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