out there that can unlock as much value from a simple strategic decision to introduce price points over $1 at Dollar Tree. “Breaking the buck” can be worth an extra $2-3 in EPS. The opportunity is clear as day. Management just needs to reach out and take it. The growth and return characteristics in fixing these problems would warrant a high teens multiple at a minimum which would engender a target price of $200.
It’s game time. Like, right now.
-- McGough
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Biolsi’s Call Notes/Thoughts
Sales weakened
- Corporate SSS increased 1% vs. expectations of +1.4%. Dollar Tree SSS increased 2.3% (the lowest comp since 2016) against a difficult 5% comparison. October was the strongest month of the quarter.
- Family Dollar SSS decreased 0.4% against the most difficult comparison of the year of 1.5%. August and September were slightly negative continuing the negative trend from July, but improved to slightly positive in October.
- Consumables, snacks, beverage, and candy were strong categories for both banners. Halloween seasonal was a strength for Dollar Tree, but not for Family Dollar which could use that seasonal merchandising expertise.
Gross margin trends highlight the difference between banners
- Company-wide gross margins contracted 110bps. Sequentially gross margins worsened by 40bps YY, but on a two-year basis were flattish.
- Dollar Tree gross margins contracted 30bps. Higher DC payroll costs and shrink were the primary causes. Increases in freight costs were offset by improved markdowns and mix benefit from sales of snacks, candy, and Halloween seasonal items. There aren’t that many companies that were able to offset higher freight costs in Q3 like the Dollar Tree banner did. The fact that Dollar Tree can largely offset industry pressures without being able to raise prices is why I consider the concept and management team to be best in class. Unfortunately the high praise does not extend to the other part of the corporate enterprise.
- Family Dollar gross margins contracted 220bps. The detractors to gross margin were myriad including 1) 60bps of higher merchandise costs including freight, 2) 11bps of hurricane impact, 3) 50bps of higher markdowns, 4) 10bps of damaged inventory, 5) 40bps of higher shrink, 6) 40bps of higher DC payroll costs, 7) 30bps of occupancy deleverage. Very few of the Family Dollar headwinds appear to be one-time in nature so the contraction in gross margins will likely continue in 2019. Inventory psf increased 5.4% at Family Dollar stores which suggests future markdowns will remain a headwind.
- Reviewing the headwinds and tailwinds to gross margins for the two banners would lead one to believe they compete in two entirely different industries. There are significant differences in how the banners come to market, but after four years of integration (or lack thereof) there should be more similarities this quarter.
SG&A upside makes for a lower quality beat
- SG&A leveraged for the first time this year. SG&A leveraged 15bps with Dollar Tree leveraging 10bps and Family Dollar leveraging 20bps.
- My inference is that corporate costs and bonuses were cut in order for EPS to come in line with guidance. Incentive compensation was lower at the Dollar Tree banner in Q3. Dollar Tree’s results were not substantially different than the first half of the year and lower incentive compensation was not mentioned in either quarter. Without knowing internal goals I can not say definitively that Dollar Tree employees will see lower bonuses due to the struggles at Family Dollar, but indisputably the lower stock price is having an even larger impact on management’s compensation.
- The C suite seems to have pursued an integration process that has the least distraction on Dollar Tree employees, but that is impossible to do entirely. Arguably by not involving more Dollar Tree employees in making changes at Family Dollar it has led to a worse outcome for both sets of employees.
Store remodels shouldn’t be first
- I think a large capital program to invest in store remodels is premature. Family Dollar has not made a lot of changes to its operations since the acquisition. More accurately the changes have not been executed at the store level (which DLTR management has now learned are two entirely different concepts).
- It has been five years since the announcement of the acquisition and we will see the first tangible sign of integration with the consolidation of support functions in Fall 2019. I wonder if management is accelerating the remodel plan in order to appease investors or deter potential activist investors.
- I think the larger decisions over merchandising, systems, and real estate need to be made before investing $125mm in capital to fix up stores. The timing of accelerating store renovations now sounds like a plan from the old Family Dollar management. Management intimated that another 1,000 stores may be renovated in 2020. It’s imperative that an activist investor act soon in order to pause this capital outlay.
- Dollar General is seeing success with its remodel program, but it had already made improvements to its distribution and operations. Until Family Dollar upgrades its merchandising and store management it does not have all the information it needs to determine which real estate requires remodels and which requires relocations or closures.
What’s wrong is written in the (Hallmark) cards
The recent collaboration with Hallmark is an example of what Dollar Tree does so well – merchandising and creating compelling value for its customers. That Dollar Tree was able to offer a disruptive bargain with a very well-known brand in an important category for its customers is an example of why investors think so highly of the management team. On the other hand there was nothing similar for Family Dollar. Merchandising can drive reasons for shopping visits (traffic) and Family Dollar is in desperate need of a similar initiative from its buying team. Failing to leverage Dollar Tree’s best in class buying organization is probably the biggest disappointment from the integration thus far.
