Structured Finance: A $20B Miracle

I was reminded of the importance structured finance holds in modern finance when I came across the news about Electronic Arts (EA) being taken private by a consortium of PIF, Affinity Partners and Silver Lake for $55BB with a huge chunk ($20BB) being provided by JPMorgan, and rather than building a fully blown out LBO model to look at the possible returns, I decided to use this fortuitous opportunity to talk about structured finance- a modern financing technique that I am chronically intrigued by- and its vitality to the overall economy of the world.  

The ideal position to start a discussion of this variety would be the definition of structured finance and the typical features that collectively categorize a transaction under the umbrella of this financing technique, but there isn't an academically or universally accepted definition for structured finance. Some believe it to be a structured credit transaction which is also known as "Securitization" in which illiquid assets are pooled together to make them more liquid (think MBS, CMBS, ABS and CDOs); while others believe it to be any transaction other than the typical loan transaction; I on the other hand, believe a transaction to be a structured finance transaction if it has the following attributes:

• Nominal equity contribution:
• One of the features of structured finance is that the sponsors end up contributing a nominal amount of capital compared to the overall cost of the project.
• Ring-fenced:
• Another prominent feature of a structured finance is that it is ring-fenced which is a fancy way of saying that the lenders or providers of capital have no recourse or cannot pursue the sponsors in case of default or lapse of obligatory payments. 
• Cash flow based lending:
• The third identifying feature of structured finance is that the lenders provide capital, among other things, based on the underlying assets' ability to generate cash flows. 

Nowadays, structured finance is the pre-eminent avenue for raising capital when dealing with projects that involve assets that are extremely expensive, require an exorbitant amount to build, can take years to complete and can be in operations for multiple years if not decades. Structured finance is the perfunctory course of raising capital and reaching investors in industries such as PE, asset finance, project finance and securitization. 

We can examine structured finance transaction from two distinct points of view: lenders and sponsors. Parties part-take in a structured transaction for various reasons, let's look at some of the reasons why sponsors prefer a structured finance transaction over a vanilla corporate transaction.

• Cash flow based lending:
• As mentioned before, if the sponsors are looking to raise capital for an asset or a project that has the potential to generate steady and healthy cash flows in the future then it might behoove them to raise capital that is backed by the cash flows of the project or the asset rather than accumulating it on their balance sheet. This comes in handy for instances when sponsors might already be over their ideal leverage in their capital structure or they might be restricted by various covenants levied against them by their existing lenders. 
• Capital structure optimization:
•  Debt is generally considered to be the cheaper form of debt due to the fact that it sits at a higher position on the totem pole when compared to equity but also because interest paid on debt is tax deductible and it reduces the taxes an enterprise pays, and due to this reason, most companies end up raising a lot more capital then effectively needed foolishly thinking that the benefits far outweigh the cons, but in the long-haul, being over-levered can prove as daunting and fatal as missing out on indentured obligations. Imagine a scenario: the management has come across a project or an asset, development or acquisition of which could lead to monumental growth in the future, but they are already heavily levered and therefore are either unable to raise more capital or they might be able to but at a far higher and deathly gearing then normal, what would their ideal course be? Should the management abandon the idea or should they raise capital despite threatening terms? The ideal solution would be to set up an SPV, contribute a nominal amount of capital and raise the remaining needed cash through the asset or the project's ability to generate cash flows. This ability has generally been the primary reason of financial disintermediation in the recent years where capital providers are connecting with seekers without the typical middlemen. 
• Debt maturity:
• Structured finance transactions involve the development, operation or acquisition of assets and projects that cost an exorbitant amount to build, have a long operational life and could be movable assets such as planes trains and these assets tend to have decades long operational lives, as a result, debt raised under structured transactions can have maturities that could theoretically go on for 10+ years. This elongated maturity allows an ample amount of time for sponsors to develop and construct the project that they are dealing with rather than having to worry about necessary obligations and covenants. 
• Tax benefits:
• Most of the structured finance transactions also allow sponsors tax benefits that they can then utilize to raise more capital. This is prevalent in renewable energy projects in the US where the sponsors, due to the high cost of development and construction, tend to have losses in the early years of the project and these losses result in tax benefits that the sponsors in return can use to raise capital colloquially referred to as tax equity. Additionally, renewable energy projects also have investment tax credits (ITC) and production tax credits (PTC) that can also extend avenues for additional capital. 
•  Liquidity:
• Structured finance also allows companies and sponsors to use their existing assets in operations to raise more capital. For instance, if a firm has a large amount of accounts receivables or a bank has loans outstanding (considered assets because banks are owed their capital plus interest) they can ideally pool their assets together and sell securities that are backed by the underlying assets and their potential future cash flows in a process known as "Securitization." This allows companies to raise capital without having too much impact on their own balance sheet, gives them the ability to isolate the risks and also get in touch with capital providers that are outside of the normal sphere of banks.  

These are just a few of the benefits of structured finance for the sponsors but there are myriad of other reasons why sponsors would or should choose the structured finance approach rather than the corporate route. With somewhat understanding of the sponsors side, I think we are in a better position to now look at the other side of the coin: Lenders. 

Not too dissimilar to the sponsors, lenders also engage in structured finance transactions for a multitude of reasons. Structured finance permits lenders, financial and institutional, to participate in transactions that they typically wouldn't be able to, i.e., engaging in private equity deals, funding the acquisition of assets such as planes, trains and containers, partake in project finance and infrastructure transactions, and last but not least, structured finance allows lenders to initiate "Securitization" transactions. Some of the reasons why lender might be interested in structured finance are as follows:

• Diversification:
• Structured finance provides capital providers with an ample amount of avenues to efficiently and effectively allocate their capital. Typical lending transaction is when a firm or an enterprise is looking to raise capital at the corporate level; this debt at the corporate level is impacted by various factors such as the company's current rating (investment or non-investment), current level of debt, current asset utilization and ability to generate cash flows, current macro conditions and lastly the investor sentiments to name a few. These factors, one way or another, limit the number of transactions that banking or institutional investors can engage in; this is where structured finance enters the picture. It allows lenders to lend capital to a diversified set of clients rather than just corporations, i.e., they can choose to lend to a certain renewable energy or an infrastructure project, they can select a transaction where they make loans in the asset finance category or they can take part in a securitization transaction and buy securities that are backed by an amalgam of assets such as MBS, CMBS, ABS, CDOs, and CLOs. 
• Ability to pick and choose assets:
• Structured finance allows creditors the ability to pick and choose the assets that they would like to invest in. For instance, in a typical corporate transaction, when lenders, financial institutions or other institutional investors, invest in a company, they do not get to pick and choose how the management utilizes the capital, they are more or less the limited partners, but in a structured finance transaction, lenders can quite literally pick the assets that they would like to lend to. For instance, lenders might not be interested in investing in an IPP (independent power producer) but they will more than likely invest in a solar or wind project initiated by the same IPP that is backed by a long-term power purchase agreement. 
• Risk management: 
• Since structured finance transactions are not only backed by the cash flows of the underlying assets but also mortgages and liens that they can use in case the sponsors can't meet their necessary obligations this allows lending institutions to utilize a lower amount of their capital which improves their risk weighted assets (RWA). 

Again, these are just a few of the benefits to the lenders, but there are plenty of others. Now to drive the point home, lets look at how this take-private transaction of EA sports is a structured finance transaction. One of the first steps that the sponsors most likely took was to set up a hold Co., and use this holding company to raise the $20BB that they got from JP Morgan. The loan that they got was more than likely backed by EA's ability to generate steady and healthy cash flows in order for sponsors and the hold co. to meet their obligations, and in case they can't, JP Morgan has no recourse to the sponsors (ring-fenced), and the most sponsors can loose is their equity contribution. JP Morgan has also, without a doubt, taken guarantees in the form of mortgages and liens belonging to EA Sports. 

In conclusion, Structured finance is one of the most riveting inventions in finance, and it will only increase in its usage and deployment as time goes on. It allows certain securities and assurances to all parties involved, and this makes it an enticing avenue for both lenders and sponsors. I believe structured finance doesn't only connect lenders with capital seekers, but it also increases liquidity in the overall market, and with time, will only increase the on-going disintermediation in the financial markets. 

Walgreens: LBO Analysis

(Disclaimer: Excel file attached below the post) 

I came across the news of Walgreens being taken private by Sycamore back in March and the recent approval, and wanted to analyze the deal, but I've been so pre-occupied with work and other chores that I  didn't really get the chance to do so. But, I have a couple of days now, and figured this to be as good a time as any. The company announced back in March that it has agreed to be purchased by an SPV owned and operated by Sycamore; the PE firm has agreed to pay WBA $11.45 per share in cash, which represents about 8% premium. The total value of the transaction is expected to be around $23.7BB which includes $3.00 per DAP Rights, plus net debt, capital leases and present value of the company's opioid liabilities. What could the returns look like for the sponsors? The lenders? The target? I will try to analyze the deal in as much a detail as I can, and will try to not lose you along the way. Without any delay, lets dive right in. 

Walgreens Boots Alliance

Walgreens is an integrated healthcare, pharmacy and retail leader serving millions around the country for the past 175 years. A global and well know brand, the company has ~12,500 locations across the U.S., Europe and Latin America; the company plays a critical role when it comes to the overall healthcare system of the U.S. through dispensing medicines, improving access to pharmacy and health services, providing high quality health and beauty products and offering anytime, anywhere convenience across its digital platforms. The company owns ~311,000 employees with presence in eight countries and consumer brands including: Walgreens, Boots, Duane Reade, No7 Beauty Company and Benavides. With this brief introduction, lets start looking at Walgreen's historical financials. Below is snapshot of the company's historical income statement:

The retail pharmacy and health services sector has recently been going through a bit of turmoil, not only with the emergence of digital pharmacies such as as Amazon and Walmart but also due to the negative perception around litigious issues such as the Opioid lawsuits to name one. WBA's topline growth has been suboptimal at best, the company reported revenues of $148BB for FY '24 which was a 6.2% increase from last year's reported revenues of $139BB. The company's cost of sales or COGS has gradually been increasing over the last few years; the company reported cost of sales of $104BB (78.8% of total revenues) for FY '21 and fast forward to today, the company reported cost of sales of 82% or $121BB for FY '24; clearly over the last few years the company has either lost its competitive advantage or it has dwindled significantly as is evident from a higher growth in cost of sales when compared with the company's topline. This mismatch of growth between revenues and cost of sales can also be seen in the company's gross margins; the company's gross margins have shrunk from 21% in FY '21 to 18% in FY '24.

Speaking next of the company's indirect costs, SG&A has always, for obvious reasons, been a huge part of the company's income statement.  Company's SG&A for the most recent year was $28BB or 19% of total revenues which is in line with the company's historical reported SG&A numbers. Additionally, WBA reported a goodwill impairment charge of $13BB for FY '24 majorly due to its acquisition and subsequent investment in VillageMD. Due to the above reasons, i.e., the slower growth in sales, faster growth in COGS and somewhat increased SG&A, the company's margins have collapsed over the last few years; the company's reported operating margins of -9.5% in FY '24 as opposed to 1.8% for FY '21. An avid reader might wonder if the margins look any better without the reported impairment of goodwill, sadly, they do not; even if we were to take the impairment of goodwill out of the equation, we still end of with an operating loss of roughly $1.4BB or margins of ~-0.9%. Finally, moving down to the company's bottom-line, the company reported NI of -$8.6BB (or net margins of -5.8%) which is a further reduction into negative territory when compared to last year's NI which was -$3BB (net margins of -2.2%). With an overview of the company's income statement, I think we should now look at the company's historical balance-sheet and see it has weathered the last few years. 

On the assets side, at the end of the company's last reported fiscal year, the company had $3.1BB in cash and cash equivalents, I have included marketable securities in cash only because I believe that these are securities that are short-term and liquid and so they should be considered cash for analytical purposes. Company does seem to have a healthy need for NWC on YOY basis as evident by the year over year increase over the last few years which, of course, translates into cash outflow. Let's now break the working capital down to its pivotal factors and see how the company fares in terms of its DSO, DPO and DIH. If we look over the course of the last few years, namely last four years, we can see that the company's DSO has improved from 15.6 days back in FY '21 to 14.5 days in FY '24, this, of course, means that WBA has been able to recoup their receivables at a faster pace which translates into a cash inflow and helps the company with its liquidity. Moving onto company's DIH, which measures how long it takes on average for the company to sell and replace its inventory, we can see that WBA has also improved this metric; from 28.5 days in FY '21 to 25.07 by the end of FY '24. Lastly, DPO, which measures how long it takes for the company to pay its suppliers and business partners, we can see that WBA has also managed to enhance this measure as well; from 38.9 days in FY '21 to 42.43 days by the end of FY '24.

Let's move onto the other side of the balance sheet, liabilities and equity. WBA had short-term debt of $1.5BB by the end of FY '24 as well as $8BB in long-term debt. The company also reported operating lease liabilities (short and long-term), which for the purpose of this exercise I will treat as debt, of roughly $23BB. Lastly, the company reported total equity (which includes preferred stock, common stock and APIC, treasury stock and retained earnings and non-controlling interests) of 12BB for its latest fiscal year. The last statement we need to look at before we move onto our LBO analysis is the cash flow statement. As I suspect most of  you understand, cash flow statement really is the ONE statement we have to analyze in order to better understand any given company's liquidity and true cash inflows and outflows for reasons that I will not delve into in this post. Here is a snapshot of the company's historical cash flow statement:

Since cash shows up under cash on the balance-sheet, I decided to not copy the historic cash flow into my excel model, but from a cash flow and liquidity perspective, I believe I should still review what the company's cash flow statement looks like, and what the typical operating, investing and financing activities are. Starting off with the company's operating activities, latest fiscal year (FYE '24) is clearly negatively skewed due to the accrual based loss resulting from the impairment (which get added back on the cash flow statement) charge the company took, but other items such as changes in working capital items and other non-cash add backs are pretty on par with the historic numbers. The company reported operating cash flows of ~$1BB, $2.6BB and $3.9BB for FYEs '24. '23 and '22, respectively. 
Looking at the company's investing activities, primarily capex, we can see that capex has historically been within the 1-1.5% of total sales range. Total cash flow from investing activities was positive due to the proceeds from the sale of assets as well as the proceeds received from the sale of leaseback transactions and other activities. Last but not least, apart from miniscule financing activities, we can see that the company's management is pretty comfortable with raising debt and then paying it back or refinancing it. The financing activities also shows the fact that the company paid a constant amount of dividends ($1.7BB) but ending up curtailing it to $1.26BB for FYE '24. What does all this mean? It means that Walgreen's has been adding onto its cash balance for the last three years. 

With an understanding of what the company does, and its historical financial statements, I believe that I am in a good enough position to start discussing the crux of this analysis: the LBO.

LBO Analysis

I should preface this analysis with two distinct facts: first, I do this to satiate my own thirst and secondly, I have had to make a few assumptions. To start off, let's look at the various assumptions that I have made. 

LBOs are typically structured either as an explicit offer per share or as a multiple of EBITDA, and even though I have used the offer price per share option, I have left the multiple optionality in the  model. As announced, the offer price per share was $11.45, and given the diluted shares outstanding of 865MM, we get an equity value (or an offer value) of $9.9BB. As of the latest 10K, the company had total debt (excluding leases) of $9.5BB, non-controlling interest of $1.7BB and cash and cash equivalents of $3.1BB resulting in an enterprise value of $18BB; I have ignored the DAP rights and other earnouts which is why this is lower than the proposed enterprise value of ~$23.7. 

Additionally, since I couldn't find the exact break down of the new capital structure, I have assumed 5 different debt structures that the sponsors could potentially pursue, and as we will see down the analysis, returns can look drastically different depending on the chosen structure. For the sake of this analysis, I have assumed structure 3 to be the prevailing capital stack which includes a revolver commitment of $2BB, term loans A, B, and C with principal amounts of $6BB, $4BB, and $2.5BB, respectively, senior notes of $2BB and subordinated notes of $2.3BB, all of which results in an equity contribution of roughly $2.7BB. I have also assumed amortization of $292MM in financing fees and an immediate expense of $198MM in transaction and other fees. 

With the transactions assumptions out of the way, lets review my base case scenario.

Future

LBO transactions are structured in a certain way, and there are a few levers that the PE sponsor can pull in order to improve their returns at exit. I would like to go over some of those levers in my base case.

• Sales
• The company reported sales growth rate of 4.8% and 6.2% for fiscal years '23 and '24, respectively, and I do not see a significant delta either way going forward and there are a few reasons for that. Firstly, the company has been facing an increased amount of competition over the last few years resulting from online pharmacies such as Amazon and Walmart as well as from its traditional rivals such as CVS. Secondly, over the last few years while its competitors such as CVS have been able to pivot their business model, Walgreens stuck with its retail pharmacy business as the main source of revenue. Lastly, the overall drug and pharmacy industry has been severely impacted by various litigious and pending legal issues. In my base case, I think given Sycamore's strength in this industry and their portfolio, top line revenue should grow from 6.2% in FY '24 to 6.7% by the end of FY '29, and then gradual reduction to 6.5% by the end of FY '34. I believe that this modest growth in sales over the next five years is reasonable given the headwinds and issues the new owners will have to cope with. 
• Cost of Sales
• Another lever that the sponsors and their management team can pull is reduce the costs over the holding period which results in higher margins and therefore higher value at exit. Walgreens reported COGS as a percentage of sales of 82%, 80.5%, and 78.7% for fiscal years '24, '23 and '22, respectively. I believe over the next five years, the sponsors should be able to gradually reduce the costs to around 80% of total sales by the end of FY '29. I see these cost reductions resulting from better asset utilization, reduction through better trade and vendor relationships resulting from Sycamore's expertise in the industry and from various potential divestitures.
• Deleveraging
• In my base case, I believe the company will operate at minimum cash which I have assumed to be at $500MM. Moreover, I believe that the company generates enough cash flows for the management to be able to meet their obligations such as interest expense and debt amortization. As the debt schedule shows, not only is the company able to pay its terms loans early due to cash sweep, but also that the management does not have to draw on its revolver for any of the years in the holding period- which I have assumed to be 10, even though LBOs are typically held for 5-7 years. 
• EBITDA Expansion
• Given my assumptions around sales and COGS, I expect the company's adjusted EBITDA to grow from $5.2BB (3.6% margins) in FY '24 to $7.8BB (3.9% margins) by the end of FY '29. I believe this higher EBITDA will for sure result in higher value for the sponsors at exit. 
• Multiple Expansion
• Multiple expansion is considered by professionals to be one of the hardest ways for PE sponsors to amplify their returns and for good reasons too. Multiple expansion is a matter of how well the markets are, the industry's performance and not to mention the size of the company and access to capital, and since I don't care to venture a guess on any of these variables, I will assume that the company exits at the same multiple that it entered which is 3.4x.

Pro-forma Financial Statements

With the assumptions out of the way, let's now look at what the income statement could like going forward, please note that I have forecasted for the next 10 years instead of 5. 

As mentioned in the assumptions section, I expect the company's total sales to grow from $148BB in FY '24 to $202BB by the of FY '29 (year 5), and I have already gone over where I see that growth stemming from. Moving on, assuming my prognostications around the company's COGS, I expect the company's gross margins to improve from 18% in FY '24 to 20% by the end of year 5. If everything plays out the way I expect it to, I believe the company's operating margins will improve from -9.5% in FY '24 to 2.1% by the end of FY '29. Moving onto the non-operating expenses, we can clearly see the impact of new interest expense on the company's earnings as the company could have around 2% in net margins by the end of the holding period (five years). Having discussed the company's income statement, let's move onto the company's balance sheet. 

As the pro-forma balance sheet shows, I expect the company to operate at its minimum cash balance which I have assumed to be $500MM. Moving onto the important part of the balance sheet, we can see that the management will have to deal $16.5BB in debt (excluding leases), and we can also see that through operations defined by growth initiatives and cost reductions the company should be able to reduce its debt balance from $16.5BB in FY '25 to $2.2BB by the end of year 5; this very clearly signifies Walgreens ability to generate significant cash flows that could make this LBO a successful transaction for the sponsors as well as the lenders and the management. Let's review the company's pro-forma cash flow statement and see how that looks in my base case. 

As the cash flow statement shows, despite accrual based losses in income statement, the company generates a healthy amount of operating cash flows which in turn fuel the investment and the financing activities. Additionally, as evident from the screenshot above, interest income is almost trivial which is why I ignored it in the income Statement. What does all of this mean? Well, let's look at the returns in my base case and look at what the PE sponsors can expect when they decide to exit in five years. 

Returns Analysis

If we make an assumption that the sponsors exit at the same multiple that they entered at which is 3.4x, we can see that the IRR in FY '29 or year 5 could be 58% while the MOIC (money-on-money) multiple could be around 10x. PE firms typically target IRR in the range of 20%-30% depending on the industry and other factors, and by that target, this seems like it could be a great deal for Sycamore and its partners. This, of course, is in my base case, and if we were to make more optimistic or pessimistic assumptions, our returns could look either good or really bad. Let's look at some additional stuff to further understand how good or bad a deal this could be.

Summary Financial Data

As we can see from the summary financial data, in my base case, the company could have cumulative free cash flows of $13BB by the end of year 5. Let's look at the company's capitalization for the forecast period next.

As is evident from the screenshot above, the company will need to operate at minimum cash balance, and also that the company is able to pay off all of its debt by year 7 which is fiscal year 31. Additionally, we can also see that the company is able to pay off all of its senior debt by the end of year 5. Let's last look at the potential credit statistics. 

The image above shows a similar story which is the fact that the company is able to operate in such an efficient way that they are able to expand their EBITDA and lower their obligations which result in pretty good statistics by the end of year 5. 

Conclusion

I conduct these analyses not to criticize the teams or the firms that have worked on the transactions, but to purely quench my own intellectual curiosity. Based on what I have assumed in my base case, the transaction seems pretty lucrative from IRR, MOIC and deleveraging perspective. As always, I am well aware that everyone thinks and strategizes differently, and so I have linked the Excel file right below the post for you to play with and put in your own assumptions and make your own conclusions.

Links:

Walgreens LBO Analysis

 

   

Home Depot (HD): A Company Analysis and Valuation

(Disclaimer: Excel file attached below the post) 

Home Depot, Inc. is the largest home improvement retailer in the world based on net sales of $152.7BB for FY '23. The stock has returned +18.95% in 1 year while the S&P 500 returned +22.34%, but the story reverses course if we look at the last 5  year's returns; HD's returns increased +95.35% while the S&P 500, in the same timeframe, returned +81.34%. The stock is currently trading at 27.9x its earnings and at 18.8x EBITDA. Additionally, I was amazed by the company's performance over the last quarter in which HD was expected to post EPS of $3.64 but ended up reporting $3.78, easily beating the estimates. So, is this one of the best dividend paying value stocks? I will begin by looking at the company, its business, past and historical performance, compare the company to some of its contemporaries, and finally end the post with what I think is its fair intrinsic value. 

Home Depot

Home Depot is the largest home improvement retailer in the world, and offers customers a wide assortment of building materials, home improvement products, lawn and garden products, decor products, and facilities maintenance, repair and operations products as well as providing a number of related services such as home improvement installation and tool and equipment rental. As of the end of FY '23, HD operates 2,335 stores that are strategically located throughout the U.S., Canada and Mexico. The stores average approximately 104,000 square feet of enclosed space with approximately 24,000 additional square feet of outside garden area. Home Depot also maintains a network of distribution and fulfillment centers along with a number of e-commerce websites in the U.S., Canada and Mexico. Home Depot serves three distinct types of customers: Do It Yourself (DIY), Do It For Me (DIFM), and Professional Customers (Pros). 

Historical Performance

Historically speaking, Home Depot has been one of the best performing companies; the company has put up consistent numbers in terms of revenue and revenue growth rate, COGS as a % of net sales or total revenues, operating income and margins and net income and net margins. If we look at the the last five years, HD's top line grew from $110BB in FYE '20 to $153BB by the end of FYE '24. Cost of goods sold, or COGS in wall street parlance, has consistently been around 66% of net sales, which given the growth and the ebbs and flows of net sales, is an amazing operational achievement. Additionally, over the last 5 years, the company reported gross margins in the range of 33% to 34%. SG&A expense has understandably increased from $19.7BB in FYE '20 to $26.5BB by the end of FYE '24 given the top line growth. I believe where the company truly stands out is in its margins; HD has reported consistent margins (gross, operating and net) over the last five years despite issues such as supply bottlenecks, pandemic, inflation, high interest rates, and geo-politics. 

As you can see from the image above, historical margins over the last five years have been consistent despite the multitude of micro and macro factors impacting the company, its broader industry, and specifically its subsector. Starting with its gross margins over the last five years, the company reported consistent gross margins in the range of 33% to 34% and this consistency in gross margins implies that the company clearly has a competitive advantage and is vividly able to dictate terms with its suppliers and business partners. Operating margins tell a similar tale where the company has been able to notate margins in the range of 14%-15% clearly solidifying the company's competitive advantage and its position in the industry. Lastly, HD reported 10% net margins over the last five years, and as we know, positive net margins directly translate into dividends and share repurchases. With an understanding of the company's business and its performance, here is a peak at its historical income statement:

Home Depot's income statement highlights why the company is trading at the multiples that it is, but income statements are typically ruined by the fact that companies follow accrual accounting and so the numbers the companies put out in their income statements reflect profitability in terms of GAAP rules and regulations, but give no insight as to the company's ability to generate positive cash flows or its ability to meet is obligations; in order to better understand any given company's liquidity and its ability to meet its near and long-term obligations, we have to look at its cash flow statement as that is the one statement where we can tell exactly how much cash has come in and gone out of the business, so here is a look at HD's cash flow statement over the last three years:

As we can see, not surprisingly, HD has had positive operating cash flows over the last three years (the company reported OCF of $21BB for FYE '24), and this positive cash flow is driven by multiple factors; firstly, the company's growth in its NI and that is the first line item in company's operating activities; secondly, it is further accentuated by the additions of non-cash items such as D&A and stock based compensation; and lastly and perhaps most importantly, HD's grip on its current assets and current liabilities. If I were to dissect the company's working capital items I would see a really impressive inventory turnover, its superior ability to turn its AR into cash, and its bargaining power in the shape of AP among other things.

As is also evident from the image above, the company has reported FCF of $14BB, $11.5BB, and $18BB for FYE '22, FYE '23, and FYE '24, respectively, which also explains the company's ability consistently issue dividends and conduct share repurchases along with meeting its debt obligations. Let's now take a look at the company's balance sheet as it highlights the company's long-term position.

To quote every finance and accounting book out there, balance sheet is a snap shot of a company's assets, liabilities and equity at any given point in time, and if we need to assess a company's liquidity, balance sheet probably is as crucial as the cash flow statement. HD has kept a reasonable amount of cash on hand as well as having more current assets than current liabilities which obviously equates to the fact that the company, over the last five years, has been in a comfortable position in terms of liquidity. One off-putting thing that I see here is the amount of debt the company has on its balance sheet; as we can see, for FYE '24, the company has long-term debt in the amount of $43BB, excluding the operating lease liabilities, which explains its high interest expense. I believe that the company has a solid enough credit profile as well as FCFs and liquidity, but raising further debt could impact the company's debt profile and as a result, its margins and profitability. Lastly, we look at the company's financing activities, we can clearly see that the company is using its FCFs to return value to the shareholders in the form of massive buybacks and dividends. With this understanding, I believe we are in a suitable place where we can look at other companies in the sector and compare HD's performance with its peers before we move onto the valuation. 

Comparable Companies Analysis

This is not a full blow comparable companies analysis where I try to value/price the company based on its peers and their performance, but rather this is a nuanced approach where I will compare HD to a select few contemporaries and look at a few data points and try and assess if the company is trading at a premium, discount or par. For the purposes of this exercise, I will compare Home Depot to three of its very close peers: Loew's, Floor & Decor, and Arhaus.

Home Depot:

Home Depot has a market value, as of this post, of $407BB, and given its debt and cash and cash equivalents, an enterprise value of $468.6BB, which means that the company is trading at 18.76x EBITDA. The company based on 14.73 diluted earnings per share, is trading at 27.80x times its earnings. The stock has returned 17.32% over the last year. As of this post, the company reported revenues of $152.6BB, operating expenses of $29.2BB, operating income of $21.7BB, and gross profit of $50.96BB. HD has inventory of approximately $23.9BB and AR turnover of 33.72. As stated before, for the last reported fiscal year, the company reported OCF of $21.17BB and FCF of $18BB. Company reported operating, gross, and profit margins of 14.2%, 33.4, and 9.9%, respectively, for the latest reported year. Additionally, the company reported ROA of 16.91% and ROIC of 26.88%. 

Lowe's

Lowe's has a market cap, as of this post, of $142BB and an enterprise value of $178.6BB, which means that the company is trading at 14.37x its EBITDA. The company is trading at 20.95x times its earnings and has a diluted earnings per share of 12.02. Over the last one year, the company has returned 12.99%, which is lower than HD which, as stated before, returned 17.32% over the same period. According to the latest numbers, Lowe's reported revenues of $83.7BB with operating expenses of $17.5BB, operating income of $10.3BB, and gross profit of $27.8BB. Lowe's has inventory of $17.6BB, OCF of $9.82BB, and FCF of $7.82BB with capex of $2BB. As of this post, the company reported operating, gross, and profit margins of 12.33%, 33.21, and 8.17%, respectively. Lastly, the company has basic EPS of 12.04, ROA of 15.67% and ROIC of 29.57%. 

Floor & Decor

Floor & Decor has a market equity value of $10.47BB and an enterprise value of $11.98BB. The company is trading at 54.22x it earnings and 25.46x its EBITDA, which of course imply that the company is trading at a premium compared to HD or Lowe's. The company, over the last year, has returned -8.01% which is of course lower than both HD and Lowe's. As of this post, the company reported revenues of $4.4BB, operating expenses of $1.6BB, operating income of $288.3MM, and gross profit of $1.89BB. Additionally, the company has approximately $1.05BB and an AR turnover of 43.51 which is higher than that of HD's which has an AR turnover of 33.72, and when it comes to AR turnover, the lower the better, because it means that the company is able to turn its AR over quickly which translates into more cash for the company. Floor & Decor has cash from operations of $606.4MM, capex of $483.3MM, and FCF of $123MM and is trading at 2.40x its sales which is higher than Lowe's but slightly lower than HD's price to sales ratio of 2.63x. Moreover, the company reported operating, gross and profit margins of 6.57%, 42.9% and 4.45%, respectively. The company has basic earnings per share of 1.82, ROA of 4.08% and ROIC of 5.41%. 

Arhaus

As of this post, Arhaus has a market equity value of $1.77BB and an enterprise value of $2.11BB, and the stock is trading at 22.50x its earnings which is significantly lower than Floor & Decor and HD, but higher than Lowe's. The stock has returned 6.70% over the last year which is lower than HD's one year return, which as stated above was 17.32%. According to the latest numbers, the company reported revenues of $1.27BB, operating expenses of $404MM, operating income of $99.4MM, and gross profit of $503.7MM and the company has roughly $294.6MM worth inventory. As of this post, the company reported OCF of $139.8MM, capex of $126.9MM and FCF of 12.92MM. Additionally, the company is trading at 1.40x its sales and has operating, gross and profit margins of 7.84%, 39.72%, and 6.19%, respectively. Lastly, the company has basic earnings per share of 0.57 and ROA of 6.75% along with ROIC of 9.76%. 

Comparable Companies takeaway:

 

I think the next logical question on anyone's mind would be, "What do all the numbers mean?" Before I answer that question, I believe it is paramount to understand what multiples are and what they signify. multiples, broadly speaking, are functions of ROE/ROIC, growth rates, cost of equity/ cost of capital, reinvestment, dividend payout and retention, tax rate, operating margins and D&A, and to try and explain why companies trade at the multiples that they trade at is a futile exercise; the most we can do try and explain it, because it is more an art than science. Having said that, what can we say about HD and where it is currently trading at, is it at premium, discount or par? I believe that the stock is currently trading at par in that the company has higher ROA compared to LOW, FND and ARHS as well as a higher ROIC than FND and ARHS but lower than LOW. Moreover, the company has basic earnings per shares (NI divided by basic shares outstanding) of 14.77 which is higher than other three companies that I looked at. HD's price can be further justified when we look at the company's margins; compared to its contemporaries, the company has higher operating and profit margins while gross margins are amongst the lowest when compared to the other three companies. 

The company is trading at 18.76x its EBTIDA which is the second highest among the four companies. The company also has significantly higher FCF than its competitors as well as revenues and gross profit. Based on the comp analysis, I'd say the company is trading at par, but what about its value based on its own cash flows, expected growth, cost of capital and risk? Next we look at the company's price per share based on its discounted cash flows. 

DCF Valuation

I think I am in a better position now to talk about the company's future, or my version of it. 

Home Depot (HD) has been around for a minute now, and I think it is in a position in its corporate cycle where it is more concerned with returning value to shareholders rather than growth. Logically speaking, I believe what should transpire in the future is the management's intention to continue to return value for its shareholders through dividends and share repurchases, and not spend an obscene amount on its growth. I am not comfortable with the amount of debt the company has, but at the same time, it is not surprising at all because the company has a good credit profile and a storied history of operations which make the company's access to capital easy, but I believe they should now be more focused on repaying debt rather than raising more as they have done in the past; and this is because I believe the company's healthy amount of interest expense is eating away its profitability and value. I also believe that the company's double digit growth days are in the rears now, and going forward, the company should grow at a modest growth rate of 3% to 5%, with this in mind lets look over my base case assumptions. 

Base Case Assumptions

Revenues: Going forward, as I stated above, I do not expect double digit growth for HD, and as such, I expect Home Depot's top line to grow from $152BB in FYE '24 to $221BB by the end FY '34. I expect the revenues to grow at a constant pace due to the company's brand and its solid position as the biggest home improvement retailer in the world among other factors. I believe the company will have to traverse the harsh waters of geo-politics as well as the current administration's efforts to re-shore everything through incentives, tariffs and import taxes. 

Cost of Sales (COGS): As mentioned before elsewhere in this post, the company reported consistent numbers in terms of COGS as a % of total sales; over the last five years, HD's COGS margins (COGS divided by total sales) have hovered around 65% to 66%, and going forward, I have no reason to believe that these costs will reduce thereby improving the company's margins, and so I am estimating cost of sales somewhat in the same range for the next ten years. 

Gross Profit and Margins: Given my assumptions for total revenue growth and cost of sales, I expect the company to continue to post gross profit and gross margins in line with its historical range of 33% to 35%. I believe that, for my base case, this is a conservative enough approach to assume that the numbers will not change that much from historical trends and that the management will continue to perform the way it has been up to this point. 

Operating Income and Margins: As we saw in the comparable companies analysis section, HD has the highest operating margins amongst the four (HD included) companies that I looked at, and I believe this trend will continue into the future. I believe the company's operating income will increase from $21.7BB in FYE '24 to $36.3BB by the end of FY '34, and margins to improve from 14% in FYE '24 to roughly around 16% by the end of the projection period. I believe that the company has a competitive advantage and very clearly has a bargaining and purchasing power, and that coupled with its brand name, investment in technology and sophisticated supply chain should help the company improve its margins in the future.  

Capital Expenditures: HD's capex is the highest in the sector and that is not surprising when we look at its top-line, its global presence, and its margins. The company has historically invested about 2% of its total revenues in capital expenditures and going forward, I believe this trend will continue. I have assumed a decent top-line growth rate and to support that growth, the company will have to continue to invest in capex; going forward, I believe the company's capex should be around 2% of its total sales for the project period. 

Dividends and Share Repurchases: As I mentioned at the beginning of this section, HD is in a stage in its corporate lifecycle where it should be concerned with returning value to its shareholders, and based on that belief and assumption, I believe the company will continue to pay dividends and buy-back its own shares in line with its historical numbers. 

WACC: At the time of this analysis, the company had a beta of 1.02, the market equity risk premium was 4%, and the risk free rate was 4.53% which means that the cost of equity for HD is 8.61%. This DCF is based on FCFF and not FCFE, and so I looked at the company's footnotes to try and finesse my way around its true cost of debt. I came across the company's disclosure for its outstanding debt issuances and their respective yields, and so I decided to take the weighted average of all of its outstanding debt and use that yield as my pre-tax cost of debt, which was 3.64%, giving me a WACC of 8%. 

With my assumptions on the side, let's look at the company's going forward income statement:

As stated in my assumptions above, I expect the company's revenues to be around $221BB by the end of the projection period as well as gross, operating and profit margins that are in line with historical trends with slight improvements as the company moves into the future. I have also made some assumptions about the company's capex and by extension its PP&E along with its share repurchases and dividends, so let's see what the going forward balance sheet looks like.

If we were to believe my version of the future, I believe the company will continue to perform the way it has in the past; I expect a decent amount of cash balance along with current assets that are more than its current liabilities as well as consistent share buybacks and dividends in order to return value to the company's shareholders. Balance sheet is considered by many to show a company's strength as it is long-term compared to income statement which is short-term, and based on my assumptions, I believe the company will be in a solid position over my projection period. Let's now look at the company's pro forma cash flow statement.

As expected, I suspect the company's OCF will increase from $21BB in FYE '24 to $31BB by the end of FY '34, and I expect this increase to come from the company's growth in its NI as well as effective management of its working capital items. I have assumed capex of about 2% for the next 10 years and so I am expecting only modest growth in the company's FCF as shown in the image above. 

With an understanding of the company's statements, I think we can finally move onto DCF. Here is a snapshot of my DCF analysis:

Based on my assumptions about the company's future top-line growth, capex, margins and its WACC, I am getting a price per share of $308.29 through perpetuity growth method and $373.04 if I were to assume an exit EBITDA multiple of 15x. The stock at the time of analysis is trading at $416.36, and based on my analysis of the company and my version of the future, I believe that the company is overvalued. In order to give some credence to my analysis, I will next try and look at the changes in price per share given variations in some of the factors that I believe impact a DCF analysis. 

Sensitivity

Image 1 shows us the changes in the company's implied price per share given the changes in its WACC and long-term growth rate, and as we can see, the market is assuming that the stock is either trading at lower cost of capital and low long-term growth rate or lower cost of capital and a higher long-term growth rate, and looking at the data table, I believe that the price per share of $308.29 seems justified to me. Image 2 looks at the changes in the implied price per share given variations in terminal year EBITDA and WACC, and as we can see, if I were to assume the same WACC, the company is trading at around 17x to 18x its exit EBITDA.  Let's now look at the company's price per share given changes in revenues and margins by the end of the projection period. 

As we can see, given my assumptions around the company's operating margins of 16% and revenues of $221BB by the end of FYE '34, I do not even see the company's current stock price of $416.36 in the data table which means that the markets are attributing either higher revenues in the next ten years, higher margins or both, and I, frankly, am not comfortable with either of those scenarios. Image 4 shows changes in the price per share given variations in the company's WACC and its exit EBITDA. 

Conclusion 

In short, I believe that the company is overvalued and the markets are assigning it growth that I do not see in its future, but I guess only time will tell. As for this analysis, this is purely to satiate my own hunger for this kind of work and not a recommendation for you to buy or sell the stock; that decision I believe should only be done after you have conducted your own analysis, and to that end, I am sharing the excel file for you to play around with, and change the numbers based on what you think about the company and its sector's future, growth and risk. 

Links:

Home Depot- Analysis and Valuation

Home Depot- Latest 10K

Dollar Tree (DLTR): A Company Valuation

(Disclaimer: Excel file attached below the post) 

Dollar Tree is one of the stores that my wife and I frequent, and it is not due to competitive prices but because of the wide variety of assortments that the stores carry, and being that I am a loyal patron, I wanted to delve deeper into the company's financials and see if it meets my criterion for holding it in my portfolio. I will be looking at the company's financials for the past 5 years and, with my understanding of its business and the retail sector overall, I will try to value the company based on its intrinsic characteristics and compare that to its current market price. 

Dollar Tree

DLTR 10-K

DLTR is one of the leading retail discount stores operator in the US and Canada and functions under the Dollar Tree, Family Dollar, and Dollar Tree Canada banners. As of the end of FY '23, the company operates 16,774 stores across 48 states in the US and five Canadian provinces. The company reports revenues and numbers for two segments: Dollar Tree and Family Dollar. 

Dollar Tree Segment

The Dollar Tree segment includes 8,415 stores operating under the Dollar Tree and Dollar Tree Canada banners, and has 15 distribution centers in the United States and two in Canada. Dollar Tree stores generally range anywhere from 8,000-10,000 selling square feet. Company primarily carried $1 items in its locations up until the recent past, and then made the pivot towards an increase where now the lowest end of the range is $1.25 whereas the upper range is in the $5 vicinity; the change was, of course, driven by the unquenchable desire to increase shareholder value as well as other number of factors that we will get into in the sections below. 

The Dollar Tree brand carries approximately 8,000 items and as of the end of FY '23, roughly 27% of the items were automatically replenished while the remaining items were either allocated to the stores or managed by direct store delivery vendors. The merchandise mix in the Dollar Tree stores consists of:

• Consumable merchandise, which includes everyday consumables such as household paper and chemicals, food, candy, health and personal care products, and in most stores, frozen and refrigerated food. 
• Discretionary merchandise includes:
• Variety merchandise, which includes toys, durable housewares, gifts, stationery, party goods, greeting cards, softliners, arts and crafts supplies and other items.
• Seasonal goods, which include, among others, Christmas, Easter, Halloween and Valentine's Day merchandise. 

Dollar Tree has historically been the largest part of the company's top line; the segment has consistently contributed more 50% of the company's total sales. As for the segment itself, net sales for this segment increased 8.9%, or $1,365MM, and this increase was mainly due to an increase in comparable store net sales of 5.8%. Gross profit margin for the segment decreased to 35.8% from 37.5% on a YOY basis even though the overall revenues increased. This decrease in gross profit margins could be attributed to an increase in merchandise costs, distribution costs, shrink costs (theft, etc.) decrease in markdowns and occupancy costs. 

Operating margin for the Dollar Tree segment also decreased  from 16.5% in FY '22 to 13.6% in FY '23. The reduction in operating margins was due to wage investments, minimum wage increases and other general liability claims. 

Family Dollar Segment

Family Dollar is the second largest part of the company's total revenues and accounted for anywhere from 45% to 48% of total sales over the last 5 years. The Family Dollar segment includes 8,359 stores operating under the Family Dollar brand and has 10 distribution centers as of the FYE '23. Merchandise at Family Dollar locations range from $1 to $10 and locations have historically ranged from 6,000- 8,000 selling square feet. 

Family Dollar stores generally carry around 11,800 items, and as of FYE '23, ~75% of the items were automatically replenished. The merchandise mix in the company's Family Dollar locations includes:

• Consumable merchandise, which includes food, beverages, tobacco, health and personal care products, household chemicals, paper, and automotive supplies. 
• Discretionary merchandise, which includes:
• Home products, which include housewares, home decor, giftware, and domestics, including comforters, sheets and towels;
• Apparel and accessories merchandise, which includes clothing, fashion accessories and shoes. 

Net sales for Family Dollar segment increased 7% on a YOY basis to $13.8B; the increase was due to an improvement in comparable and noncomparable store net sales. Gross profit margin for the Family Dollar Segment decreased from 24.4% in FY '22 to 23.9% by the end of FY '23; this decrease was due to an increase in shrink costs, increased markdowns, and increase in distribution and decrease in occupancy and merchandise costs. 

Operating margin for this particular segment decreased to (19.3)% resulting from the gross profit margin decrease, and increase in SG&A expense rate which includes the impairment charges reported for FY '23. 

Historicals

With an understanding of the company's segments, lets now look at the company's financials for the last five years starting with the income statement.

Historical Income Statement

As you can see, the company reported total net sales of $30.6BB for FY '23, which was an increase of 8% on a YOY basis and this increase was due to the increase in the Dollar Tree and Family Dollar segments we discussed in the section above. One of the things that stands out is the fact that company's COGS as a % of its total net sales have consistently been hovering around the 70% mark, and it could be due to micro reasons such as higher costs, increased in inventory as well as macro factors such increase in inflation and freight costs, or it could just be because retail industry has historically been a low margin business. Although gross margins decreased on a segment basis, the company reported positive gross margins, around 30%, for the last 5 historical years. 

Company's total operating expense as a % of net sales have also consistently been in the 22%-25% range, with the exception in FY '23 when the company reported the impairment of its Family Dollar brand that the company purchased back in 2015. Dollar Tree has also reported subpar operating margins over the last 5 years, in the 5%-8% range; I am excluding FY '23 when the operating margins were (2.9)% due to the impairment charge the company included in its yearly operating expenses. Lastly, net margins have also been consistently low; around 5% from FY '20 to FY '22, and (3)% for FY '23, again due to the impairment charge of over $1BB. Let's now move onto the company's historical balance sheet. 

The balance-sheet is pretty self-explanatory, but there are a couple of things that I think I would like to bring to your attention: the first one is the company's healthy cash and cash equivalents balance, which as you can see, was $757.2MM as of the end of the FY '23; second would be the reduction in goodwill and its related impairment for FY '23; and lastly, although the company has no short-term debt, it does have a healthy amount of long-term debt and operating lease liabilities which for analytical purposes are treated as debt. 

Industry and Competition

I think that after reviewing the segments, their performance, and the historical numbers, and before we can talk about the company's valuation, it is prudent for me to briefly discuss the retail industry and its future as well as Dollar Tree's competition. 

Retail Industry

My overall outlook of the retail industry is positive, I believe that after navigating the tumultuous COVID times, companies are well positioned to handle future headwinds. I believe that companies have acclimated to the fact that rates will be higher for a little while longer, even given the recent reductions, and are taking appropriate actions such as healthy inventory sizes, price increases, and managing their supply, occupancy, and freight costs. I also believe that companies have begun to seriously consider diversifying their offerings, take DLTR for instance, the company reports revenues in a third segment which primarily comprises of advertising revenue. With solid numbers reported in the latest employment numbers, the economy added more than 250,000 new jobs, I believe that consumers will continue to spend in the future, even going either as high as the pre-pandemic levels or maybe even higher.    

Although my outlook is positive, there are a few underlying issues that I believe will make it hard for the companies in this industry to grow their top line and margins, at least in the near future, and I would like to briefly discuss these issues.  

• Interest Rates: The Federal Funds Rate, the rate at which financial institutions lend capital to other financial institutions, usually overnight, at the time of this post is 4.25%-4.50%. If you remember, we have had rate cuts but nearly not as much as investors were expecting which is why treasury yields have recently been rising; the yield on a 10-year treasury note was 4.8% a couple of days ago but has since come down to 4.58% as of the timing of this post. The reduction in this rate is not nearly as rapid as investors or consumers were expecting and that is partly because of the strong employment numbers as well as inflation which I believe is still around 3%. Remember, the basic premise behind rate hikes is to reduce inflation and bring employment within the FED's goals and expectations, and since that is not happening, I believe we might end the year with 3.75%-4.00% of Federal Funds Rate, and since high rates impact both the companies and the consumers, I believe Dollar Tree will not only have to earn a higher return on its investments, but will also have to compete aggressively with other players in the market for consumers and their limited budgets which will hinder the company's top line and margins, at least in the near future.  
• Consumer Expectations: As of the writing of this post, consumer expectations have also risen in terms of what they think will happen with food prices and other everyday necessities. I believe that this increased sentiment will only be propelled by the new government's policies as well as healthy labor market and inflation. I believe that this will lead to consumers further tightening their wallets and limiting their spendings for the near future which will make it harder for companies like Dollar Tree to grow their top-line and improve their margins in the near term. 
• Political: Dollar Tree has around 25 distribution centers which means that about 90% of Dollar Tree's locations and 70% of Family Dollar locations get their inventory from the company's own distribution centers, with remaining inventory coming from third party vendors and independent distributors. But the issue that I see here is the fact that those 25 distribution centers get their inventory from other countries such as China, and given the US's on-going quarrels with China, it should not only make it hard for the company to restock its shelves, but it might also increase the costs. 
• Governmental Policies: Donald Trump was inaugurated as the US president on Jan 19th, and I believe his policies in terms of tariffs and trade that he has proclaimed throughout his campaign and also in his inaugural address will make it costly for Dollar Tree to do business in the country. This would mean that not only will the company need to pass the costs through to customers, which could back-fire, but it could also compel the management to spend heavily in the US in order to lessen the company's dependency on foreign distributors and business partners.  

Competition

Dollar Tree operates in not only a low-margin business but also in a industry that is highly saturated with players such Walmart, Target, Costco, Aldi, Lidl and Dollar General; not to mention your corner delicatessens and other local and regional brick and mortar brands. Dollar Tree's competitors, especially the major ones, have an immense buying and purchasing power and some have even gone so far as to create separate sections with highly competitive prices. I believe that the heightened nature of the market and its players should make it difficult for Dollar Tree to not only grow its revenues and expand its business but also make it difficult for the company to improve its margins and profitability. 

Valuation

Before we move onto the valuation, I think it might be beneficial for us to break down my assumptions (base case) for the future.

• Revenues
• Dollar Tree: I expect Dollar Tree segment to continue to be a huge part of the company's top-line in the future (staying relatively flat for the next 10 years with slight fluctuations on year over year basis); I believe that this will be due to Dollar Tree's strong brand name and customer loyalty. I expect revenues for this segment to increase from $16.7BB in FY '23 to $21.6BB by the end of FY '34.
• Family Dollar: I expect family dollar's revenues as a % of the company's net sales to reduce from 45% in FY '23 to about 44% by the end of FY '34. I believe this reduction will be due to Family Dollar's weaker brand as well as the issues I mentioned in the section above. I expect Family Dollar's revenues to increase from $13.8BB in FY '23 to $17.3BB by the end of FY '34.
• Cost of Sales: I expect cost of sales to continue to be a huge pull-down for the company's margins and profitability. I expect cost of sales to increase for the next 5 years due to the issues that I mentioned and then finally begin to decrease in year 6th and end the projection period on a high note. I expect cost of sales as a % of total sales to increase from 69.5% ($21.2BB) in FY '23 to 70% ($24BB) by the end of FY '29, and then decrease to about 65% or $24.4BB by the end of FY '34.
• Operating Expenses: Company reported operating expenses of $9.1BB or 29.9% of total net sales, and I do not see a reason for reduction in the near future. On the contrary, I expect operating expenses to continue to rise for the next 5 years to 30% or $10.4BB for FYE '29 due to increase not only in wage and minimum wage but also to stay competitive and retain employees and talent. I expect as the company gets a better hold of its business, operating expenses should decrease to $9BB or 23% by the end of FY '34.
• Operating Margins: As a result of my expectations surrounding company's revenues, COGS, and SG&A, I expect relatively non-existent operating margins for the next 5 years, and starting FY '30, the margins should begin to improve and end at about 12% by the end of FY '34.
• Capex: Dollar Tree reported capex margins of 6.9% for FY '23  and given my expectations in revenue growth, I expect the company to continue to invest in capex until the end of the projection period with capex margins of 5% for FYE '34.
• WACC: The risk free rate as of this analysis was 4.80%, DLTR's beta is 0.92, and the market risk premium is 4.00%, giving us a cost of equity of 8.48%. I could not find the yield on the latest debt the company raised and so I am making an executive decision and using 5% as my pre-tax cost of debt, and assuming a marginal tax rate of 25%, I get an after-tax cost of debt of 3.75%. Why 5%? I looked at the company's debt and the cost of debt that the company disclosed in its footnotes, and they were all a few years old, meaning the cost of debt that the company disclosed is not in line with the current market conditions, and having done these sorts of analyses before, I believe that 5% is in line with the current macro conditions. With the company's 61.08% weight of equity and 38.9% weight of debt, I get a WACC of 6.64%.
• EBITDA Multiple: As I have said at ad nauseam at this point, I do not believe in EBITDA multiple being a part of an intrinsic valuation, but it seems to be an enticing term that everyone on the street seems to think is of paramount importance, as such, I have only recently started utilizing it in my own work. I do not know the multiple Dollar Tree is trading at due to my limited resources, but I can finesse my way into deriving one with the information I do have; my implied EBITDA multiple given my growth in perpetuity of 0.5% and WACC of 6.64% is 9.10x, and for conservatism's sake, I will assume an exit EBITDA multiple of 8x. 

With my assumptions in place, here is what the future income state looks like:

As you can see, in my base case, I am not expecting much growth in the company's future for the next 10 years and the reasons are an amalgam of what I have hinted at in the sections above. I feel like with the risks and the nature of the market, the revenue growth that I have assumed is pretty solid, of course things change if I switch to best case or deteriorate if we move into the weak case. As mentioned above, I am assuming COGS and operating expenses to slightly reduce over the next years with slight fluctuations throughout the years. Here is a look at the company future balance sheet:

As is evident from the projected balance sheet, I expect the company to raise further debt for the next 8-9 operating years and as a result have a minimum cash balance of $500MM throughout the next 9 years with ending the projection period with $1.67BB in FY '34. Let's now look at the company's cash flow statement to better understand the company's liquidity for the next 10 projected years.

As expected, I am expecting moderate growth in the company's operating cash flows and increase in its capex activities which yields negative free cash flows for the next 5 years, and as the company enters the second phase, I expect the company to turn positive and end the projection period with $3.7BB in free cash flows to the company. With all of the financial statements in our rearview, let's now look at the crux of this whole analysis: DCF derived price per share. 

Based on my base case assumptions, I get a price per share of $115.54, the stock is currently trading at $73.48, giving us an upside potential of ~50%. It goes without saying that one of the inherent flaws with a DCF is that it is based on what I think about factors such as growth, risk and the company's cash flows, and so to offset some of that risk, I have created scenarios around the price; my base case price per share, as mentioned before, is $115.54, and in my best case, I get a price per share of $214.09, and $63.54 in my weak case. I think in order to better manage the risk around my assumptions, it would also be beneficial to look at a few data tables and see how the price changes due to alterations in some of the variables. 

Sensitivity

The tables in the images above are pretty self-explanatory, and without going into too much detail, image 1 shows the changes in price per share given changes in the long-term growth rate and WACC; whereas image 2 shows us the impact on price per share given the changes in our EBITDA multiple and the company's WACC. Let's look at another set of tables that shows us the price per share given changes in revenues, EBITDA multiple, and margins by the end of FY '34.

As you can see, if I assume changes in my final year revenues and operating margins, my price per share could end up being dramatically different than what I have gotten in any of my scenarios; the same impact goes for changes in EBITDA and WACC for the final year of the projection period. 

Conclusion

Every time I do an analysis of this kind, my goal is always to understand all of the micro and macro factors that I possibly can so that my value ends up in a range that makes sense to me, but all of this is based on my inherent thinking of the company, its business, the industry, and the larger economic picture, and I can of course be wrong. So, if you end up disagreeing with my analysis, I have attached the file below for your review, please, feel free to go ahead and make the changes and convert the numbers into what you might think make more sense. Of course, DCF is an intrinsic valuation, and so if you try to compare this to what Dollar Tree's peers are trading at, well, that becomes a pricing game, and that comes with its own pros and cons. But, I have lately been thinking of conducting not only a DCF analysis but also couple it with a comparable analysis; but as can be expected, it becomes an arduous and time consuming journey, and so I'll just roll with the punches and see what I end up doing in the future. 

Links:

Dollar Tree Valuation- 01/22/2024

02/02/2024 10-K