I am recommending to short Dollar General stock (DG) and use the proceeds to purchase Dollar Tree stock (DLTR). An investor stands to benefit from two angles:
- The relative valuation between Dollar General and Dollar Tree is so wide that it doesn’t make sense. DG is currently trading at 18.5 times 2019 EBITDA vs 11 times for DLTR. The two companies operate similar business models and are impacted by the same externalities and trends.
- With both uncertainty and stock market valuations high, this bet is uncorrelated with the general market. It would likely outperform in a falling market and provides opportunity for return regardless of where the market goes.
The Businesses
Dollar General is a discount retailer operating small box sizes in predominantly rural areas lacking competition. Its scale, along with low capital intensity, afford it nice margins and returns on capital. Solid execution and expansion has led to years of strong sales and cash flow growth. Management estimates potential for 25,000 stores, up 50% from current, implying 7-10 years of MSD fleet growth. Offerings for value conscious consumers help the company to thrive in difficult economic times.
Dollar Tree is also a discount retailer operating two store segments: Dollar Tree, at the $1 price point, and Family Dollar at the $10 or less price point.
The Dollar Tree (DT) store segment has been one of the most successful retail concepts of the past several decades due to excellent returns on capital with initial store investment payback period of 18-36 months. There is still a growth runway as management believes the market can support over 10,000 DT stores, up 30% from current. The product offering is a value for consumers which gives the business defensive characteristics in tough times. The $1 price point is not feasible from an e-commerce standpoint, allowing for brick and mortar growth at high ROIC.
The Family Dollar (FDO) segment, on the other hand, has been difficult since acquisition and severely underperformed its closest peer, Dollar General. It runs an operation nearly identical to DG, but suffers from poor sales productivity and low gross margins because of weak discretionary sales. It is currently marginally profitable.
Current Market Valuation
For two very similar businesses, the valuation discrepancy is stark.
Clearly the valuation difference is due to profitability. Breaking it down by segments changes the story and shows how much value is being masked by the marginally profitable Family Dollar.
The key variables here are:
- What will profitability look like at each segment a few years from now?
- What is a square foot of selling space worth at each segment?
Because investing results depend on what happens going forward, not the past, we need to try to guess where the puck is going and skate there.
Dollar Tree vs Dollar General: Relative Comparison
The Dollar Tree segment has higher margins than DG, a similar growth opportunity, and also benefits from the same drivers: the convenience of the weekly fill-in shopping trip, selling high margin, high value discretionary items, and a defensive business model that benefits in tough environments. The Dollar Tree segment profited 20% more per square foot than DG in 2019. If DG has an EV of $402/sq ft then it is warranted for the Tree segment to be worth at least that, if not more, on a purely comparable basis. It earns more and is just as high quality.
On the basis of conservatism I will give the Tree segment the same EV/sq ft as DG of $402.
Next. The big question is whether Family Dollar will improve profitability. The market’s pricing implies they won’t, but I believe they will, partly thanks to COVID-19 boosting value shopping behavior and also the H2 renovation program.
Now, FDO sales per store are roughly $1.4 million vs. almost $1.8 million per store for DG, even though the two have similar box sizes and offerings. FDO gross margins lag DG by about 500 bps from both weak sales volumes and a product mix that needs more discretionary sales at high margins.
On the bright side, FDO compares favorably on the basis of SG&A efficiency. FDO’s SG&A has averaged 21.9% of sales the past two years compared to 22.3% of sales for DG in 2019. This is rather surprising considering much of SG&A is fixed costs that should deleverage with lower sales. This confirms that there is a gross profit problem for FDO and better merchandising can lead to much higher profitability.
Fortunately, a few things are working in Family Dollar’s favor:
- The H2 renovation program is boosting comp sales over 10% in the first year, continuing for almost two years now.
- COVID’s effect in the most recent quarter had comp sales up 15% and operating income up 91% at the FDO banner
- Adding Dollar Tree branded $1 discretionary product sections in FDO stores
I believe these factors will improve Family Dollar’s profitability in a manner like so:
COGS has some fixed costs which should expand gross margin on higher sales along with better merchandising from the $1 Dollar Tree product additions. SG&A is roughly two-thirds fixed costs and will not rise nearly as much as sales. Consequently, the sales boost from H2 and merchandising changes should increase operating profits in a big way. To back up these numbers, note that FDO actually just posted a 4.2% operating margin in Q1 with comp sales up 15% compared to my pro-forma margin of 4.1%.
If this is to be executed, Family Dollar would then be making about half as much as Dollar General per sq ft. Not the best but not nothing. While DLTR management does think FDO can double its store base, due to its uncertainty I will value it at 40% per sq ft of what the market is valuing Dollar General. That would be $161 EV per sq ft at FDO.
So, I believe that the Dollar Tree segment should be valued just as richly as DG, which today is $402 per sq ft. And due to the factors I’ve listed that already began to develop in Q1, FDO should be worth around 40% of DG’s value, which is $161 per sq ft. It will require $2.5 billion to complete the H2 program on all stores which I will deduct from FDO’s value.
These factors leave us with:
Today, DLTR trades at less than half of the price of DG, even though reasonable comparable valuations would show that DLTR should be worth around two-thirds of DG.
For many years, the two used to trade largely in-line on a per-share basis until Q3 2018 when Family Dollar started to trend poorly. Sentiment has entirely shifted since then to create a massive valuation gap that blew out in 2020.
If DG is worth $189 as the market says, then DLTR should be worth at least $128. That is 40% higher than the current market price. This pair trade would generate around 35% return net of borrow costs thanks to a low DG dividend. Additionally, it would be uncorrelated to the general market which isn’t super appealing to be long right now. I’m not sure if Dollar General’s price needs to come down or Dollar Tree’s needs to go up to correct this valuation gap, but upcoming quarterly results from the Family Dollar segment should highlight how comparable the two businesses are and expose a relative undervaluation of DLTR stock.
Catalysts
Quarterly results: material Family Dollar operating income growth, comps pick up at Dollar Tree
DG valuation declines: its currently trading at 18.5 times 2019 EBITDA vs. 11 times for DLTR
Corporate action: Sale or spin-off of Family Dollar and an independent valuation for Dollar Tree segment similar to DG valuation
BD Capital 