Prepared by Stephanie, analyst at team BAD BEAT Investing
Dollar Tree (DLTR) is a favorite of traders at BAD BEAT Investing, a name that swings higher and lower. Our community has leveraged the swings to profit on the long and short side, though the turnaround in markets has been sharp and fast. The COVID-19 crisis has created new winners and losers mostly as a result of huge shifts in consumer spending patterns and expectations, in conjunction with government-mandated shutdowns. That said, we have been watching the company for a while to see how it was doing during COVID-19. Besides the reliable trades that can be made, this is a great long-term holding. Well, we are once again eyeing this name again and think it is heading back over $100. Make no mistake, there are still some reasons to be cautious, but we think that on any pullback shares are a good buy. Shares at $90 are attractive if you can get them there. Let us discuss.
Holding up well
We see an opportunity in Dollar Tree longer term, though there is of course a lot of competition. The company held up well during this COVID-19 crisis. WE will talk about this more in a moment but Dollar Tree had a 7.1% comp increase for the first eight weeks of Q1, but was beginning to see a material drop-off due to traffic and the initial shelter-in-place as we approached Easter. In March, seemingly overnight, there was a hyper focus on stocking up consumables. As concern spread, schools, church services, weddings, and parties were canceled and widespread stay-at-home orders were mandated.
While the company saw a material decline in demand for many of the seasonal and discretionary products related to celebrations and large gatherings, it saw huge demand for cleaning supplies, food, paper products, etc. This was similar to other retailers, but the cost pricing in a downturn made Dollar Tree look attractive.
Make no mistake, Dollar Tree is in a highly competitive segment of retail, and we do expect competition to ramp up in the future. It did well in COVID-19, but as things normalize, we have to be thinking of competition. This is not just because of other major discount chains, but also because of online retailers selling discounted items, as well as many local dollar stores. Competition from direct physical locations will be felt on the pricing end for similar items as well as the all-important battle for location. Big box stores and convenience stores also offer sources of competition. However, shares are attractive relative to performance and future expectations.
Fundamental discussion and value
Dollar Tree shares currently trade at just 0.97 times sales, which is still below the average 1.07 times sales seen in the last 5 years, and this remains well below the average seen in the last decade that is over 1.2 times sales. In addition, the name is favorably priced on several basic valuation metrics relative to years past:
Dollar Tree boasts a multiple of 28 times trailing earnings which is historically fair, but is only 21 times adjusted trailing earnings which is cheaper than we have seen historically. If we look on a forward basis, we expect $5.00-$5.30 in earnings for fiscal 2020, which puts shares at only about 19 times those estimates, which is also rather attractive for the name, historically.
The name is also way below its usual price-to-cash flow metric, and below that of the index, and is also discounted on a price-to-book basis. This is undervalued in our opinion, and would be even more so if shares were to pull back.
The company beat our sales expectations for an even $6 Billion by $290 million. They also beat consensus expectations by $144 million. We think sales were strong as they rose 8.2% to $6.29 billion from $5.81 billion last year. We see this as very positive growth. We do know the company reduced its store base as part of its optimization plan to get Family Dollar up and running again, and was operating under reduced hours in late March and April. As such, we want to look at the performance of existing shops to get a sense of strength.
When it comes to retail, we like to look at same-store sales. We think for the most part there was good news on this front. As a whole, same-store sales increased 7%. Same-store sales for the Dollar Tree-branded shops fell 0.9%, which was about what we expected, but Family Dollar did incredibly well. Sales have been positive at Family Dollar and are no longer dragging down performance. Same-store sales for Family Dollar stores were also up 15.5%. The combination of the party category and Easter seasonal product negatively impacted Dollar Tree’s Q1 comps by approximately 490 basis points. For the quarter, the consumables delivered a positive 9% comp, and the discretionary side of the business was down nearly 9%
Thanks to costs rising however, they offset the rising sales a bit, with gross profit rising to $1.79 billion in the quarter, a 3.9% improvement from a year ago. The astute investor may note that as a percent of sales, gross margin took a hit. They decreased to 28.5% compared to 29.7% last year. The decrease in gross margin was driven by merchandise mix, incremental tariffs of $23 million, markdowns related to Easter merchandise, and higher distribution center payroll costs, partially offset by leverage on occupancy costs from stronger same-store sales. At the same time, selling and administrative expenses were 22.70% of sales compared to 23.1% of sales last year. Much of that was due to lower corporate and occupancy costs. Putting it all together, we saw operating income decline a touch.
Operating income fell to $365.9 million compared with $385.5 million in the same period last year and operating income margin was 5.8% versus 6.6% of sales last year. As a result, earnings were pressed, but better than expected. Net income was down $248 million with earnings per share of $1.04 compared to $1.12 last year. This result was above our expectations for $0.90, and was a $0.20 beat versus consensus.
When we look at the quarter as a whole, we are pretty bullish. The stock has rallied off the bottom but that is because of market strength. We were not buyers until we had data to support the action. It was unclear if DLTR would be a winner or loser in the COVID-19 sales battle. We knew Amazon (NASDAQ:AMZN), Target (NYSE:TGT) and Walmart (NYSE:WMT) would be, but were unsure here. Overall, we were impressed. The company pulled guidance, but we are maintaining our expectation for $5.00-$5.30 for EPS in the year, with positive comps and sales growth in the single digits.
We love the company’s store optimization plan. You really cannot go a few miles without seeing one of the company’s properties, at least here in New York. While comp sales are doing well for the most part, in the tight space that is low-end retail, we wanted the company to be aggressive in shuttering losing operations. While the optimization plan took into account much of this, the COVID-19 pressures have led to spending changes. Changes to the planned capital expenditure plan have led to the planned opening of 500 new stores this year compared to the original plan of 550. These will be comprised of 325 Dollar Tree and 175 Family Dollar, which includes a reduction of 25 planned stores for each brand. Due to the COVID-19-related suspension of its renovation program, management is planning 750 Family Dollars being moved to the so-called H2 format for fiscal 2020 compared to its original plan of 1,250.
We are happy to see the company being much more aggressive in property planning and management. During the quarter, the company opened 99 new stores, expanded or relocated 21 stores, and closed 14 stores. Additionally, the company completed 220 renovations to the Family Dollar H2 format. This reduction and reorganizing is very positive news in the long term. This is evidenced by same-store sales at Family Dollar now being positive.
The company is closing losing operations and we are impressed with comp growth. The valuation is discounted, and would be especially attractive if shares could be acquired under $90. Dollar Tree has now delivered 47 consecutive quarters of positive same-store sales, and nine consecutive quarters with two-year stacked comps exceeding 6%. While COVID-19 has changed the outlook for the mix of sales, it has improved the outlook in other product areas. On a pullback, we think you can comfortably get long. In our opinion, this retailer is a winner in the COVID-19 landscape.
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Disclosure: I am/we are long DLTR. 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.