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Don't Trust the Dollar Tree Rally

Nicholas Rossolillo, The Motley Fool

Shares of retailer Dollar Tree (NASDAQ: DLTR) -- operator of its namesake chain as well as the Family Dollar stores it acquired back in 2015 -- have been rallying after a rough 2018. It's not that full-year results were anything to write home about, but investors have apparently decided to muster courage on hopes that a trade deal between the U.S. and China will offer some reprieve, and optimism surrounding Dollar Tree management's decision to accelerate floundering Family Dollar store closures.

It's a move that has been a long time coming, so it's understandable there would be investor excitement over more underperforming store closures. Nevertheless, prudence would be advisable, here, after a double-digit stock rally since the 2018 lows.

2018 by the numbers

Last year wasn't a great one for Dollar Tree and its Family Dollar subsidiary. Underperforming stores dragged down top- and bottom-line results, and a one-time impairment charge on the Family Dollar chain of $2.73 billion drug the bottom-barrel retailer into the red.

Metric

12 Months Ended February 2, 2019

12 Months Ended February 3, 2018

Change (YOY)

Revenue

$22.8 billion

$22.2 billion

3%

Gross profit margin

30.4%

31.6%

(1.2 p.p.)

Operating expenses

$5.16 billion

$5.00 billion

3%

Earnings (loss) per share

($6.66)

$7.21

N/A

Adjusted earnings per share

$5.45

$4.86

12%

Data source: Dollar Tree. YOY = percentage point. P.p. = percentage point. 

On an adjusted basis, which excludes the impairment charge on Family Dollar and one-time tax expenses related to U.S. corporate tax reform passed in 2017, earnings still notched an increase. However, preliminary expectations for 2019 don't look like a walk in the park for Dollar Tree.

What happens next?

The tariff situation is what it is right now as the U.S. and China continue to iron out their differences, so there is little for Dollar Tree to do at the moment but wait. What it can do is address its ill-advised $8.5 billion takeover of Family Dollar back in 2015, the reason for the impairment charge.

CEO Gary Philbin had this to say:

In fiscal 2019, at Family Dollar, we plan to complete at least 1,000 store renovations and 200 rebanners. We are further accelerating store closings and expect to close as many as 390 underperforming stores that because of age, layout, location, unfavorable lease terms or other factors are not expected to provide an adequate return on investment for the cost of renovation. Final number of actual store closures will be affected by ongoing lease negotiations.

With nearly 8,200 Family Dollar locations at the end of the last fiscal year, closing down 390 underperforming stores and rebranding another 200 to Dollar Tree will put a decent dent in the total count. However, it doesn't solve the inflation problem, which doesn't manifest itself in price hikes because everything at Dollar Tree is under $1. It does mean product gets smaller and lower quality, though -- an unsustainable trend over the long term.

A woman clutching a handful of dollar bills

Image source: Getty Images.

Management has yet to comment on a specific proposal from activist investor Starboard Value to explore price increases. While that would violate the "$1 or less" mantra, it could help the company expand its sales and profit margins. In the meantime, there isn't much to be excited about. Revenue is projected to rise 4% to 5% in 2019, and earnings per share are expected to range from $4.85 to $5.25 -- implying yet another decrease in the bottom line.

A discount retailer with falling profits isn't exactly a promising investment, and shares aren't cheap to compensate. The forward price-to-earnings ratio sits at 19.3, and price to free cash flow (money left over after basic operations and capital expenditures) doesn't help the picture any -- it's currently at 25.7. Though Dollar Tree has rallied in recent months, the stock is in a precarious position. Don't expect much more upside unless the tariff situation suddenly clears up.

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Nicholas Rossolillo and his clients have no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.