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Family Dollar results improving, capital structure largely unsecured

admin | March 8, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Now that the Family Dollar turnaround is bearing fruit, trends for better margins at the Family Dollar banner will benefit the enterprise margin. Term loans have been repaid and with no secured debt maturing ahead of the unsecured bonds, Dollar Tree spreads could collapse closer to Dollar General. Although less likely to happen over the near term, any removal of the collateral on the revolver would serve as a positive catalyst for spread compression.

Earnings recap

DLTR (Baa3/BBB-) posted solid 4Q results underscored by better than expected enterprise same store sales growth largely due to improvement at the Family Dollar banner. Enterprise same store sales of 2.4% came in ahead of consensus of 1.6%. Dollar Tree stores posted same store sales of 3.2%, its 44^th consecutive quarter of positive growth. Family Dollar posted same store sales of 1.4%, its first quarter of growth since 4Q17 and better than street estimates, which were expecting same store sales growth to be flat. The improvement at the Family Dollar banner was largely due to the 522 stores renovated in 2018, which are witnessing an average comparable sales lift of over 10%. DLTR also re-bannered 52 stores to the Dollar Tree brand and closed 122 underperforming Family Dollar stores. DLTR ended the year with 15,237 stores in total, with 7,001 Dollar Tree stores and 8,236 Family Dollar stores.

Similar to peers, DLTR saw margin contraction in the quarter. Gross margin declined 220 bp year over year to 30.8%, primarily reflecting higher markdowns, increased domestic freight costs, occupancy and shrink. Management was able to hold SG&A/sales flat year over year at 21.3%. Lower incentive compensation and workers’ compensation costs were offset by an increase in hourly payroll, a result of the company’s planned tax reinvestment. Consolidated EBITDA margin for the quarter was 11%, down 60 bp from the year ago period.

Family Dollar transformation results encouraging

While Family Dollar is not fully out of the woods, the 4Q results are encouraging and demonstrate that management is on the right path with respect to the transformation. Given the improved performance from optimizing the Family Dollar real estate portfolio, the company plans to renovate at least 1,000 Family Dollar stores in 2019, while re-bannering 200 and closing 390. The final number of actual store closings could be affected by ongoing lease negotiations. Management noted that the consumables business drove traffic and sales at Family Dollar in the quarter, with consumable comps exceeding 2.5%. While discretionary sales continue to comp negatively, management saw a 100 bp in improvement Family Dollar discretionary comps sequentially.

Tariffs remain a focus

DLTR has been actively involved in tariff mitigation. Despite the Section 301 tariff increase from 10% to 25%, originally scheduled for 3/2/19, being postponed, management built its annual plan and forecast under the assumption that tariffs increase. Furthermore, management is expecting 2H19 to be stronger from a margin perspective as costs associated with the Family Dollar transformation are to be incurred disproportionately, with 75% to be taken in 1H19 and 25% in 2H19. Should tariffs not increase, there could be further margin opportunity primarily in the back half of 2019.

Debt reduction continues – all secured term loans and bonds repaid

Since the Family Dollar acquisition closed on 7/6/15, DLTR has been steadily repaying debt. The company utilized secured term loans totaling $4.95 billion and unsecured debt to fund the deal. DLTR reduced debt by approximately $1.4 billion during 2018, bringing total debt reduction to $4.1 billion since the close of the acquisition in 2015. Of the $1.4 billion repaid this year, $782 million was prepaid under the secured term loan, bringing the secured term loan balance to zero. While the revolver remains secured, DLTR has nothing outstanding on the line. Even if the line were to be fully drawn, secured debt as a percentage of total debt would be below 25%. The overall debt reduction – in particular the reduction of the secured term loans – is a positive for spreads on the unsecured bonds. S&P estimates adjusted leverage now stands at roughly 2.7x, down from 5.0x at the close of the deal.

Relative value

Now that the Family Dollar turnaround is bearing fruit, trends for better margins at the Family Dollar banner will benefit the enterprise margin. On a last twelve months basis, DLTR’s EBITDA margin was 11.0%, comparing favorably to Dollar General’s (DG – Baa2/BBB) EBITDA margin of 10.2%. Furthermore, leverage (based on S&P’s adjustments) at DG and DLTR are roughly equal at 2.7x. With the term loans now repaid and no secured debt maturing ahead of the unsecured bonds, spreads could collapse closer to DG. Currently DLTR 4.2% 2028 bonds trade roughly 65 bp (g-spread) behind DG 4.125% 2028 bonds, while in May 2018, the bonds were trading roughly 15 to 20 bp apart. While less likely to happen over the near term, any removal of the collateral on the revolver would be a positive catalyst for spreads.

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