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Dollar Tree's Turnaround Could Be Threatened by Higher Tariffs

Leo Sun, The Motley Fool

Dollar Tree (NASDAQ: DLTR) has underperformed its biggest rival, Dollar General (NYSE: DG), by a wide margin over the past few years. The reason is simple: Dollar Tree weighed itself down by acquiring its struggling rival Family Dollar in 2015.

The growth of Dollar Tree's namesake banner, which sells all its products for $1, was consistently offset by the weak growth of Family Dollar, which sells products at higher price points. Activist investor Starboard Value urged Dollar Tree to sell Family Dollar earlier this year, but backed down after Dollar Tree unveiled an aggressive turnaround plan.

A dollar bill in a shopping cart.

Image source: Getty Images.

Dollar Tree stated that it would close hundreds of Family Dollar Stores, renovate about 1,000 locations, and rebanner 200 locations as Dollar Tree stores. In March, it stated that the newly renovated Family Dollar stores, which sell alcohol and include a $1 Dollar Tree section, generated over 10% comparable sales growth. It also started testing out higher price points at certain Dollar Tree stores.

Dollar Tree segment comps rose 2.5% during its fiscal first quarter of 2019, marking the company's 45th straight quarter of positive comps growth. Family Dollar's comps rose 1.9%, marking a significant acceleration from its previous quarters, while overall comps improved 2.2%. Those numbers indicate that the company's turnaround efforts are working -- but Dollar Tree has also warned that higher tariffs could derail its earnings growth.

Improving comps and contracting margins

Dollar Tree finished the quarter with 7,102 Dollar Tree stores and 8,162 Family Dollar stores. It opened 91 new locations, expanded or relocated 11 stores, and shuttered 16 Family Dollar stores and nine Dollar Tree stores. It also rebannered 45 Family Dollar stores as Dollar Trees.

As a result, its total store count rose from 14,957 locations in the prior year quarter to 15,264 locations, making it one of the few U.S. retailers still expanding its brick-and-mortar presence. Here's how the two banners fared in terms of lifting comps over the past year:

Comps growth

Q1 2018

Q2 2018

Q3 2018

Q4 2018

Q1 2019

Dollar Tree

4%

3.7%

2.3%

3.2%

2.5%

Family Dollar

(1.1%)

0%

(0.4%)

1.4%

1.9%

Source: Dollar Tree quarterly reports.

Dollar Tree's first quarter comps were boosted by robust sales of consumables and seasonal products. Family Dollar's aforementioned turnaround efforts boosted its sales of consumables and offset the soft sales of its discretionary products, which still face stiff competition from Walmart and Amazon. Dollar Tree expects its total comps to rise by the "low single digits" for both the second quarter and full year.

That top line growth looks stable, but the company's margins were wobbly in the first quarter. Dollar Tree's gross margin stayed flat annually but contracted sequentially, while Family Dollar's gross margin declined annually but improved sequentially.

Gross margin

Q1 2018

Q4 2018

Q1 2019

Dollar Tree

34.5%

37.1%

34.5%

Family Dollar

26.7%

23.6%

24.8%

Source: Dollar Tree quarterly reports.

Dollar Tree's gross margin was weighed down by higher payroll and freight costs, and a higher percentage of sales from lower-margin consumables. Family Dollar's gross margin contracted annually for similar reasons and was exacerbated by markdowns at shuttered and rebannered stores.

Its industry peers are experiencing similar pressure. Dollar General's gross margin slipped 30 basis points annually to 30.2% in the first quarter, mostly due to higher freight costs and higher sales of consumables.

The looming threat of higher tariffs

Rising tariffs forced Dollar Tree to slash its full-year guidance from $4.85-$5.25 to $4.77-$5.07, which represents a 7%-12% decline from 2018. It stated that the guidance factored in 25% tariffs on List 1, 2, and 3 products from China, which mostly include capital goods rather than consumer goods.

However, Dollar Tree warned that its reduced guidance didn't include President Trump's recent threat to place 25% tariffs on List 4 products. Those tariffs, which could be levied on an additional $300 billion in Chinese goods, could impact 67% of consumer products according to Citi analysts.

American and Chinese shipping containers collide in mid-air.

Image source: Getty Images.

During the company's earnings conference call, CEO Gary Philbin stated that Dollar Tree still sourced the "vast majority" of its products from China, and warned that List 4 tariffs would "be impactful" to its business and "consumers in general." However, he stated that the company wouldn't update its guidance until it had "more clarity" regarding the tariffs.

Dollar General made similar comments during its recent conference call, with CEO John Garratt warning that "shoppers will be facing higher prices as 2019 progresses."

Too many uncertainties ahead

Dollar Tree has been a retail survivor over the past few years. Its comps growth is stable, but it doesn't have much room to raise prices, and its margins and earnings could face intense pressure if the trade war escalates. Investors should avoid Dollar Tree until it offers a clearer battle plan to counter those headwinds.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Leo Sun owns shares of Amazon. The Motley Fool owns shares of and recommends Amazon. The Motley Fool has a disclosure policy.