Biolsi putting back on the buy-side hat.
I’m putting on my buy side hat (that I wore for 14 years) here on DLTR. The reality is that the dynamics around change-agents at this company just changed. In several ways management took steps to de-risk the stock. A distracting and costly proxy contest has likely been side-stepped with management effectively refuting one plank of the activist campaign (selling FDO) and seemingly adopting the other plank (breaking the buck) in what seems to be a genuine good faith effort. Management is headed down the path of the greatest value creation opportunity as we outlined in our original black book, breaking the buck and fixing FDO, which we think puts a $230 stock in play. Selling FDO was part of the easiest path for an activist, but not the way to create the most upside. Softening the tone around not breaking above a $1 price point was the key factor we were looking for heading into this print – and that’s exactly what we got. The myriad of initiatives outlined require some time in order for the cumulative number of store updates to reach a critical mass where overall results are impacted. In other words management has time to show progress. With EPS guidance set so low a meaningful quarterly miss has likely been avoided while upside has likely been set-up. Since guidance was set so low for inventory clearances and costs to implement the store renovations a margin miss is much less likely. So the only way for DLTR to really disappoint investors is if Family Dollar comps hit a wall and comp down meaningfully as a near term acceleration is not expected. Otherwise it is difficult to see what would realistically disappoint shareholders from here. Being a dollar store, shares of DLTR are unlikely to sell-off if the outlook for consumer spending weakens. Of course if Dollar Tree had a comp miss that would be disappointing, but that is the bet I am very willing to make.
For our latest black book on DLTR: CLICK HERE
The print
- Dollar Tree reported Q4 EPS of $1.93 vs. consensus of $1.92 and my $1.94 estimate.
- Dollar Tree banner SSS increased 3.2%.
- Family Dollar banner SSS increased 1.4%.
- Gross margins contracted 90bps at Dollar Tree and 260bps at Family Dollar. At Dollar Tree the pressure was from lapping the extra week plus higher freight costs. At Family Dollar the pressure was from markdowns, higher freight, and lapping the extra week.
- EBIT margins contracted 200bps due to the 260bps decline at Family Dollar and 80bps decline at Dollar Tree.
- Inventory was higher due to the timing of tariffs. At Dollar Tree inventory psf increased 5.8% while at Family Dollar it increased 10.8%.
Guidance
- Management set a low bar with 2019 EPS guidance of $4.85-5.25 vs. consensus of $5.78. Management’s guidance includes $.31 of costs from store support center consolidation, incremental initiative costs based on project count and velocity, and store closure costs. The $95mm of costs are likely to be excluded from adjusted EPS. So the adjusted EPS guidance is $5.16-5.56.
- Management’s plan also includes the tariffs on Chinese imports increasing to 25%. If the tariffs are not increased it “provides opportunity for margin improvements.”
- Management said the potential tariff impact for 2019 for Dollar Tree is $100mm while at Family Dollar is it $40mm. That equates to $.45 per share, but Dollar Tree would have mitigated the tariff impact through merchandising, sourcing, planning changes, and pricing at Family Dollar.
Family Dollar is staying
- Dollar Tree a couple of weeks earlier spoke through Yahoo Finance (which was weird) that it would not look to sell Family Dollar. Today management provided an integration update that was meant to suggest it is too difficult to separate the two companies now. “Nearly all systems, functions, and departments… have been substantially integrated with the primary exceptions of merchandising, store operations, and loss prevention.” That has resulted in annual savings of $50mm with another $15mm once the HQ is consolidated. I’m OK with this.
- Family Dollar will close 390 more stores this year, re-banner 200 to Dollar Tree, renovate 1,000 stores (catch up on deferred capex), stock beer in 1,000 more stores, and expand coolers and freezers in another 400 stores. If management is correct/telling the truth about a store renovation adding 10% comp lift the lift to the entire chain would be ~120bps. The other initiatives could add another 100bps to the comp.
- If Family Dollar can add two percentage points to its comp next year and report 3-4% SSS increases it should be able to leverage expenses. With the consolidation of the HQ only four months away management would like to move past the talk of selling Family Dollar citing all the lost synergies that would result.
- The God’s honest truth is that if I had a 3-5-year duration, I’d want to see this team actually fix FDO instead of divest it at a loss. That puts another $2-$3 per share in earnings within reach. It’d be painful, capital intensive, and downright nasty from a competitive perspective, but there is more upside over a tail duration.
Breaking the buck
- Management sang a different tune when it came to introducing price points above $1 at Dollar Tree. Today management said, “Our customers are very loyal to what Dollar Tree represents. We all know that. It’s a brand. It’s not just price and item.” Contrast to a comment made on a previous call in 4Q 2016, “I will tell you this, At Dollar Tree we are – for 30 years we’ve been $1. You talk about the price point.”
- We estimate Dollar Tree can add another $2-3 per share in EPS from adding multiple price points. It represents the largest EPS opportunity for the company with the lowest associated risk. Management has to be careful how value is conveyed with price points above $1, but I am confident that this management team is hyper focused on customers’ perception of a higher price point.
- Management said that Dollar Tree $1 merchandise in rural Family Dollar stores seemed to have the greatest impact. Rural markets generally do not support a Dollar Tree store with a greater amount of discretionary merchandise, but a smaller assortment within a Family Dollar seems to be very appealing. I don’t have full confidence in how committed management will be to a true multi price point test, but they sounded like a complete reversal on the call. I rely on Starboard to make sure there are significant resources behind the test. With Family Dollar staying in the fray, you can bet that Starboard will be religious as it relates to staying on top of the ‘buck breaking’ initiative.
Proxy battle avoided?
- Dollar Tree also announced the appointment of Carrie Wheeler to the board. She retired from TPG where she was a partner and head of consumer and retail large cap private equity efforts. She is currently a board member of J. Crew and was previously on the board of Neiman Marcus and PETCO.
- So in the past year three directors with private equity experience/expertise have been added. It would be hard to argue that the board does not have transactional expertise.
- The next move is Starboard’s to make. My guess is that it would accept 1-2 board seats with potentially a board committee to oversee the multi-price point strategy. Starboard may feel the integration, renovations, and multi price point test are all in good hands and a proxy battle could be avoided for now.
Store renovations more than deferred capex
- Management said the H2 store model is seeing a 13% comp lift or 10% above the control base. More coolers and freezers, more productive end caps, more beer, better adjacencies, and Dollar Tree $1 merchandise are all driving an improvement.
- As we highlighted in our store checks there remains a lot of low hanging fruit from store merchandising and layout improvements.
- Store level management and execution is arguably more important which leaves further improvement on the table. Integrating the HQ may facilitate progress with Family Dollar’s operations. It certainly shouldn’t hurt for Family Dollar operations to see up close how Dollar Tree executes in the store.
