Will Family Dollar Hold Dollar Tree Back Again in Q4?

With activist investors pushing Dollar Tree (NASDAQ:DLTR) to undo its purported mistake of buying the Family Dollar chain in 2015, the deep discounter is under pressure to prove that its strategy of staying the course is the right one.

It's not just an academic question, because hedge fund Starboard Value is trying to gain a majority of seats on the board of directors to influence the outcome. Once Wall Street's favored dollar-store chain because of its superior performance, Dollar Tree saddled itself with a broken business and needs to spend considerable time and money to try to fix it.

With Dollar Tree's fourth-quarter earnings report scheduled for Wednesday, March 6, here are the top two things investors should watch for.

Image source: Getty Images.

1. Same-store sales growth

Dollar Tree has seen weak comparable-store sales trends throughout 2018. The Family Dollar chain posted flat or declining comps in each of the first three quarters of the fiscal year. Even Dollar Tree's namesake stores have been suffering of late, with comp sales rising just 2.3% in the third quarter, compared to 5% growth in the prior-year period.

Dollar General (NYSE:DG) has posted more robust growth, with comp sales up 2.9% year over year for the first three quarters of fiscal 2018 combined.

Competition from the likes of Walmart and grocery chains Aldi and Lidl has put pressure on the dollar store chains recently. Furthermore, the combination of low unemployment and tax reform -- which put more money in most Americans' wallets -- has caused some of their customers to widen their shopping experiences.

In a letter to Dollar Tree's board arguing for a sale of Family Dollar, Starboard Value notes that the gap in comps between Family Dollar and Dollar General has widened, not improved, since Dollar Tree acquired the chain. Dollar General has posted fairly consistent growth, but Family Dollar has gone from slightly positive comp sales growth just prior to the merger to negative comp sales on a year-to-date basis.

2. Profit pressures

The Family Dollar chain's poor results are weighing on Dollar Tree's profitability. For the company as a whole, gross margin narrowed to 30.3% in the first nine months of fiscal 2018, down from 31.0% a year earlier. Over the same period, operating margin contracted to 7.3% from 7.8% a year earlier (or 8.1% if you exclude a one-time receivable impairment that Dollar Tree recorded in 2017).

Rising costs for freight, labor, and even tariffs could continue to pressure the company's margins this year. (Imported merchandise accounts for between 40% and 42% of the Dollar Tree chain's sales, according to Reuters.)

The deep-discount space is a low-margin business, so there's not much room for Dollar Tree to maneuver. That's why one of the other prongs in Starboard Value's plan to shake up the company is to have the Dollar Tree chain "break the buck" -- i.e. sell some products at prices higher than $1. It would not be the sliding scale that Family Dollar currently uses, but some items could be priced at $1.50 or $2. Canada's Dollarama benefited from a similar change in its pricing scheme a decade ago. With the option of higher price points, Dollarama was able to add more and better products to its selection, driving strong growth in sales and earnings.

Final thoughts

Dollar Tree has been trying to fix Family Dollar for nearly four years, yet the chain is arguably in worse shape than it was back in 2015. Nevertheless, management is taking a hard-line stance on the prospect of selling Family Dollar. Not only does it plan to keep the chain, but it's investing even more money into expanding it and remodeling existing stores.

This intransigence suggests that investors shouldn't have high hopes for Dollar Tree's upcoming fourth-quarter earnings report.