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Takeaway: I liked the progress at both Tree and FDO this quarter – should accelerate into 2H. Best Idea Long.

Though the absolute earnings algorithm was a solid ‘meh,’ I like what I saw and what I heard out of this DLTR event. While comps missed slightly at the Dollar Tree Banner, the company is being more proactive on rolling out the multi-price point test than I’d have expected at this stage in the game. Interesting to see it's going as high as $5 in certain categories (if you own Five Below – you don’t want to see this). Management’s tone on the conference call sounded like this test is the real deal – not like it was strong armed by activists and bitter shareholders. I’m confident that once the merchandising organizations are merged under the same HQ this fall, the benefit of the test will become more apparent and accretive to comps and margins. Without a successful go at this initiative, there’s no fundamental reason to own this stock if you’re looking for big upside. But to that end, Family Dollar beat comps. Yes, you heard that right. It put up a +1.9%, and while under-comping Dollar General’s 3.8% level, this was the best stack we saw out of FDO since the deal was consummated over four years ago. Store remodels appear to be working for comps, but are they the right fix for the long term business vs improved merchandising and management? I’ll take both…These two initiatives – turning Tree into a multi-price point retailer and fixing FDO – are each worth $2-$3 per share in EPS. There’s a double from the current earnings run rate. This story is going to take time and patience to play out, but today’s report was a meaningful step forward to unlocking one of the biggest value disconnects that exists in retail today. DLTR remains on our Best Idea List as a Long.

-McGough

OVERVIEW OF THE QUARTER – DANIEL BIOLSI

An inline Q, but some underlying changes

  • Dollar Tree reported Q1 EPS of $1.14 in-line with consensus and at the high end of $1.05-1.15 guidance. 
  • SSS at the Dollar Tree banner decelerated to 2.5% while Family Dollar accelerated to 1.9% even with a SNAP pull forward into the prior quarter.
  • Gross margins contracted 75bps with flat results at Dollar Tree being offset by Family Dollar. Family Dollar was negatively impacted by higher merchandise costs, freight, shrink, distribution and occupancy costs.
  • SG&A costs deleveraged 40bps mostly due to higher payroll costs at both banners.
  • Operating margins for the Dollar Tree banner contracted 20bps YY, stabilizing after contracting in 2018 from a combination of higher wages and freight costs.
  • Operating margins for the Family Dollar banner continue to be under pressure as it contracted 200bps from a litany of higher costs.
  • Inventory was up a tightly managed 2.4%. 


Breaking the Buck test

  • Management provided much more detail around the higher price point test. Dollar Tree reminded us that the company learns through testing and that is where the plans to accelerate store remodels came from.
  • In 100 stores across the country Dollar Tree has rolled out four foot or end cap sections of “Dollar Tree Plus!” merchandise. The sections are clearly marked with in-store signage and the items have price tags with $2, 3, 4 and $5 (whole dollar) prices.
  • The test serves a legitimate long term purpose whether or not management wants to introduce price points above a dollar in the near term. Management demonstrated that the ‘Dollar Tree Plus!’ test is being taken as a sincere best effort and not just to assuage an activist investor.
  • We are not overly fond that the merchandise so far featured in the Dollar Tree Plus! tests looks very much like Family Dollar merchandise, but that only makes sense given the speed that the test was rolled out. Many of the items we have seen are name brand items that are not often found in Dollar Tree, but would not be out of place in Family Dollar. Some of the items are at compelling price points at or below the lowest priced competition while others hardly seem low priced or cheaper than other discounters. The upside of such a large test is management will be able to learn a lot in a short period of time about what works and where.
  • We do like management stressing that the new price points are not price increases on existing items. That is very important, so is messaging that to customers. The Plus items should scream value, but because of the >$1 price points they could not be in the store earlier.
  • We also like that there is no time period defined for the test.  The important thing to remember is that this is a test. How management evolves the test will determine the future of higher price points in Dollar Tree. With more time merchants should find branded close outs, source more private label goods, and shrink more package sizes to lower prices to make the Plus! offering more compelling. A whole-hearted test will take more than 6-12 months and will evolve.

 

Progress at Family Dollar

Family Dollar reported the strongest comp increase since the company provided the banner level comp despite the headwind from SNAP pull forward into Q4. Management is clearly pleased with the results so far from the store remodels.

The store remodels increase the square footage of the better performing categories of refrigerated goods, $1 items, and seasonal. The stores are also adding refrigerated drinks as well as alcoholic beverages, both traffic drivers. Seeding 21 sections of the Family Dollar store with Dollar Tree like items is giving the adjacencies an overall halo of effect of compelling value. “It's not just the dollar sections alone, but we get better penetration in some categories than we have seen in our traditional format, so very excited about that.” The Dollar Tree items are also not planogrammed. Corporate empowers a store employee to manage the items and the faster velocity. That's one of the most important elements of fixing FDO, IMO.

Dollar Tree’s best in class merchandising was always one of the more compelling reasons for the companies to merge in the first place and the changes are finally starting to happen four years later. I think we will see even more progress when the HQ is combined later this year.

The strength across regions and product categories confirms that there are process improvements in the chain. Family Dollar is early in a turnaround, but it is promising to see the sales acceleration first as the brand’s largest area for improvement is sales productivity.

Buy into tariffs fears

Shares of DLTR have pulled back about 14% since the Trump administration started threatening increasing the tariff rate to 25% on lists 1-3 in early May. Shares of Dollar General pulled back less than half as much despite having similar long term impact from the tariffs. Investors still fear an impact multiple times greater than the $12mm impact the company incurred from the ribbon duty.  We continue to believe Dollar Tree’s best in class merchants would be able to offset most of the tariffs through changes in merchandising and sourcing. A roll-out of multi-price points would be the best tool to offset the tariffs.  Though what it would do is broaden the product availability more so than simply be used to raise price to offset higher costs. If items can be sourced cheaper outside China Dollar Tree will go there, so the company will not simply raise prices for tariffs. I expect the company to demonstrate its ability to offset the tariffs this year and would be buying into investors’ fear of additional tariffs.


Changes to our model

Our estimates are remaining about the same at $5.40 for 2019 while including more of a headwind on freight costs offset by better occupancy leverage from store closures. We had contemplated a staged multi price point roll-out over the course of many years like Dollarama has implemented. If Dollar Tree rolled out its current Dollar Tree Plus sections across the chain we would see the sales and margin benefit in a more compressed time-frame. Merchants would no doubt improve the Plus! offering over time, but the largest comp benefit would likely come in the first two years.