April 3, 2017

At current valuations, DLTR looks undervalued, as it is priced to fade from cycle-high profitability to near cycle-lows, but fundamental tailwinds and management sentiment signal otherwise


  • Markets expect DLTR to see Adjusted ROA fade from current high 12% levels to near cycle-low levels of 8% over the next five years, levels only seen twice in the past 15 years
  • Management is confident about gross margin and SG&A improvements, their assortment, and the consolidation of services shared with Family Dollar, which should help them maintain current margins and turns to beat market expectations
  • DLTR currently trades at a 2.1x Adjusted P/B metric, which is in line with its peer group, but with far stronger growth prospects, further signaling the potential for multiple expansion with limited equity downside
  • DLTR’s returns are materially distorted by how as-reported GAAP accounting treats operating leases as an expense as opposed to an investment, and by how GAAP accounting understates earnings around acquisitions

 

Embedded Expectations Analysis

As investors, understanding what the market is embedding in the stock price in terms of expectations is paramount to making good decisions. Without understanding what the market is pricing in, it is impossible to claim that the market is wrong. We derive market expectations for the firm from valuations and historical performance trends, to give a clearer picture into what the market is projecting for the firm.

DLTR is currently trading at a 21.8x UAFRS-based P/E (Fwd V/E’), which is near recent highs. However, even at these levels, the market is pricing in expectations for UAFRS-based ROA to decline from 12% in 2015 to 8% by 2020, accompanied by 15% UAFRS-based Asset growth. These expectations imply the market believes improvements to profitability since 2009 were the result of an upturn in the firm’s sales cycle, rather than permanent improvements to the underlying business.  However, several indicators, including recent profitability trends, valuation relative to peers, and management sentiment signal that these expectations may be too negative.

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Performance and Valuation Prime™ Chart

Dollar Tree, Inc. (DLTR) is a leading operator of discount variety stores across North America. While discount & variety stores have traditionally generated countercyclical returns due to the low price and perceived inferiority of their goods sold, the discount retail industry as a whole has done a good job of sustaining profitability throughout the entire recovery from the Great Recession, and into the current bull market. This is due in part to consolidation in the industry, which is largely an oligopoly between DLTR, Dollar General (DG), and to a lesser extent, Wal-Mart (WMT) and Target (TGT). In 2015, DLTR completed its acquisition of the third largest competitor in the industry, Family Dollar Stores, Inc. The acquisition positioned the combined entity to realize significant cost savings while simultaneously improving their supply chain and their e-commerce channel.

Prior to 2009, DLTR had seen profitability slowly fade, with Adjusted ROA declining from 15% in 2000 to a low of 8% in 2008. However, in 2009, during the worst part of the recession, Adjusted ROA began to recover, stabilizing at 11%-12% levels from 2010-2015. Meanwhile, the firm has generally seen consistent Adjusted Asset growth that had ranged from 7%-21% from 2004-2014, with outsized 52% growth in 2003 related to the firm’s acquisition of Greenbacks, and 83% growth in 2015 attributable to the firm’s acquisition of Family Dollar.

Given recently sustained improvements to DLTR’s Adjusted ROA and the recent consolidation in the industry, the market’s current expectations for a fade back to trough levels of profitability are likely too bearish.

For context, the PVP chart above reflects the real, economic performance and valuation measures of Dollar Tree, Inc. (DLTR) after making many major adjustments to the as-reported financials. This chart, along with all of the charts included in this article, as well as the detail behind the graphics, can be found here.

Peer Analysis – Valuations Relative to Profitability

A major benefit of adjusting as-reported financial statements is to clear away accounting distortions to allow for more accurate peer-to-peer comparisons. To this end, we have included a scatter chart below that plots DLTR against its peers based on their Adjusted Price-to-Assets ratio (V/A’) and Adjusted ROA (ROA’).

Looking across industries, markets, and time, there has been a very strong relationship between a company’s ROA’ relative to the corporate average (6%) ROA’, and the multiple the market will pay above the value of the company’s Asset’ base, in terms of a UAFRS-based P/B (V/A’) multiple. A company that generates a 6% ROA’ will tend to trade at a 1.0x Adjusted P/B, and a company that generates an 18% ROA’ will trade at a 3.0x Adjusted P/B, etc.

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Relative to its peers, DLTR is likely fairly valued at worst, with its 2.1x UAFRS-based P/B (V/A’) and 11% Adjusted ROA, placing it in-line with its competitors, not considering growth potential related to the Family Dollar acquisition. In order to justify current valuations, DLTR need only improve the fundamentals of its newly acquired business to levels of the legacy Dollar Tree business, about which management shows no concerns, without any need to find incremental growth.

Analyst and Management Expectations

Analysts have bullish expectations relative to the market, projecting Adjusted ROA to fade only slightly to 10% in 2017. Analysts appear to believe the firm will have success integrating the Family Dollar acquisition, and improve what was a worst-in-class business to DLTR’s fundamentally best-in-class legacy business.

In addition, Valens’ qualitative analysis of the firm’s Q4 2016 earnings call highlights that management is confident about their gross profit margin improvement, and about SG&A being flat or slightly improving in 2017. Additionally, they are confident that they are focused on consolidating their shared services to drive performance, and they can offset cost changes with their assortment. Moreover, they are confident that Q1 2017 EPS will be comparable to Q1 2016 EPS minus last year’s tax benefit.

Given management’s confidence about gross margin and SG&A improvements, their assortment, and the consolidation of their shared services, DLTR appears poised to maintain current levels of profitability, and equity upside may be warranted.

Performance Drivers – Sales, Margins, and Turns

It can be helpful to break down Adjusted ROA into its DuPont formula parts, UAFRS Earnings Margin and UAFRS Asset Turnover, which are cleaned up margins and turns metrics used to calculate Adjusted ROA. The chart below details both Adjusted Earnings Margin and Adjusted Asset Turns historically, to help us better understand the drivers of the firm’s profitability and performance.

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As mentioned above, DLTR has materially improved its business since 2008.  Recent improvements in Adjusted ROA have been driven by increasing UAFRS-based Earnings Margins, partially offset by slight declines in UAFRS-based Asset Turns. From 2003-2008, Adjusted Earnings Margins ranged from 5%-6%, before improving to 8%-9% levels in 2010-2014, and improving further to 10% in 2015. Meanwhile, Adjusted Asset Turns have slowly but steadily declined from 2.3x in 2003 to 1.3x in 2015.

For the company to fade back to near-trough Adjusted ROA, they will need to see Adjusted Earnings Margins compress materially.  However, as mentioned above, management is confident about their gross margin improvements, and about their ability to offset cost changes with their assortment, meaning they have the ability to limit margin compression.  Additionally, management is confident they are focused on consolidating shared services between Dollar Tree and Family Dollar stores, which is a likely catalyst for improving asset efficiency. As a result, in particular, Adjusted Earnings Margin, but also Adjusted Asset Turns will likely remain flat if not improve going forward.  This makes it unlikely the company will see returns decline to levels to warrant current valuations.

Impact of UAFRS Adjustments

This analysis uses Uniform Adjusted Financial Reporting Standards (UAFRS) metrics, or adjusted metrics, which remove accounting distortions found in GAAP and IFRS to reveal the true economic profitability of a firm. This allows us to better understand the real historic economic profitability of a firm as well as allows for better comparability between peers. To better understand UAFRS, please refer to our explanation here.

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The chart above highlights via common-size financial statements the impact UAFRS adjustments have on DLTR’s asset base and earnings. The largest adjustments to the firm’s Adjusted Net Asset base and Adjusted Earnings comes from UAFRS capitalization of operating leases and one-year adjustments for the company’s acquisition of Family Dollar.

DLTR’s operating lease expense is material. The decision management makes between investing in capex and investing in a lease is not a decision between an expense and an investment, but rather a decision in how management wants to finance their investments. If they would rather spend cash up front for the asset, they will spend capex. However, if they want to spread the cost of the asset over several years, they will instead choose to lease the asset. That said, as-reported accounting statements treat one as an investment, and the other as an expense that does not impact the balance sheet.

DLTR’s acquisition of Family Dollar last year also creates material short-term distortions to the company’s financial statements which need to be adjusted to understand the company’s real underlying profitability.  In particular, thanks to the timing of DLTR’s acquisition of Family Dollar part way through the year, there is a mismatch between the balance sheet, which shows the end-of-year snapshot assets that DLTR had post-acquisition, and the income statement, which is a periodic statement that shows the earnings performance of the combined businesses since the acquisition closed.  To better understand the actual returns of the business, that underreported earnings needs to be adjusted to reflect Family Dollar’s earnings power pre-acquisition, to not artificially understate how the combined company did last year.

Valuation Matrix – ROA’ and Asset’ Growth as Drivers of Valuation

When valuing a company, it is important to consider more than a singular target price, and instead the potential value of a firm at various levels of performance. The below matrix highlights potential prices for DLTR at various levels of profitability (in terms of Adjusted ROA) and growth (Adjusted Asset growth). Prices that are in excess of 10% equity upside are highlighted in black, and prices representing an excess of 10% equity downside are highlighted in red.

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To justify current prices, DLTR would need to see Adjusted ROA fade to near cycle-low Adjusted ROA levels last seen prior to 2009, accompanied by 15% Adjusted Asset growth. Given the fact that the firm has consistently grown its Adjusted Asset base between 7%-20% over the past decade, and management sentiment indicates that Adjusted ROA is likely to remain stable if not improve to new highs, markets appear to be pricing in the worst-case scenario, limiting near-term equity downside.

Moreover, when considering fundamental tailwinds and management communication signals, the firm may exceed market expectations, potentially driving material equity upside going forward.

 To find out more about Dollar Tree Inc. (DLTR) and how their performance and market expectations compare to peers, click here to access the open beta of the Valens Research database.

Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article. Professor Litman is regarded around the world for his expertise in forensic accounting and “forensic fundamental” analysis, particularly on corporate performance and valuation.