Even as Competitive Pressures Rise, Dollar Tree Keeps Its Edge

The benefits of the Family Dollar acquisition span both cost and revenue synergies. For one, management targets achieving $300 million of annual run-rate synergies by July 2018, which strikes us as reasonable. Although, we don't anticipate the entirety of these savings will fall to the bottom line, but rather will be utilized to lower prices as a means to drive traffic and offset intense competition. But not only can the firm extract cost synergies from better procurement and SG&A efficiencies, we portend the combined business stands to produce revenue synergies by re-bannering existing stores and opening units that more effectively cater to the surrounding demographics. Given the Dollar Tree banner serves mostly middle-Americans in suburban locations with $1 price points, and Family Dollar serves urban and rural customers that maintain low incomes at many price points, we think the consolidated firm can target a broader range of customers and geographies.

Since the deal was inked, the firm has focused its attention on integrating and re-bannering existing locations at the expense of unit growth (which slowed to 4% from 7%, lagging the mid- to high-single-digits of its closest dollar store rival,

Intangible Assets, Cost Advantage Garner Narrow Moat

We believe Dollar Tree has garnered a narrow moat consisting of intangible assets and a cost advantage, which we believe will support returns on invested capital above its cost of capital over the next 10 years. The company blends value and convenience, which is advantageous to its consumers, who are often time-starved and lower-income. Consumers are increasingly viewing dollar stores as an occasional mass-merchant substitute, in line with our stance that the firm's convenient locations and experience are valued in the eyes of consumers. And given the Dollar Tree banner's more suburban locations and its consumer base (which consists of more middle-income consumers), we believe that it stands to benefit from this trend to a greater extent than its peers (including Dollar General, with its rural locations and greater exposure to low-income consumers). Clientele also prefer smaller products that often come with lower absolute prices, typically under $10, enabling the firm to charge a higher average mark-up (between 35% and 45% versus the low teens to high 20s that we estimate Wal-Mart and

However, we believe the firm's competitive edge also reflects a cost advantage, stemming from its ability to procure merchandise at attractive levels, operate with low-cost unit economics, and secure a distribution edge in its clustering of stores with other merchants. Family Dollar, which was acquired in July 2015, has helped to bolster the company's cost advantage by doubling its size, which brings more bargaining power to the table when procuring merchandise. Its minimal 7,000-8,000 stock-keeping units allow the company, a leading player in the dollar store space with around $21 billion in sales, to concentrate these sales and extract better terms than smaller rivals. Also, we surmise that its minimal SKU count--which is far below the more than 120,000 Wal-Mart stocks--simplifies operations and can indirectly improve its cost structure by reducing costly missteps.

Units are very economical for the dollar stores when considering the minimal employee needs, below average rent, and--more specific to Dollar Tree--lower distribution costs as stores are typically clustered with other merchants in suburban areas. Each store has one general manager with three to five other employees varying by demand in season; this compares with Wal-Mart and other larger merchants staffing 50 or more team members at one time. To operate these stores, we calculate Dollar Tree pays an average rent of $11 a square foot, below that of typical retailers paying $15-$20 a square foot. In aggregate the firm's cost edge is supported by its below average operating costs (excluding depreciation) per square foot, which amounts to just $36, lagging that of Wal-Mart and Target at $78 and $56, respectively. Even if we were to adjust for the firm's below average rents and assume rent per square foot aligns with its peers, we estimate its operating expense per square foot would approximate $40--still below that of its mass-merchant rivals.

A combination of these aforementioned factors has enabled Dollar Tree to generate returns on invested capital above its cost of capital over the previous five years, supporting our narrow-moat rating. The acquisition of Family Dollar has driven ROICs to 9% from 16% previously, still marginally above its cost of capital but nonetheless, lower. It is our belief that returns will continue to improve gradually but will remain permanently lower than historical periods since the lower-margin Family Dollar banner was added to its mix, as we model ROICs averaging just 10% over the next five years--creating economic profits over its 8% cost of capital.

We Lowered Dollar Tree's FVE When Amazon Entered Food Chain We are lowering our fair value estimate to $90 from $92 after the news that Amazon intends to purchase Whole Foods, which we believe could bring incremental margin pressure to the company. With this update, our new fair value implies a forward fiscal 2017 price/earnings ratio of 21, enterprise value/EBITDA ratio of 11 times, and a free cash flow yield of 4%. Longer term, we anticipate mid-single-digit annual sales growth and 100 basis points of operating margin expansion to just north of 9%. Our valuation also incorporates our expectations for lower effective tax rates due to corporate tax reform in the U.S., resulting in a reduction of Dollar Tree's tax rate to around 27% from 37% historically. In July 2015, Dollar Tree acquired another leading dollar store operator--Family Dollar--which doubled its store footprint. Given the time and energy associated with this deal, the company has opted to slow its unit growth down (from 7% previously to around 4%) and focus its resources on the integration. We model average top-line growth of 5% over our 10-year forecast period, driven by 3.4% unit growth and 2.0% comparable same-store growth. Given the vast divergence in operating margins, 13% at Dollar Tree and just 4% at Family Dollar, consolidated margins dipped 550 basis points in fiscal 2015, to 7.0%, but we anticipate that efforts to extract costs and leverage its more substantial scale should enable profitability to rebound to more than 9% over our forecast period. While we expect that intense competitive pressures stand to eat into gross margins (which we forecast to remain compressed at around 31% over our explicit forecast, down from 35% prior to the deal but in line with fiscal 2016), we assume 50 basis points of operating margin improvement will come from better procurement and efficiencies within the Dollar Tree banner and almost 300 basis points (above the nearly 4% generated in fiscal 2016) from the Family Dollar banner--arriving at our 9% operating margin assumption. In this vein, management believes $300 million in annual run-rate synergies can be extracted from the tie up through better procurement, distribution, format optimization, and SG&A efficiencies, which we view as reasonable.