A Moat Downgrade for Dollar Tree

Zain Akbari: We believe that Dollar Tree and Dollar General should continue to benefit from their value-oriented, convenient positioning even in an increasingly digital retail landscape. However, we contend that while Dollar General's portfolio of advantaged locations and favorable cost standing are worthy of a narrow economic moat rating, we now reach a different conclusion for Dollar Tree, a reflection of its troubled Family Dollar unit.

While its namesake banner has advantages borne of its differentiated, everything-for-a-dollar format, we believe that Family Dollar competes for an especially price-sensitive consumer in areas with more competitive alternatives than Dollar General's more rural and small-town focused store network. While we expect Family Dollar's performance to improve as Dollar Tree's management team continues to integrate the two chains' supply chain and distribution capabilities as well as their corporate functions, we do not anticipate the unit's adjusted operating margin will rise much further than the mid-single-digits, only a little above its 4% two-year average. As a result, we now assign a no-moat rating to Dollar Tree.

We believe investors should monitor both retailers for buying opportunities, particularly as investors' justified fears of Amazon's rapid rise in the broader retail sector may lead to an underappreciation of the dollar stores' protections against such competition, particularly the difficulty in absorbing or passing on shipping costs for relatively small orders of low-priced merchandise and lower income consumers' lack of Amazon Prime memberships or even access to a credit card. Although shares of both retailers currently trade near our fair value estimates, we suggest investors pay particular attention to Dollar General as its competitive advantages and lack of a turnaround story should allow it to embrace the changing retail dynamic, as seen in its recent investments in its mobile app and moves to test scan-and-go, cashier-less payment.