Dollar Tree and Family Dollar One Year Later: How are they doing?

It has been a year since Dollar Tree Stores (NASDAQ: DLTR) bought out its failed competitor Family Dollar. This brings up the natural question: How are the two small box discounters doing as a combined company? Is the merger paying off or not?

If you judge the combination in terms of revenue, the answer is definitely yes. Dollar Tree’s revenues have shot up by $6.898 billion over the past year. At the time of the buyout in January 2016, Dollar Tree reported a TTM revenue figure of $8.602 billion that grew to $15.5 billion a year later.

Dollar Tree certainly has a lot more revenue and buying power with Family Dollar, but is it making more money? Not if you go by terms of income. Dollar Tree reported $599.3 million in net income in January 2015 and $282.4 million in January 2016. Even though revenues have increased dramatically, the net income is $316.9 million less than it was last year.

Dollar Tree has More Cash

Even though it has less income, Dollar Tree does seem to have more cash. Its free cash flow grew to $687.8 million on Jan. 31, 2016. That’s an increase of $220.7 million, which is rather impressive.

Despite the increased cash flow, Dollar Tree is generating less cash. It reported $926.8 million in cash from operations in January 2015 and $780.9 million in cash from operations this past year, although Dollar Tree does have quite a bit in cash and short-term investments for a small box discounter – $740.1 million in January 2016.

It’s a slight decrease from $864.1 million in January 2015, but far better than rival Dollar General (NYSE: DG), which reported $157.95 million in cash and short-term investments on the same day. It looks as if Dollar Tree’s business model is capable of generating more cash than Dollar General’s. Dollar Tree also reported $6.070 billion in cash from financing, which probably comes from the money it borrowed to finance the Family Dollar acquisition.

So is Dollar Tree a Value Investment?

Naturally, a lot of people will be wondering if Dollar Tree is a value investment. I would say not because of the low free cash flow and the recent share price, $80.47 on March 21, 2016. That seems a little high given the nature of Dollar Tree’s business and the low net income.

To be fair, it should be noted that Dollar Tree is considered undervalued right now. It had a market cap of $18.89 billion and an enterprise value of $25.39 billion on March 21, 2016. I do not think that is necessarily accurate because of the shaky nature of Dollar Tree’s business. One problem here is that real estate, which does not automatically generate revenue, is also included in the enterprise value.

Dollar Tree’s Questionable Future

This retailer seems to base its business model on propositions that are far from guaranteed:

• A high level of disposable income among working and middle class individuals.

• The assumption that nobody else can undercut its prices.

 

• The sheer convenience created by the smaller size and greater number of Dollar Tree and Family Dollar stores will lure customers away from larger retailers, such as Walmart Stores Inc. (NYSE: WMT) and Costco Wholesale (NASDAQ: COST).

The problem for Dollar Tree is the underlying factors these assumptions are based upon are no longer true. Dollar Tree and Dollar General face a dramatically changing society and retail marketplace in which their business model may not be as competitive as it once was.

The Average Income for Dollar Tree’s Customers is Dropping

The median wealth of the average middle class American household fell by 28% between 2001 and 2013, Pew Social Trends reported. The same study found that the income of the average middle class household fell by 4% between 2000 and 2014.

Incomes for Dollar Tree’s target market, the lower class, fell even more. Pew reported that the average lower class household made $26,496 a year in 2000 and $24,074 in 2014. That is a $2,422 drop in income, meaning that the average lower-class household’s income has fallen by 10% in 15 years.

Many Americans have less to spend, which both helps and hurts Dollar Tree. The income drop means people are more likely to shop at dollar stores, but they have less to spend. Another problem here is that recent increases in buying by lower and middle class households were triggered by a fall in gasoline prices, not increases in income.

Competitors are Undercutting Dollar Tree’s Prices

Declining incomes mean that offering the lowest prices is now critical for stores like Dollar Tree. Unfortunately, it now has competitors that can undercut its prices. The biggest potential direct threat to Dollar Tree is the fast-growing privately-owned discount grocer Aldi, which offers extremely low prices and a greater selection.

Some other retailers are also managing to undercut some of Dollar Tree’s prices. One major threat is the grocery giant Kroger (NYSE: KR), which reported a TTM revenue of $109.83 billion on Jan. 31, 2016. That means Kroger, which aggressively engages in deep discounting, has more leverage to put on suppliers and force them to lower prices. Like, Aldi Kroger can offer a wide variety of items that Dollar Tree cannot, including prescriptions and gasoline.

Beyond Kroger, there’s Walgreen (NASDAQ: WBA), which now has revenues of $112.92 billion. Walgreen operates small box stores in direct competition with Family Dollar and Dollar Tree and it can offer customers the added benefit of prescriptions.

Another threat is Walmart, which is opening smaller and more convenient Neighborhood Market stores that offer a far wider selection than Dollar Tree. Some Neighborhood Markets also offer gasoline, and most of them have pharmacies. If Kroger, Walgreen, and Walmart can match or undercut Dollar Tree’s prices, they can take serious market share from it, particularly if they can become just as convenient.

How Convenient are Dollar Stores?

The final assumption underlying the argument for dollar stores is that they are very convenient places to shop. Aldi, Walgreens, and Walmart Neighborhood Market are also smaller and convenient. Walgreens and Walmart Neighborhood Market offer the added convenience of amenities dollar stores lack, including gas pumps and pharmacies.

An even greater threat in the convenience department is Kroger, which also offers a wide variety of precooked food in its delis and groceries. Most Kroger stores also offer a higher level of customer service, which many customers value more than convenience.

A longer term threat is online shopping in the form of Amazon.com (NASDAQ: AMZN), which is the most convenient experience of all. It can offer very low prices and eliminate the need for shopping completely, an experience that many customers love. Now Amazon is starting to offer some of the products found at dollar stores, including private label groceries and toiletries. It could be in a position to take business from them.

A closely related threat to online shopping is the same day-delivery services that Amazon, Walmart, and Kroger have been testing in some markets. These also provide convenience and eliminate the need for a shopping trip.

Dollar stores may not offer the most convenient shopping experience around, which eliminates much of their appeal. It remains to be seen whether these threats pan out, but we must remember that dollar stores operate at a low margin. Something like Walmart, Aldi, or Amazon could kill Dollar Tree by taking just a small percentage of its business.

It looks as if Dollar Tree’s takeover of Family Dollar has been successful, but the company is still in a shaky position. My guess is that it will take several years to see if this new company can survive because the revenue growth may not be generating enough cash to sustain the enterprise.