Dollar Tree Company--"Just an Old Stump?"

Since its founding in 1986, Dollar Tree Stores, Inc. (DLTR-$27.43) has become the leading operator of discount variety stores offering merchandise at the fixed price of $1.00. At January 28, 2006, the Company operated 2,914 single-price point stores under the names of Dollar Tree, Dollar Bills and Dollar Express.

Management prides itself on maintaining a disciplined, cost-sensitive approach to store site selection in order to “minimize the initial capital investment required and maximize the potential to generate high operating margins and strong cash flows.” In other words, corporate primarily looks for ‘lower-rent’ districts—like strip shopping malls—and prefers to lease (as opposed to owning) the store properties.

Dollar Tree’s business model translates into a Value Merchandising Offering strategy. The Company strives to exceed its customers’ expectations over the scope and quality of products that they can purchase for a buck by offering items that management believes would typically sell for higher prices elsewhere.

Dollar Tree offers a wide selection of everyday basic products, supplemented with seasonal and closeout merchandise. The Company attempts to keep certain basic consumable merchandise in its stores continuously to establish its stores as a destination. Closeout merchandise is purchased opportunistically and represents less than 10% of corporate purchases.

The merchandise mix consists of:

• consumable merchandise, which includes candy and food, health and beauty care, and household consumables such as paper, plastics and household chemicals and in select stores, frozen and refrigerated food;
• variety merchandise, which includes toys, durable housewares, gifts, party goods, greeting cards, hardware, and other items; and,
• seasonal goods include Easter, Halloween and Christmas merchandise, along with summer toys and lawn and garden merchandise.
  

The Company has added freezers and coolers to approximately 200 stores in 2005 and plans to add them to approximately 250 more Dollar Tree stores in 2006. As a percentage of purchases and sales, consumable merchandise grew 350 basis points year-over-year to 44.9% by February 1, 2006.

In 2005, corporate expanded the tender types accepted at Company stores. Prior to May 2005, approximately 900 stores accepted debit cards. By the end of 2005, approximately 2,300 stores accepted debit cards as a result of the debit rollout. Dollar Tree also began accepting food stamps at certain of its stores in 2005.

The 10Q Detective believes that the aforementioned moves made by corporate will grow Dollar Tree’s image among consumers as a ‘destination’ store. This enhanced visibility will help to grow the topline, for both the average dollar size of transactions [more ‘impulse’ buys] and repeat business will expand.

Implicit in advertising product(s) at the $1.00 price-point is cost-control. Dollar Tree minimizes potential markdowns by buying products on an order-by-order basis and making sure that no vendor accounts for more than 10% of total merchandise. Using point-of-sale data (POS) software installed in 2004, the Company has been successful in reducing its inventory per store (approximately 12% and increase inventory turns in the current year—3.7 times in 2005).

The Company’s operating margins (looking at comparables) are swamping the competition. Direct competitor comparisons of operating margins for Dollar Tree, 99 Cents Only Stores (NDN-$12.02), Dollar General Corp. (DG-$17.08), and Family Dollar Stores (FDO-$26.73) are 8.35%, 2.35%, 6.55%, and 5.70%, respectively. [ed. note. Operating margins for Dollar Tree actually fell year-over-year for FY ended January 28, 2006—more on that later.]

Additionally, existing stores are throwing off enough cash flow to permit the Company to self-fund infrastructure investment and new store openings.

Contrary to this tight-fisted public image, our readers might be surprised to read about the spendthrift ways of the Company “in private.” The 10Q Detective has unearthed some great water cooler gossip in the DEF 14A filed last week with the SEC:

• Non-employee Directors receive an annual retainer of $80,000. During 2005, the Board held five formal meetings, which equates to a $16,000 payment per meeting! [The 10Q Detective did not include committee meetings in this total—suffice to say that Directors are compensated with additional $$$ for other duties, too.]

Same-store sales comparables fell (0.8%) in the FY ended January 28, 2006 compared to the prior year and operating income as a percentage of sales dropped 110 basis points to 8.3 percent. ROA fell 120 basis points to 9.7% and ROE slipped 160 basis points to 14.9%. Nonetheless, in late 2005, in order to improve performance incentives, the Compensation Committee approved the acceleration of vesting for all outstanding stock options for both officers and non-officers. Huh?

• Dollar Tree’s Chief Executive Officer. Bob Sasser, was paid a base salary was $700,000 in 2005. At the beginning of the fiscal year, the committee established certain operational and managerial goals for Mr. Sasser for the fiscal year ending January 28, 2006. In recognition of his achievement of certain operational and managerial goals and the company’s performance in 2005, Mr. Sasser earned a bonus of $171,920. Huh? [One can only drool with envy at the thought of what his bonus might have been—had the Company’s financial showing been even better in FY 2005.]
• Macon F. Brock, one of the Company’s founders, currently serves as Chairman of the Board. For fiscal 2005, Mr. Brock’s base salary was $400,000. This payment was justified on the merit—cough! Cough! —Mr. Brock is STILL CONSIDERED to be a KEY employee: “whose responsibilities included long-term and strategic planning.” Readers ought to note that Mr. Brock resigned as CEO back on January 1, 2004. [In 2003, he received $50,350 towards his ‘purported’ retirement. This amount included $15,432 of tax preparation services that the Company paid on his behalf and a retirement gift of $34,918.]
• At the beginning of the FY 2005, the Compensation Committee established certain operational and managerial goals for Mr. Brock. In recognition of his achievement of these goals and the company’s performance in 2005, Mr. Brock earned a bonus of $102,760. Huh? The 10Q Detective could have sworn we just read that he retired in 2003/04?
• In fiscal 2005, the Committee also granted him the option to purchase 20,000 shares of common stock and awarded 5,000 restricted stock units. [ed. note. Not that Mr. Brock needs to accumulate additional shares, for he already owned approximately 2.2 million shares, or 2.1% of the Company.]
• J. Douglas Perry, one of the three founders of Dollar Tree back in 1986, became Chairman Emeritus of the Board in 2001. [ed. note. How many Chairman of the Board does one company need?] On January 29, 2005, the company entered into a consulting agreement with Mr. Perry that provides for an annual consulting fee of $30,000. Payment of such will ensure his continued eligibility in the company’s group health plans. [ed. note. The man owns 1.1% of the Company, or approximately 1.2 million shares, worth about which translates into about $32.92 million—and he’s worried about health insurance? Try Medicare, Part D!]
• Not to be left out, the third founder, H. Ray Compton, who retired from the Company in 2004, also negotiated the same consulting agreement as J. Douglas Perry.
• Remember the aforementioned comment that Dollar Tree prefers to lease their stores? Filed under Certain Relationships & Transactions: “We currently lease three stores from lessors who are affiliated with officers or directors of our company. We lease a store from Hampton Roads Enterprises, Inc., controlled by Mr. Perry [founder]. In addition, we rent two stores from DMK Associates, a partnership controlled by Mr. Perry and Mr. Brock [founder]. Rental payments on the three stores totaled approximately $220,000 in 2005…. terms were not negotiated on an arms-length basis and accordingly the terms of the leases may not be as favorable to us as those that we could have obtained from an independent third party.”
• The son of Bob Sasser, CEO, is an account executive with an office supply company, which provides Dollar Tree with certain items for all of its locations, including the Store Support Center, Distribution Centers and stores. During fiscal year 2005, the supply company received approximately $657,000 in payment for goods provided.
  
  

So have the insiders justifiably earned the aforementioned compensation dollars heaped upon them? Using gains on dollars invested as the benchmark definition of performance—the answer is NO! Comparing the cumulative total shareholder returns on Dollar Tree Common Stock against a cumulative total return of the S&P 500 Retailing Index, Dollar Tree under performed in four out of the last five years.

Perhaps the name of the Company should be changed to The Giving Tree. For those who do not remember—The Giving Tree is a children’s book written by Shel Silverstein, who tells the story of a tree that loved a little boy…and gave and gave of itself to satisfy every want of the little boy…until the tree had nothing left:

And after a long time
the boy came back again.
“I am sorry, Boy,” said the tree, “but I have nothing
left to give you—I wish I could
give you something…
but I have nothing left. I am just an old stump. I am sorry….”

In go the spears full sadly in arest [sic]--- Geoffrey Chaucer (ca.1343-1400)

Despite declining operating margins in FY 2005, how do the prospects look for the Company going forward? And, is the stock a BUY based on its current trading price?

The primary growth drivers to Dollar Tree’s net sales growth have been new store openings, an active store expansion and remodel program, and selective mergers and acquisitions. From 2001 to 2005, net sales increased at a compound annual growth rate of 14.3%. Corporate expects that the majority of its future sales growth will come primarily from new store openings and secondarily from store expansion and relocation program.

Ergo, management believes the use of selling square footage yields a more accurate measure of store productivity (than same store comparables). In the last five years, the average selling square footage per store and per new store opened (less than a year) has grown 2,770 square feet and 2,686 square feet to 7,900 square footage and 9,756 square footage, respectively. [Net sales per selling square foot fell $17 year-over-year to $152 for the FY ended January 28, 2006.]

Corporate expects to increase its selling square footage in the future by opening new stores in underserved markets and strategically increasing its presence in existing markets via new store openings and store expansions (expansions include store relocations). [ed. note. Increasing the size of the store is meaningless unless accompanied by a parallel increase in average sale per transaction & aggregate volume of transactions—i.e. store traffic. For example, despite an overall increase in year-year sales, the aforementioned decrease in comparable store net sales was the result of a decline of 2.6% in the number of transactions, partially offset by an increase of 1.9% in transaction size.]

In fiscal 2006 and beyond, Dollar Tree plans to predominantly open stores that are approximately 10,000 selling square feet. At January 28, 2006, 673 of its stores, totaling 39.1% of selling square footage, were 10,000 selling square feet or larger.

Risk Factors.

• Corporate profitability is especially vulnerable to material cost increases. Future increase in costs such as the cost of merchandise, shipping rates, freight costs, fuel costs, wage levels and store occupancy costs may reduce profitability. As a fixed price retailer, Dollar Tree cannot raise the sales price of its merchandise to offset cost increases. Unlike multi-price retailers, the Company is primarily dependent on its ability to operate more efficiently or increase its comparable store net sales in order to offset inflation. Albeit corporate expects comparable store net sales will be about flat to slightly positive in 2006, management has demonstrated its ability to contain SG&A costs. [As a percentage of net sales, SG&A remained stable at 25.2% year-over-year ending January 2006.]
• The mix of products sold affects Dollar Tree’s profitability. Refrigerated consumable goods are growing as a percentage of total sales but carry higher material costs. Gross profit will decrease unless corporate can increase the amount of its net sales sufficiently to offset any decrease in product margin percentages. [Witness the 110 basis point drop in gross margins to 34.5% for the year-ended January 28, 2006.]
• Ability to expand store square footage as profitably as planned. The Company’s failure to achieve its expansion plans could materially and adversely affect its business, leading corporate to lower guidance in the coming months.
  

Management recently issued guidance for FY 2006. The Company estimates sales will range from $3.845-$3.940 billion. This estimate is predicated on a square footage growth of 12-14%, which includes the 138 Deal$-Nothing Over a Dollar discount-chain (purchased in March 2006), or about 5% of the annual increase. Comparable store sales performance is projected to be nearly flat to positive low single digits.

Fiscal year 2006 diluted earnings per share are forecast to be in the range of $1.68 to $1.80. These estimates exclude any impact of share repurchase in 2006. The Company has $173 million available to repurchase shares under an original $300 million authorization.

Rising energy costs do not just impact business, but the discretionary income of households, too. The 10Q Detective suspects that Dollar Tree faces a real threat to top-line growth because if faced with the choice of gas for their cars or a snack & soda, low-income consumers are going to choose the gasoline.

We also believe that despite the benefits of the POS system, margins will be pressured with trying to integrate the Deal$ acquisition (as well as previously mentioned increasing product costs).

At a current price of $27.43, the 10Q Detective believes the risk/reward ratio is listing unfavorably for new investors of Dollar Tree Common Stock. Dollar Tree is selling for 16.3 times the low-end FY 2006 EPS of $1.68. Given its PEG ratio of 1.12, we believe that the current stock price has already discounted management’s guidance. Any misstep will lead to a P/E multiple contraction, with a corresponding drop in Dollar Tree’s Common Stock Price below critical support of $25.30 per share (200-day moving average). AVOID