Prepared by Michael, analyst at team BAD BEAT Investing
Dollar Tree (DLTR) is a favorite of traders at BAD BEAT Investing, a name that swings higher and lower. Our community has leveraged the swings to profit on the long and short side in this stock and many others, though the turnaround in markets has been sharp and fast. However, DLTR stock has moved sideways to down in recent weeks. We stand by a general trading rule here. Buy in the $80s and sell in the high $90s, or more preferably, over $100.
We see an opportunity in Dollar Tree longer term, though there is, of course, a lot of competition. The company held up well during this COVID-19 crisis. The company saw a material decline in demand for many of the seasonal and discretionary products related to celebrations and large gatherings, but it saw a huge demand for cleaning supplies, food, paper products, etc. This was similar to other retailers, but the cost pricing in a downturn makes Dollar Tree look attractive.
Make no mistake, Dollar Tree is in a highly competitive segment of retail, and we do expect competition to ramp up in the future. Shares are attractive relative to performance and future expectations. It has started buying back shares again. In this column, we check in on valuation and discuss performance metrics from Q2 that you must be watching for when Q3 is reported later this month.
Fundamental discussion and value
Dollar Tree shares currently trade at just 0.97 times sales, which is still below the average 1.07 times sales seen in the last 5 years, and this remains well below the average seen in the last decade that is over 1.2 times sales. In addition, the name is favorably priced on several basic valuation metrics relative to years past:
Dollar Tree boasts a multiple of 25.1 times trailing earnings which is historically fair but is only 18.7 times adjusted trailing earnings which is cheaper than we have seen historically.
If we look on a forward basis, we expect $5.20-$5.50 in earnings for fiscal 2020, which puts shares at only about 18 times those estimates, which is also rather attractive for the name, historically.
The name is also way below its usual price-to-cash flow metric, and below that of the index, and is also discounted on a price-to-book basis. This is undervalued in our opinion and would be even more so if shares were to pull back to under $90 where you should buy shares.
Q2 performance and the metrics to watch in Q3
We will walk through the Q2 earnings, but we stress that these are the metrics we also want you to watch for when Q3 is reported. The company beat our sales expectations for $6.25 billion by $30 million. They also beat consensus expectations by $51 million. We think sales were strong as they rose 9.4% to $6.28 billion from $5.74 billion last year. We see this as very positive growth. We do know the company reduced its store base as part of its optimization plan to get Family Dollar up and running again and still is operating under reduced hours in some jurisdictions. As such, we want to look at the performance of existing shops to get a sense of comps.
When it comes to retail, we always like to look at same-store sales. We think for the most part there was good news on this front. As a whole, same-store sales increased 7.2%. Same-store sales for the Dollar Tree-branded shops rose 3.1%, which was about what we expected, but Family Dollar did incredibly well.
Sales have been positive at Family Dollar and are no longer dragging down performance. Same-store sales for Family Dollar stores were also up 11.6%.
Margins were also strong for the company. Gross profit rose to $1.92 billion in the quarter, a 16.2% improvement from a year ago. We will closely be watching these key metrics in Q3. The astute investor may note that as a percent of sales, gross margin improved nicely as well. They increased to 30.5% compared to 28.7% last year. The increase in gross margin was driven by improved merchandise costs including freight, leverage on occupancy costs from stronger same-store sales, reduced markdowns and improved shrink results, partially offset by higher distribution costs, which included $11.4 million in COVID-19-related payroll costs, and incremental tariffs of approximately $10.8 million. Putting it all together, we saw operating income improve markedly.
Operating income rose to $374.9 million compared to $268.9 million in the same period last year and operating income margin was 6.0% versus 4.7% of sales last year. As a result, earnings were strong and better than expected. Net income was down $261.5 million with earnings per share of $1.10 compared to $0.76 last year. This result was above our expectations for $1.00 and was a $0.16 beat versus consensus.
When we look at the quarter as a whole, we are pretty bullish. The company pulled guidance, but we are maintaining our expectation for $5.20-$5.50 for EPS in the year, with positive comps and sales growth in the single digits.
We are happy to see the company being much more aggressive in property planning and management. During the quarter, the company opened 131 new stores, expanded or relocated 22 stores, and closed 26 stores. Additionally, the company completed 76 renovations to the Family Dollar H2 format. This reduction and reorganizing is very positive news in the long term. This is evidenced by same-store sales at Family Dollar now being positive.
We still like that the company is closing losing operations and we are impressed with comp growth. The valuation is discounted and would be especially attractive if shares could be acquired under $90. You should buy them if they fall into this range. The metrics in Q2 were strong and we will closely be watching all of these lines when Q3 is reported. Dollar Tree has now delivered 48 consecutive quarters of positive same-store sales, and ten consecutive quarters with two-year stacked comps exceeding 6%. Dollar Tree is still a winner.
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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in DLTR over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.