Let’s be up front and transparent – this is clearly not the result we were expecting out of DLTR’s 3Q. I don’t know if I’m more miffed or more humbled by the result. Both options stink. Comps were broadly in-line, but the company missed by a nickel, and printed absolute EPS down 10.7% on a 2.9% comp. Is that enough to send the stock down 15%? Probably not as results were technically within guidance range. It’s more about the 4Q guide, which was down by 10% due to higher costs at both banners – including freight, mix, DC expenses and tariffs. These costs might be transitory, but from a modeling perspective we have to assume some pressures remain.
One thing is abundantly clear to me, and it's that there is ZERO reason to own this stock without a successful ‘break the buck’ strategy at Dollar Tree. Fortunately, management was clearly committed to the moving the test forward on the conference call and getting bigger in multi-price points. The higher costs associated with the guide alone speak to the need for higher prices in the stores. Inflation is a $1 store’s enemy, and inflation is definitely back. Is a system-wide roll-out in the cards for 2020? Probably not – though we’d expect the test to at least reach 500 stores (currently at 115 stores). But we do think that it happens in 2021. Simply put, the company won’t screw this up and will take the time to ensure success. If it goes poorly, you definitely don’t want to be the CEO that oversaw the strategy change away from a successful 30-year selling paradigm. There’s zero room for failure, which is why I think it will take time for this to play out. Our 2021 estimates are 14% above consensus, which assumes an incremental $0.75 per share in sales and gross margin benefits from higher price points and a superior value proposition inside the store while protecting one of the more defendable brands in retail today.
The other half of the business – Family Dollar – was hardly overwhelming. Margins at Family Dollar are on track to contract 100bps in 2019 despite a ~2% comp lift. But the upside from fixing this business over a TAIL duration is just as meaningful as breaking the buck at Tree. Keep in mind that in five years since buying the FDO asset, DLTR has seemingly done nothing to it. Then all of a sudden this year we’re seeing it make up for years of sitting down by doing the following all within a nine month time period – a) expanding alcohol to 500 stores in 2019, b) re-bannering 200 stores to Dollar Tree, c) closing 420 stores, d) converting over 1,200 stores to the H2 renovated store format, and e) expanding the merchandising of $1 items. It’s almost like the integration of Family Dollar started in 2019, four years after the deal closed.
At $95, we’re back to a point where you’re getting the Family Dollar asset for about ~$15 per share, and there is nothing baked into valuation for success in selling multiple price points at Tree. In other words, it assumes failure on both sides of the house. Realistically you only need one of these to play out successfully to make this a solid stock at current levels, and with both it is an outright home run. We’re banking on the buck break, and hoping for the FDO trunaround. But either way, there’s far more upside than downside over a TAIL duration, and the company just de-risked 4Q with a nice little sandbag. We'd be buying into the hate-selling.
