Summary
- DLTR's 12% post-earnings stock decline is a reflection of near-sighted investors.
- DLTR's gross margin did decline, but the cause is DLTR making moves that will improve gross margin in future quarters.
- DLTR adjusted net income still reflects a big increase year-over-year.
- DLTR has a lot to gain from FDO, and its stock weakness will prove lucrative for buyers.
First and foremost, investors need to realize that Dollar Tree just increased its store count by nearly 8,800 to total 13,864 in July. Anytime a company's storefront grows by such a large count so quickly, there are going to be integration hiccups. And when combined with one-time acquisition related costs, providing EPS guidance is very difficult. In fact, adding so many stores makes providing reliable guidance almost impossible, which is why I think Dollar Tree likely guided conservatively.
Nonetheless, the acquisition of Family Dollar makes Dollar Tree a company with $19 billion in annual sales, up from $8.6 billion last fiscal year, and one that's expecting $21.4 billion next year. That's a big business, and it's important to keep in mind that the merger just closed on July 6. As a result, Dollar Tree's 48% revenue growth in the second quarter wasn't a proper reflection of what the new business will look like, as Dollar Tree had just one month for Family Dollar to contribute to the company's top and bottom line. Yet Dollar Tree realized all those acquisition-related one-time costs.
Dollar Tree realized $811.6 million in revenue from Family Dollar and $105.9 million in gross profit. Dollar Tree, excluding Family Dollar, grew comparable sales by 2.7% and created revenue of nearly $2.2 billion and gross profit of $749 million. As seen, there is a huge gap between the gross margin from Dollar Tree and what Family Dollar produced in its one month, 34% versus 13%, respectively. This disconnect played a large role in the company's gross margin decline from 34% last year to 28.4% in the second quarter this year. However, when you look at the components, it's easy to identify the culprit, Family Dollar.
With that said, Dollar Tree's decline in gross profit played a big role in why the stock fell double digits after earnings. While investors expected one-time expenses to drive its EPS and net income lower, gross margins were expected to remain strong and were considered an important metric for this first quarter of inclusion for Family Dollar. However, Dollar Tree's management is doing something that I love to see in companies after large acquisitions - it's making moves to quickly improve the business with little regard for the stock. The impact is often a lower stock price, but a business that improves much faster than analysts and investors expect. Thus, stock losses become an investment opportunity.
For example, Family Dollar had a negative impact on Dollar Tree's gross margin, but it was because of management's own doing. The company had a markdown expense of $60 million related to rationalization and liquidation of poor inventory. This is a cost that took place in the first month following the merger, and significantly affected Family Dollar's gross margin. Furthermore, Dollar Tree is working hard to phase out low margin inventory in exchange for higher margin goods. This will have a negative effect short term but long-term there's no one better to drive margin growth than Dollar Tree.
Prior to the merger, Dollar Tree had the highest operating margin between it, Family Dollar, Dollar General (NYSE:DG) and Fred's (NASDAQ:FRED) by asignificant lead. What makes this so impressive is Dollar Tree's $1 cap. Unlike all of its competitors, Dollar Tree must find, warehouse, ship, stock and then sell goods for a price of $1. The fact that Dollar Tree has an operating margin of 12% is mind boggling, especially given the way in which the dollar's value has risen. The fact that Dollar Tree has managed to produce such consistent profits and a rising margin with its $1 cap illustrates to me that it may just be the best retailer in the world at determining product assortment and maintaining an efficient fulfillment ecosystem. Notably, product assortment and warehousing are two areas where Family Dollar has often been criticized. These also are two areas that Dollar Tree's management will address and are proving to do so very quickly.
All things considered, if Dollar Tree can earn a 12% operating margin with a $1 cap, I can't imagine what it will accomplish without that cap. Dollar Tree can now stock an assortment of goods for $5, $10 or $20, and given how thrifty it has had to be historically, I tend to believe those same practices will translate to Family Dollar's business. In fact, Dollar Tree showed some proof in the second quarter that its practices and emphasis on optimization are starting to have an impact on Family Dollar. The company reported an adjusted net income of $138.9 million, thereby removing all acquisition-related costs. This translates to $0.67 per share, better than the $0.61 per share last year. Given that $60 million markdown expense and an $11.1 million charge for Family Dollar's lower margin product mix, that EPS improvement is very impressive.
Therefore, I think Dollar Tree is going to do great things with Family Dollar and that management's decision to act fast combined with the recent stock loss will prove to be very lucrative for buyers of the dip. Analysts are expecting Dollar Tree to earn $4.25 per share next year, a big increase from $2.99 last year. That big increase is the result of Dollar Tree not using too much stock as part of the acquisition, thereby keeping its share count of 214.3 million just 14% higher than it was this time last year. With Family Dollar's inclusion more than doubling Dollar Tree's annual revenue, and by belief that Dollar Tree will drive Family Dollar's operating margin well over 15%, up from the sub-3.5% margin it had this time last year, EPS should continue to soar long-term as Dollar Tree implements its strategic philosophies. In other words, Dollar Tree is a buy, hold and forget type of investment, and its post-earnings stock loss should prove to be an excellent entry point.
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