Chit Chat Stocks - Dollar Tree (Ticker: DLTR) Not So Deep Dive

Episode Date: October 17, 2023

Dollar Tree, Inc. (DLTR) is a well-known discount retail chain offering a variety of products at the one-dollar price point, serving budget-conscious shoppers across its vast network of stores, although it contends with challenges posed by competition in the retail industry. Listen closely as Brett and Ryan go through the history, financials, and future prospects of DLTR. Enjoy the show! ****************************** Chit Chat Money is presented by Interactive Brokers. Switch to the best brokerage in investing today: ibkr.com/info ***************************** Subscribe to our Substack to receive free show notes and charts that go along with every episode: https://chitchatmoney.substack.com/ Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Contact us: [e-mail] Timestamps Company Background | (4:44) Industry | (23:09) Management & Ownership | (27:58) Earnings | (33:10) Balance Sheet | (36:52) Valuation | (39:09) Our Analysis | (41:18) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

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Welcome to Chit Chat Money. On this show, hosts Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guest is not formal advice or recommendation. Now, please enjoy this episode. Welcome into Chit Chat Money. My name is Brett Schaefer, and I am joined by my co-host, Ryan Henderson. Today is our Tuesday not-so-deep-dive episode where we analyze one

stock going through its business model, ownership, financials, future growth opportunities, and more After listening to this episode, we hope you get a better perspective on the company. If you are new or haven't signed up for our free newsletter that goes along with each episode on our Tuesday Not So Deep Dives, we would recommend signing up for that. The link is in the show notes, and it will give you all our actual notes that we're doing for this episode. We'll have a lot of charts in there. We'll have a lot of comparisons, a lot of links for further reading, and it is free.

So it's going to come out Tuesday, the same time that this podcast is coming out, go sign up, it's through Substack. And today we're talking Dollar Tree, which owns both Dollar Tree and Family Dollar. We're continuing on the discount retailer slash dollar store theme. Last week, we covered Dollar General. If you didn't listen to that, and you're listening to this episode, I'd recommend listening to that one as well. But a little context here, as we get into the episode, last week, when we talked about

Dollar General, we were a little, let's say, pessimistic or worried about the management team. And that was some interesting timing because a week later, Dollar General decided to fire their CEO and bring back the person that was the CEO from, I believe, 2016 to 2021 or early 2022 so ryan i guess for anyone that listened to the dollar general episode they're probably interested in our thoughts there what do you think about dollar general's move that seems i don't know i guess it seems interesting just in that they they brought back the ceo who was already there it kind of feels like disney where they

it wasn't really the new CEO's fault, I guess. I don't think the new management team was there long enough to have this horrible impact on the business. I think a lot of these problems were lingering and would have been there no matter who was in charge. But from the board's perspective, they probably just felt like a change needed to be made and there wasn't as much confidence from the investor community. So bringing back VASOs, maybe it, I mean, it seemed to instill belief because the stock was up 8% the day of,

and then I think it came back a little bit, but I would be surprised if it had that big, if it made that big of a difference, but I could be wrong. I don't know. It felt like a lot of the problems weren't necessarily linked to bad management decisions. Right. We didn't like this new management team and basically the way they talked about their

strategy and a bunch of platitudes. However, they probably got an unfair shake here where it's just a few quarters of bad stuff that was outside of their control. But let's move on. We're covering not Dollar General today, but their biggest competitor or their biggest direct competitor, Dollar Tree. And Ryan, I'll let you go through the history here and what the business does because they have interesting roots and basically how they combined with Family Dollar is going to give some good context for the listeners today. Yeah. I'm going to start with the history this time. For those of you that regularly listen to the show, it usually goes with the business model and then the history, but there's some important context that you can get from the history here.

So I figure it's a better place to start. So Dollar Tree's roots really date back to the 1950s, there was a gentleman named K.R. Perry who opened a Ben Franklin variety store in Norfolk, Virginia. I got to say, there's, well, I can only think of two right now, but there's a good list of entrepreneurs that started out as Ben Franklin operators and then moved out. Sam Walton's one, this K.R. Perry gentleman is one. I believe a lot of the discount retailers, like you can trace some part of their history back to a ben franklin variety store at some point but hey that's a good back test right there right yeah yeah it's interesting though it's interesting for sure yeah maybe it's just the longest standing variety store or whatever but he

this k.r perry gentleman would eventually rename the store k and k 5 and 10 and about two decades later, Perry and two others would expand the concept from this K&K brand by launching a new mall-based toy store concept. So it's called K&K Toys. That concept specifically was pretty successful. And I'll foreshadow here, the history is kind of sparse. There's changes that happen where it's not necessarily that clear why they happened, but basically they rebranded a couple times or just open new banner stores. And so the K&K toy store was successful, reached 130 stores, all mall-based. And then in 1986, they decided to launch a new banner called Only $1. And as you can imagine, everything in the store was only $1 or less. And they continued to grow basically both

of these banners simultaneously until about early 1990s. They sold the K&K toy stores to I don't know if it was, I think it's called KB Toys was the company. It was owned by a larger corporation. But from there, the focus was solely on the dollar stores. And the name was changed to Dollar Tree in 1993 with the idea that they may someday need to change to a multi-price strategy. Kind of interesting because we're going to talk about that here in a little bit. That's been a part of the evolution. I'm sure they could have done it. Maybe it would have been a little misleading to do that under the banner, only $1, but Dollar Tree has stuck since. And this was around the early 1990s. So two years later,

1995, under the Dollar Tree name, the company went public, valued at $225 million market cap. And once they went public, they started to... Really, they launched this aggressive growth strategy, which was both organic growth. So they were launching or opening 150 stores a year, but they were also acquiring other dollar store concepts all around the country. And typically it was cash offers. So they were taking on some debt to do it, but it was kind of like small bites over and over. And so they did this for, I'd say, 13 years as a public company. They were kind of taking these small bites, actually more like 20 years. By 2008, the company had surpassed 3,000 stores. They officially broke into the Fortune 500. It was quite a large store

or quite a large company at that time. But come 2015, they enter into a really transformative deal to buy Family Dollar for just over $9 billion in a mix of cash and stock. All the acquisitions prior to this, they were small. They were basically these bolt-on acquisitions, re-banner the stores, reformat them a little bit, make them Dollar Tree locations, try to get them and maybe a discount as opposed to launching that many stores organically, but this one was huge. At the time, Family Dollar had 8,200 locations and that was actually larger than Dollar Tree itself in terms of store locations. Family Dollar had actually received a higher bid from Dollar General. Interestingly enough, the CEO at that time during the bidding was Rick

Drayling, who we'll talk about, is the now CEO of Dollar Tree. They rejected the higher bid from Dollar General, went with Dollar Tree. And they've really, since that time, they've kind of failed to recognize the synergies that they originally claimed. And they've been pretty much unable to get operating margins up for the family dollar business. You can go back to the Value Investors Club write-up. Brett was mentioning this to me before the show. There's a 2017 write-up that talks about basically Dollar Tree's stable. Family dollars operating margins are going to grow. Operating margins are going to expand and both are going to grow comp store sales. It's been the same sort of thesis, I'd say, for the last seven years since the acquisition,

and it really hasn't materialized. However, I will say there's still hope. And a couple of things have happened in the last couple of years that are important to the thesis here. So for starters, under Mike Witinski's leadership, who was the previous CEO, Dollar Tree finally made the decision to, quote, break the buck. So most of the items in the Dollar Tree store used to be $1 or less. It was in the name, and that was kind of their roots back to the only dollar concept. However, when they broke the buck, they decided to raise those items to $1.25, which has really opened the door for other high-priced offerings as well. Also, we're going to talk about it here in a little bit. There's the Dollar Tree Plus concept, which has allowed them to kind of move into higher

price tiers. And then secondly, right after breaking the buck, they fired Ratinsky and brought in Rick Drayling, who was, I think, executive chairman at the time as the CEO. So the guy who, from 2008 to 2015, revitalized Dollar General, architected the modern Dollar General that we see today and tried to make a bid for Family Dollar is now at the helm managing Family Dollar, which is kind of in a similar situation to where Dollar General was in 2008. Anything else to add there, Brett?

What do you think about the raising to $1.25? Because they make this seem like a big deal, but I think they just lacked any sort of courage to do this because it clearly didn't have that big of an impact. and with inflation over the last few decades they were going to have to do it eventually so i i don't get it i think it's probably good that they did it but i don't i don't see why they made it such a big deal it's like yeah you're gonna have to do it eventually yeah either you either you trade down in terms of the items or assortment that you're offering to customers or you sell things for a loss which isn't sustainable so yeah they were just scared

Yeah. They felt very scared to do that. Yeah. Yeah, exactly. There was a lot of lash back from customers. So maybe that was the worry and they fired the CEO after, but it felt like they were like, someone's got to do it. Okay. The CEO did it. And then they're like, don't worry, we got rid of them, but we're keeping the $1.25. Yeah. And what's interesting is that now, whenever they need to raise prices due to inflation, they'll be able to without hopefully as much pushback. Yeah, agreed. Let's talk about who Dollar Tree is today. So Dollar Tree is, as an enterprise combined, it's one of the largest discount retailers in the US by store count. And like I said, like I kind of mentioned earlier, it's a combination of two banners. So Dollar Tree and Family Dollar. And then there's some Dollar Tree locations in Canada, but it's really quite small. But in total, the company has 16 and a half thousand stores, and it's basically a 50-50

split between Dollar Tree stores and Family Dollars. Let's talk about Dollar Tree first. So unlike Dollar General, who we looked at last week, Dollar Tree has more of an urban presence, and it's more focused on the treasure hunt style experience. So more than 50% of the items sold at Dollar Tree are discretionary things, stuff like toys, greeting cards, arts and craft supplies, where Dollar General is mostly consumables. So Dollar Tree is actually able to command higher gross margins than consumables-based businesses. So they have, I think last year, they had 37% gross margins. It's ranged kind of in the mid-30s. And so that's really allowed them to have ultimately higher operating margins, then you might think of Dollar General and Dollar Tree

and Family Dollar, all as similar concepts, but they're really not. Dollar Tree is offering very much a different experience. The stores are also a little larger. Okay, go ahead. I was going to say, for anyone confused, just think less food at Dollar Tree. That's kind of the little mental thing I like to think about. Yeah. It's almost more like a five below. i i'd say it feels like it competes more with the five below where it's kind of like yeah i mean it's less somewhat stuff you don't necessarily need yeah somewhat but they do have like five below doesn't have any food so some of the items are right you know i think half of them are at least consumables yeah so they still offer the food but it's just less food where family dollar

dollar general they're more of a convenience store family dollar as you just mentioned is more of a direct competitor to dollar general they are slightly smaller store formats than dollar tree and they operate primarily in suburban areas so um i think i think you might have got confused but yeah they said i think you might have got mixed up from the 10k because they said dollar tree is suburban and then family dollars urban rural but either way like there were a lot more rural i'll have a map for oh sorry sorry yeah yeah not i mean you just flipped it family family dollars more rural base yeah correct yeah yeah okay suburban was the wrong word there it's more rural areas smaller towns similar to the dollar general concept almost 80 of the items

sold in the stores are consumables which is very similar to dollar general and they generate significantly lower gross margins, 24% last year. And generally, it's been in the 20% range. They have really failed to consistently generate profits. It's hard to see why specifically there's this massive gap between them and Dollar General in terms of operating margins. Some of it may be on the supply chain side of things. So only 70% of family dollars merchandise are supplied by distribution centers owned by Dollar Tree. The rest is third-party distributors. Maybe that's more expensive than Dollar Tree's supply chain. They also, Dollar General, sorry, I'm mixing up Dollar Tree and Dollar General. Dollar

General has higher sales per square foot than family dollar. It seems like there's just been general mismanagement of family dollar over the years, or maybe a failure to really optimize the store base. But we can talk about that in a little bit. Unlike Dollar Tree, there's no promise of items being $1 or $1.25. It's simply cheap goods, typically in the range of $1 to $10. And like I mentioned, a little more food and consumables. But when you look at the two businesses. I thought maybe there'd be some synergies, but it's really two different models and they feel like they're serving two different needs. But they are doing some things to try to bridge the gap in terms of the two different styles. So they're opening things called

combo stores, which have you seen these Brett? I have, I saw at least a picture. I haven't seen him in person but they seem interesting because maybe we're the wrong we're not shopping at these places but i i don't know if these brands are that relevant we're like oh dollar tree i know exactly what that is oh family dollar know exactly what that is isn't it just people think okay it's a dollar store yeah it's a cheap it's a store with cheap items yeah it's kind of it feels like a weird concept to me but they said they've been getting good returns on it it's basically it's a store where it's got both banners outside so it's family dollar and dollar store think about it like maybe people have seen these but maybe what's the one like it's a and w always mix and match

the um the yum brands ones taco bell kfc or taco pizza hut or kfc pizza hut yeah they do those combos it kind of looks like that um but the goal of these is to combine family dollars cheap consumables with some of the select Dollar Tree merchandise and cross-sell, I guess, if you want to call it that. The second revamp here is what they call H2 stores. This is really just meant to be revamp store layouts for Family Dollar. We've linked to the Investor Day presentation, or we will link to it on our Substack write-up. But basically, they go through all the different things they're trying to do to expand and improve the sales per square foot. But they're, first of all, trying to actually make the stores look a little nicer.

There's been a lot of complaints around Family Dollar's quality. But they're also including more freezer space, higher shelves. And they're saying that these H2 stores are improving the unit economics at the Family Dollar locations. Third thing they're doing, I talked a little bit about this, but Dollar Tree Plus. This is the same old Dollar Tree stores, but they're taking a portion or a part of the layout and dedicating it to $3 to $5 items instead of the traditional $1.25. This has apparently created a big boost in comp sales. It's slightly higher quality items and then also a little more bulk

items. So instead of buying a single ice cream sandwich for $1.25, you can buy five ice cream sandwiches for like $3 and they're still generating. Well, they're improving the comp sales. They said people that shop and buy in the Dollar Tree Plus category spend 2.2 times as much on average compared to typical shoppers. So it seems to be having positive benefit in terms of comp sales. And then the last thing I'll mention here, they're rolling out dual banner distribution centers. So previously their distribution centers have been dedicated to one banner or the other, but they're now working on a distribution center in Florida that would be designed to distribute to both. I'm not sure about the intricacies here. I'm not sure about how much harder it is to

retrofit, not retrofit, but change the routes coming out of a distribution center. But this is kind of the synergies they talked about when they announced the deal, where they said that they expect $300 million in annual run rate savings. This is hopefully some of those type of synergies that they're going to see. And so it's hard to judge this on a going basis. You kind of just have to follow the operating margins of both companies or the enterprise as a whole, and hopefully start to trend upwards. Here, I attached management's estimates for both businesses. But basically, the goal here is that family dollar eventually by 2026 gets to 5% operating margins, and then Dollar Tree gets to 14% or 15% operating margins,

family dollar is always going to be a lower margin business. That's just a part of really their value proposition to consumers. But I think that just about covers both the businesses. I'll ask you a question right now, and maybe it'll get into your competition segment. do you having now looked at both do you think there's any structural advantage that dollar general has over family dollar i i don't think so maybe they're more rural and if that's the case then they could have the geographic advantage but a lot of family are in spots that they're the core, really low cost provider for these very, very cheap items for the lower income shopper. So I don't think there's just an inherent competitive advantage

here outside of execution. I don't know. What do you think? I kind of had a hard time differentiating between the two, just looking at it as an investor, maybe the shopping experience is slightly different, but it seems like they offer a lot of the same items. It's name brand stuff. it's not that many KPIs no SKUs not that many SKUs

it seems like the prices are kind of they've made a point about this they're trying to make family dollars prices more similar to dollar generals they want to bring it down to price parity they're discounting prices and that's some of the concern dollar general had is that they're worried that shoppers have switched

or at least investors are just because of this price being so important. I would reference here when Ryan mentioned those long-term targets for operating margins, they currently are just under 6% on a consolidated basis. All right, let's move to industry and competition. Kind of an interesting one, but I would say a lot of the numbers are going to be similar to the dollar general discussion from last week. But hopefully after looking at both, we can get a better grip on the dynamics facing the entire sector at the moment.

So if you look at Dollar Tree and Family Dollar, they are the second scaled player in the dollar store space. Really, the only other big player is Dollar General. And if you look at other competitors, yes, Dollar General is competing, or excuse me, Dollar Tree is competing with a lot of knickknack stores, a lot of individual dollar stores. Think about how many of those are out there. There's a lot of smaller, you know, mid-level chains. There's a lot of individual dollar stores.

It's not too hard to run. And then Family Dollar is competing with Dollar General, but with a lot of other convenience stores in small towns. And as per the last episode, Dollar General claimed, at least with some old management teams, that they had a very large addressable market for all of discount retail that could be probably pushing a trillion dollars right now. But that includes the likes of Walmart, CVS, the gas stations in the middle of the big city that clearly don't overlap with them. so they have a pretty large addressable market with these rural targets with at least with dollar tree it kind of has an even bigger one because they're going after that uh maybe a little you know the shoppers with slightly higher incomes that are going for the dollar tree to find gifts and little knickknacks and stuff like that but it is not nearly as large as i think you could

get persuaded by by that investor presentation and if we look at the sales comparison dollar Tree Family Dollar combined did $28 billion in 2022 sales versus $37.8 billion for Dollar General. So similar size businesses. And then an important note for the competitive landscape, I want to hit this again. Dollar Tree, as we talked about, a little higher income consumer in more suburban areas. So they're not going to be in rural areas at all. And then Dollar General is almost entirely in rural areas and small cities. So, I think towns with that 20,000 population or less, I think it was, what, 80%, right? And then Family Dollar operates in these rural areas as well, but with an urban focus. I would go to a big city in the south, look up Family Dollar,

you'll find some store locations there. Now, how much do Family Dollar and Dollar General overlap? I'd say definitely in some places, but not entirely. So, for the smaller towns, it is uneconomical for a family dollar to say, okay, let's build a store here when dollar general already has a location and vice versa. So if family dollar has a location in a town of 20,000 people or less, or maybe even 10,000 people, dollar general is not going to go in there and say, hey, let's go into this market, build a dollar general, and then we're both going to screw each other. Below, or at least in the, not investor presentation, the sub stack, I came up with two Google Maps screenshots for basically the same area of Mississippi, which I really

misspelled there. One has the family dollar locations, and one has the dollar general locations. If you look at it, which I can just describe here, you have a couple of more sizable towns in here. And in those more sizable towns, there's a couple of family dollars and a couple of dollar generals, which clearly compete with each other. But if you look at the tiny towns, when there's a family dollar, they're not going to have any dollar generals in there because, again, that would both just drive each other out of business. Now, what do you think about that, where they have somewhat of a competitive overlap, but not maybe entirely? Because people do that big map at the United States. I've seen investors throw that out where they have family dollars and

then dollar generals, and it shows all the dots overlapping. I don't think that's really indicative because if that family dollar is 20 miles from the dollar general, that's not competing with each other. Yeah. It's interesting because if you really zoom out, you think they're all in the same location, but you're right. I mean, I don't think there's room for two of these in the same town of 10,000 people. Both of them would just go out of business. So I think it makes sense and the also the combo stores they talked about are in towns of like 3 000 or even 4 000 people so it's really really small towns at least the combo stores right they're not afraid to go smaller and what's interesting is dollar tree is not afraid to go into bigger areas like for example

we live in the suburbs of seattle there are dollar trees not too many but you know they're spread out around here. And I think that's interesting as well, that they have even a bigger addressable market than Dollar General would. Now, let's move to management and ownership. The CEO is Rick Drilling. As Ryan mentioned, he was the CEO at Dollar General during its heyday or recent heyday from 2008 to 2015, which is why the board brought him on to, you know, they wanted him to come over. now here's a discussion question i have because clearly dollar general performed well stock did well i believe it outperformed the market while he was there are you worried that he and the team that came over with him that i'll mention uh shortly just benefited a bit from macro tailwinds

since he took over at an optimal time starting in 2008 potentially i mean that success carried carried through past 2008 though you know it's not just like they did have accelerated comp sales during the financial crisis but he was successful from 2010 to 2015 as well it seems like there were also i mean maybe it was just the fact that people were trading down during the financial crisis but it seems like there were some structural improvements made as well he really expanded margins at the business that might have been just from the environment but i think there were probably some changes made as well and he you know going through that investor day it seems like he has a blueprint for for knowing what works

and knowing what changes need to be made and it's like it's little things like the type of cart you use to pack items from the truck to the shelves and a bunch of those like he lays them all out it makes just the fact that he has all these already in mind tells me that there was some actually like he had some management prowess that really helped the business yeah there seems to be about eight to ten big items that are very long-hanging fruit that they can just execute on over the next couple of years and well they have to execute on it but they're there and they can probably go after it yeah i think it's the macro environment definitely helped them but it's just something to consider it probably wasn't all just entirely the macro environment

now if you look at the other executives on here a lot of them uh came over from dollar general to dollar tree so the cfo joined in october 2022 although he was actually from curate retail the cio which is the chief information officer worked the trailing at dollar general same with the merchandising officer that's at family dollar as well as the merchandising officer at dollar tree and the supply chain officer so i think essentially he said look all the back office functions all the logistics all of that stuff i want my team that succeeded with that over a dollar general i think it's important that those are those specific people because you have the it the merchandising officers and the supply chain officer all from dollar general back when he was

there so essentially you got the boy the boys back together to try to fix this thing which i thought was interesting uh if we look at the recent proxy they lay out drayling's executive compensation right in the opening letter for everyone to read i have the full quote for the newsletter but essentially they said they approved a five-year employment agreement granted him an option to We purchased about 2.25 million shares of Dollar Tree common stock, an exercise price of $157. Today, let me get the exact price. We are at about $107, so significantly higher.

So he only gets those right if the price is above that. This was basically, hopefully, to give him really strong compensation there because he's going to be a very rich man if he can succeed in turning around this business. And the second one here I have for the executive compensation is that in 2023, the compensation committee changed the annual bonuses by adding total revenue weighted to 40% and adjusted operating income weighted to 60% for the annual bonus targets as opposed to in 2022 when it was solely on adjusted operating income. Now, they're not perfect on these, as most companies aren't, but I think that was a solid change, and you want that balance of profitability and growth, although I would like it not to be adjusted, but it's not as bad as Dollar General's was. Yeah, I think in general, I'd say this is a pretty solid proxy or incentives from what we've looked at in the past, where he's not just getting paid regardless of performance. In this case, the thesis for investors is Rick Drayling's coming in. He's going to turn around the company.

Rick Drayling gets paid if he turns around the company. So I think it aligns. Yep. And then I would note from an ownership perspective, the activist who called for management changes here called Mantle Ridge still owns around 6% of the stock and Capital World Investors owns 9.2%. Mantle Ridge has a seat on the board. I don't know if it's a big deal, but something to note. But let's move into earnings. What do the financials look like here, Ryan, for Dollar Tree currently?

So over the last 12 months, just for context, Brett already mentioned it, but they did $29 billion in revenue. In the most recent quarter, they saw 7.8% positive comp store sales at Dollar Tree. all of that is from increased traffic, which I thought was a positive the year before it kind of came off of higher prices because of the breaking the buck thing. But now they're seeing a bounce back in traffic as well. There was 5.8% comp store sales at family dollar driven by a blend of, I think it was like 3% increased traffic and two and a half of average ticket. So So I mean, I think that's solid, especially when you look at that relative to Dollar General's results, which during the same period is minus, basically flat.

So they are taking share. The margins are tightening though. So part of this is out of their control, but part of it looks like it's been much needed investments that the management team is finally deciding to make. So with gross margins, they attributed it to a number of things. So first of all, a little bit more of a mix shift towards the consumables. There was elevated shrink, which is the term for damaged goods, theft, basically inventory items that are lost before they're able to get sold. Higher expenses at distribution centers, lower markups in general, and then higher freight costs.

So gross margins decreased by basically two percentage points year over year. SG&A, or sales general and administrative, increased as a percentage of revenue as well due to, and this is a quote directly from the press release, the most recent quarterly press release, due to wage investments in-store and field payroll, higher incentive compensation, investments in repairs and maintenance to improve store standards, higher professional fees, elevated general liability insurance claims, and higher utilities expenses related to unseasonably high temperatures. basically most of those items i would say come from them

basically they've underinvested and the new management team is stepping in and seems to be making a lot of changes you can see it they lay out how many stores they basically revamped every quarter and it feels a little bit to me like target around the 2015-2016 time frame where it hurt margins in the short term, but they started to revamp a lot of these stores and really changed the branding. It was very successful for the company. So maybe it can end up like that. But in total, trailing 12-month operating income was $1.8 billion. Trailing 12-month net income was $1.2 billion. Like I said, margins have tightened. So a lot of the profitability figures look really bad year over year. I think it was down like 40%

operating income year over year. But basically, we just have to get to an assumption on what do we think they can earn in a steady state? And we can talk about that later on, but I would say their historical average is probably in the... Well, it's been mostly Dollar Tree and family dollar has been lagging, but if they're doing 14% at Dollar Tree and 5% at family dollar, I think there's a blended margin there of 8% to 9% potentially. We can talk about whether or not we think that'll be realized, but let's hit the balance sheet really quick. Really conservative balance sheet, I'd say.

$500 million in cash with, like I said, $1.8 billion in operating income over the last 12 months. Long-term debt, they only have $3.4 billion. in. However, there's a lot of operating lease liabilities, so they lease all their stores. So you're going to see a bigger net debt position. It's just whether you include operating lease liabilities as a financial debt obligation. I've excluded it for these purposes because it's, I mean, you're paying that lease over time. So it's included in the operating income, if that makes sense. Right. It's a strand. I see arguments on both sides there, but it's

It's strange that if you're going to include that, why don't you include the employees' expenses, right? Because you can get rid of these without having to pay all of them. Yeah. And I mean, it's above the EBIT line. So if you're looking at EBIT, it's already been included there, right? I mean, it's a lease expense. It's really an operating expense, the cost of doing business. So I would say when you're looking at the leverage ratios, net debt to EBIT or net debt

to operating income, you would be double counting it if you put the lease obligations in the net debt as well there. So to me, I just excluded it. But like I said, simple balance sheet here, $3.4 billion in long-term debt. Most of it's due after 2028. average interest rate, weighted average is 3.7%, so really low. And they raised a lot of debt over the last two years at really low rates, so kudos to them. But basically, net debt to operating income ratio is 1.6 times. Honestly, I think they probably could have increased it a little bit,

but they issued a decent amount at a pretty good time, so not going to knock them for it. Basically, nothing to worry about on the balance sheet side of things. Yeah. And none of it's due soon, which is nice because they're coming into, as we'll talk about towards the end of the show here, a big three to four years of reinvestment, big capital expenditures. But we'll get to that. Let me talk valuation quickly. Like with Dollar General, I'm really going to take just the Dollar Tree family dollar operations, apply some blended operating margin assumptions, and see where the valuation would look like. not the valuation, but see what the earnings multiple would look like. I'm going to use an EV to operating income multiple. And I went from 5% to 8% basically for their margins on a trailing 12-month basis. I just assumed $30 billion in revenue because they're probably going to get there on a trailing basis fairly shortly. So if we have a blended operating margin of 5%, which would mean more margin compression, which could happen maybe in the short run,

but I think it's pretty pessimistic for this blended company. Your EV to operating income would be 17.8. Now, if we go up to that 8% that Ryan mentioned, if things are like they were in the past and family dollar improves a bit, 8% margin would equate to 11.1, which seems pretty cheap, right? Especially if they can grow consistently. But I think the key here, just given that they're spending more or selling items for a little bit less.

So gross margins are coming down a tad and are spending more on their operating expenses. We need comp sales to be consistently, I mean, not explosively high, like 15% or anything, but consistently strong. Is that kind of the big thing? I think the biggest thing here, and they talk about it, which I thought was great,

is that they consistently need to have comp sales driving higher. Yeah. Yeah. I mean, I can't remember the three levers he talks about, but he says, we want to expand the sales footage. So not only the sales per square foot, but the available selling square footage. So combining those two, and it's not just going to come from price increases, part of it's like ticket mix or trying to get new items to be sold as well. i think he did a good job of that and between 08 and 2015 and really really he's he's driving

the exact same kind of formula here it looks like let's do anecdotal evidence though you got anything i got nothing there's dollar tree by me i didn't really have time to go to it but i don't i mean i don't know how much that would help uh i i don't have any experience here don't don't shop at any of these places yeah i'd say honestly it can probably distort people's view sometimes to just go to them and be like oh there's one people this one time of the day in this one location it doesn't really mean anything um no i don't i don't really have any takeaways i don't go to a family dollar i don't i can't think of any that are near me it from looking through the investor day and i know they just want to give you the highlights it feels like they're

they're making a lot of the right steps and you probably people probably would have said that in 2017 when the thesis was the exact same for family dollar but it feels like they can just they can close that gap with dollar general in terms of sales per square foot maybe i'm wrong but i don't know yeah i think it's a good setup having trailing in here Yeah, I agree. All right. Future growth opportunities. Ryan, what do you got? Well, yeah, that's a good one. Sorry, I didn't read it beforehand, but go ahead. Yeah, just closing the gap on sales per square foot with Dollar General. I just talked about it, but part of it comes from new layouts. Part of it comes from supply chain improvements, continuing to ensure a higher product quality. i have no advice here because i'm not in the industry i we usually try to come up with like new growth avenues but this is really i would say what the investment thesis hinges on dollar

tree feels like a sure thing you know you're gonna get steady probably 10 operating margins maybe a little lower but um mid 30s 10 good comp sales it's a differentiated concept whereas family dollar is kind of a direct competitor to the dollar general, and the operating margins are uncertain. So I think the closer they can get to closing that gap with dollar general, the more likely investors are to benefit here. Yeah. And I will say, I have a few devil's advocates for Dollar Tree I want to talk about during the low light section, but I agree that's two separate kind of competitive landscapes there. And I'll talk about mine, which is investing into the stores. So the bad news is that Family Dollar, and possibly a bit with Dollar Tree, but

Family Dollar clearly were underinvested in for many years. But the good news is that this new team can now reinvest into those existing stores and hopefully get solid returns on these investments. I would say as a note, there are a lot of interesting slides from that 100-page presentation they did back on June. We will try to put some of the good ones for the newsletter, pull some of those good slides and put them in the newsletters and hopefully make some comparisons with Dollar General as best we can. I'll definitely be doing the sales per square foot for Family Dollar versus Dollar General. And if we look at this slide deck we have here, they plan to invest and, well, this is kind of what they're hoping. They're hoping to generate $10 billion in

cumulative operating cashflow in fiscal 24 to fiscal 26, so a three-year timeframe. and they're planning to spend $6.5 billion on capital expenditures. So they're investing a lot, but the big question is, what return can they get on this investment? Can they drive comp sales higher with steady gross margins and earn better operating margins like we talked about? Highlights and lowlights. Ryan, what do you think here?

It's interesting because they're somewhat simple businesses. So it's hard to come up with a lot of thoughts here, but what are your thoughts? Well, I really think that if you could pick anyone to run family dollar from its current position, you'd probably pick Rick Drayling because he took over a dollar general when it was in a similar position. I think maybe it had, it was probably right around the same store count actually, but like a lot of the same problems, margins had been depressed and he was able to kind of revitalize the business with what, well, a good operating environment, but also seems like some structural changes that helped the business for really the next decade. I think he's the right guy for the job, and he probably knows how to counter position against Dollar General the best of anyone out there, because he was the guy on the other side of the table for the longest time. Dollar Tree for me is another highlight. I mean, it just looks like a solid business kind of through the cycle. I would say over the last, as a public company, Dollar Tree itself has done a good job

consistently generating earnings and growing over time. And even though it's going to have some ebbs and flows, it's a pretty sound concept and they seem to generate pretty good returns on new stores. So solid there. and then i would think this is my other highlight i would think family dollar is fixable like there's got to be ways to boost those margins yeah i agree i don't see any reason why these businesses are that different the two units family dollar and dollar general from a customer perspective i mean maybe there's slight differences

because of the urban stuff but yeah i think if they run it correctly you should have at least somewhat similar margins and they seem like to have extremely similar store layouts so besides the fact that dollar general has more of a rural focus i don't know if there's any big difference it also seems like they're they're investing in hard stuff like they're making some of the changes that are much needed even though it might not seem it might feel like a lag on margins in the short term it's this stuff that's really going to benefit the business in the long run low lights though i'm not sure i buy the synergies these combo stores i don't get it the are people really going to like oh there's the

there's the dollar tree like i gotta stop there then maybe i'm wrong maybe there's people that are like that but i wouldn't think they're like that i would think they're pretty interchangeable like if i saw a dollar general hey sorry or you mean a dollar tree versus family dollar no i mean if i saw like a dollar general or i saw a family dollar i'd be like whatever it's a dollar store even dollar tree to be honest maybe it's because i'm not really the shopper there but but I think like they're all pretty similar. I don't know why you need both banners. Probably just kind of confuses people,

but yeah, I don't know. The other low lights for me is I worry that they've over earned for a while as a whole, like margins wise, like maybe they, they are going to earn structurally lower margins for the next five years. I mean,

talk about the timu competition which we kind of hopefully debunked for people for dollar general might be more of a competition for dollar tree yeah that's part of my devil's advocate argument for them yeah that's a good one too because they're my team you it's a lot more crap you don't need which seems like it kind of overlaps well with dollar tree yep but that's what this economy is driven on so maybe there's room for both uh my highlights clearly the management as well, make me much more confident than they do with Dollar General. Although we talked about that, that management team has shifted within a week, which was funny timing. And they brought over the people from Dollar General. They're really focused on actually

improving things instead of talking in platitudes like the Dollar General management seem to do. I also like that this business has a long reinvestment runway. I think over the next 10 years, they can easily spend probably $15 billion on both store renovations, supply chain renovations, and growing their stores. I think that's got to be a good thing. Now, what are the returns on that investment going to be? It's probably a tougher question, but the reinvestment runway is there, and I think that's a big highlight for myself. And then Dollar Tree, I think, seems to be fairly insulated from physical retail competition. i don't see why that landscape would change and i might even improve

as they get this business cooking a little bit better low lights i wonder if dollar tree and family dollar locations that are not rural which again they do have rural focus but some more are urban than dollar general i wonder if they're more susceptible to competition from online and larger places uh the rural focus you know is a big highlight as the moat for dollar general. And I think that's largely, you know, the geography, I buy that the geography driven note here, it's less of a factor. And that concerns me a bit. We also talked about being more risk at Dollar Tree from competition in general. I also think that this is one where the thesis has remained the same forever. Let me read some of the highlights from the Value Investor

Club write up. So the overview, Dollar Tree is structurally well positioned to grow same store sales in new locations over the coming years. We expect Dollar Tree banners to grow at 4% to 5%, comps to grow 2%, margins to remain flat at 12.5%. We forecast family dollar banners to grow at 4% to 5% a year, comps at 2%, and margins to expand from 3.5% to 7%. They talk about short-term headwinds from food deflation and reduction in SNAP benefits. Ring a bell. And then they talk about improving the sales per square foot at family dollar versus dollar general. And again, this write-up was in 2017. And if I remember correctly, their target was $2027 in earnings per share.

It's 2023, and they're at $7 in earnings per share. So it took about twice the time they're expecting now. And there's been some margin compression, but- Yeah. Now that could be an opportunity. Yeah. As we'll talk about, maybe let's get to the bull case. You know, Ryan, the bull case is the $10 earnings per share.

So maybe you want to talk about that for why the stock could work from here. Yeah. Management laid it out. They expect, or they want to hit $10 in earnings per share by 2026. I think a lot of that's going to come down to, well, just overall margin improvement, but actually starting to see some consistent earnings out of the family dollar banner. But if you assume a 20 times earnings multiple, which is that that's actually in line with their four-year average, they tend to trade at around 20 times earnings. If you assume 20 times on $10 EPS in 2026, it's a $200 stock. That's a 20% IRR from today's prices in three years.

It seems achievable. And that's a good bull case. I mean, that's pretty good returns. The stock definitely can work if they execute, which is good. Part of me just thinks, okay, we talked about this before we hit record. It's like that Scuttleburb post. Scuttleburb, it's kind of a popular blog for those that don't know. He wrote up a piece on Dollar General.

And at one point in the article, he just goes, you know what? I bought some shares. I can't help it. I'm a sucker for a fallen angel. I think if we look out over the last 30 years between Dollar General and Dollar Tree, their margins are higher than what they're currently generating, both of them. If you think they can get back to that, which it seems reasonable for both of them to do that, these are both good investments. Yeah. And they're both like, they both have just like a massive store footprint and they both serve a valuable customer niche.

So I don't know. i think the bookcase is pretty pretty clear and it's clear it's clear i don't know i my confidence level is not high on it i wouldn't say i'm super confident what's your hiccup i think that dollar general succeeded because fam for a partially because family dollars run so poorly and if family dollars run a lot better i don't know i think that could hurt dollar general i also don't know if family dollar is that fixable maybe there is some really bad things they talked about like a rodent infestation at one of their supply chain things they could have to invest a ton of money here and not get that much in return yeah that that was funny distribute it cost them

like 65 million yeah because they had 400 of their stores shut down because the distribution center couldn't service it could be a long way here their it investments and stuff like that might need to be just a large investment here there's that capex line might be elevated for a while yeah they might need to take on some debt it's gonna have higher interest rates um i mean i see how it can work but i just don't like how the margins are such a big question here and the fact that it's a heavy capex business so those are just two lowlights i'd rather i wish it was i like capital light businesses a bit more when i'm worried a bit about the terminal growth and stuff like that and i don't i'm still not really sold on the

competitive landscape outside of again outside of the rural stuff okay I think that lays out a good bear case let's

phrase the new question like this are you more or less interested in Dollar Tree or are you more interested in Dollar

Tree or Dollar General I like Dollar Tree more it's close-ish but I like Dollar Tree more specifically

the management and the fact that they there's a lot easier. They have a lot of easier things that they can do to win or just to, to improve their business. Yeah. What do you think?

I think that's fair. The, it's just, i've grown to appreciate that margins will probably just be where they've been for 30 years right and for dollar general they're under earning now i think there's a reasonable case that dollar general can get back to the same operating margins they've had on average for the last 30 years and if they do that it's more attractive than dollar tree dollar tree they have more they haven't necessarily proven it at the family dollar

banner like it's a turnaround story yeah i can buy that i like both i don't love both i i see a lot of other things i would buy over these things but i think that sums up i like them i don't love them okay stock for next week yeah okay maybe were playing on it a little further uh the dollar store to the north we're talking dollarama apparently it's the the dollar general of canada if you want to call it that we'll see we'll we'll look at some of the analogies but um that one that one should be entertaining they've had an easier go of it in terms of results over the last decade or not easier go of it they've that better performance. Yeah, I think stock has beat both, but we'll confirm next week when we do

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