Investment summary
My previous investment thoughts on Dollar Tree (NASDAQ:DLTR) (published in late March 2024) were a buy rating because of my belief that DLTR can achieve its $10 EPS target in FY26. I continue to see DLTR as one of the best ways for investors to position themselves in this macro environment, given the strong execution seen (significant market share gains) and cheap valuation relative to the market.
The demand environment continues to be positive for DLTR
As a discount retailer, I expect DLTR to continue benefiting from this current inflationary environment, which is already evident in its financials. Contrary to what some might think, the current inflation rates are moving. The pace of inflation has been declining since March, from 3.5% to 3% in June. My view is that the rolling 3-month average is still the same as when it was during December last year, so we are not exactly in a period where the macro has normalized. And this music is to DLTR’s ears, as it operates a discount store that should continue to benefit from trade-down movements.
Using DLTR’s latest financials to prove my point, same-store-sale growth [SSSG] performance continued to stay positive at 1.7%, with a 2.8% contribution from an increase in customer traffic [still winning share of volume]. For note, DLTR performance could have been a lot better if not for the unfavorable weather in 1Q24.
More importantly, I believe DLTR has shown that it is the best operator in this space so far. Consumables SSSG was up 7.4%, with the Dollar Tree banner significantly outperforming the market in dollar sales volume and unit volume. Another example would be how DLTR SSSG performance greatly outperformed Five Below by 400 bps (Five Below saw SSSG decline by 230 bps). I believe a large part of DLTR outperformance is its multi-price point [MPP] initiative that really worked well, as evident from the share gains within the consumable space, attracting the higher-income consumer cohort, driving a larger basket size (2x than normal), and attracting more trips to DLTR stores. I am positive that DLTR can continue to win market share as it introduces more items by introducing new SKUs, which should broaden its appeal to customers.
Management’s comments that they are seeing the same demand strength persisting on a quarter-to-date basis (2Q24) very much support my view that DLTR can continue to perform well. Specifically, they mentioned that coming out of 1Q24, SSSG is in line with the 2 to 4% range (guidance for 2Q24). This has major implications for DLTR 2H24 performance because 2Q24 will face the hardest FY23 comp (2Q23 SSSG was 7.8%), and if DLTR is able to achieve ~3% (midpoint of the 2-4% guide), this implies a ~11% 2-year SSSG stack, which implies further SSSG acceleration going into 2H24, supporting an inflection to mid-single-digit SSSG. There is a good chance for this SSSG strength to continue through the rest of the year, as DLTR still has 2,000 stores (out of the 3,000) left to roll out its MPP initiative. As I have mentioned, the MPP initiatives have shown really positive results, and it was noted that MPP stores are seeing a traffic increase of ~300 bps and a pricing increase of 55 bps, with 50% of stores outperforming expectations, 25% right in line, and 25% having opportunities.
Freight cost continues to be a tailwind to margins
With DLTR further expanding its MPP strategy, which is going to result in a buildup of inventories, I thought it was good to give an update on the freight cost situation. In my opinion, DLTR will continue to see benefits from the reduction in freight costs as the supply-and-demand situation in freight remains horrible (in favor of DLTR). J.B. Hunt Transport Services (JBHT) results yesterday were a compelling data point that proved my point: domestic demand has fallen to its all-time low this year. Given that merchandising costs are the largest component of the cost of goods sold, I expect gross margins to continue tracking positively.
The Cass Freight Index, a closely watched measure of domestic demand, has declined on an annual basis for 17 straight months and in June reached its lowest level since January. By WSJ.
Valuation
Overall, DLTR ticks all the boxes fundamentally where it:
- Benefits from the current macro environment
- It has executed really well, resulting in it gaining a massive amount of share compared to the market.
- Has a strategy in place that can continue to support a 2-year stack SSSG of ~11%
Now, on valuation, while it has gone the other way of my expectations, the stock is now trading at 14.5x forward P/E, which is near its 10-year low valuation of 13.6x. To put things into better perspective, the DLTR forward PE vs. S&P500 ratio has dropped to almost the 10-year low of 0.66x, and the last time this happened was during COVID. As can be seen from the chart, shortly after this ratio touched that low point, the ratio reverted sharply, and I believe a similar trend is going to happen when DLTR reports SSSG acceleration in the coming quarters, dismissing investors’ worry that inflation has hurt the spending power of DLTR’s customer base.
Readers can refer to my previous post for my mid-term share price target, which is based on FY26 EPS. In this post, I focus on how much DLTR could be worth in the short term (1-year price target). Using management’s FY25 adj EPS guidance of $6.75, which I believe is easily achievable considering the positive SSSG, gross margin outlook, and easy comp base in 2/3Q23 (adj EPS was down 43% in 2Q23 and 19% in 3Q23), Say that DLTR achieves $6.75 (DLTR beat their own guide 6 out of the last 8 years anyway), and the DLTR forward PE ratio against S&P reverts back to 0.8x (the exact same pattern happened in 2021 after it touched 0.6643x). This implies a share price target of ~$118, or ~14% 1-year upside.
Risk
Other major retailers have been cutting prices to attract demand. This could impact DLTR’s position in the market as a “cheap” retailer if the price gap between DLTR and other retailers closes to a large extent. If inflation stays at this rate for longer than expected or increases, this could result in DLTR losing more lower-income customers than winning new higher-income customers. On a net basis, DLTR SSSG will be impacted negatively.
Conclusion
My view for DLTR is a buy rating. I expect DLTR to continue benefiting from the current inflationary environment, resulting in continued positive SSSG, driven by strong execution and its MPP strategy. Lower freight costs also provide an additional tailwind to margins. While there are risks like price competition, I think DLTR execution so far has instilled confidence in me that they can continue to win market share. Moreover, the current valuation near its 10-year low presents a good entry point.
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