Dollar Tree Avoids an Activist Battle With an Aggressive Turnaround

Back in January, activist investor Starboard Value took a 1.7% stake in Dollar Tree (DLTR -0.65%). Starboard wanted to take majority control of the retailer's 12-person board in order to persuade the company to sell its struggling Family Dollar banner and tweak its pricing model.

However, Starboard recently backed down and announced that it would no longer seek seats on Dollar Tree's board. In a statement, the hedge fund stated that it was "pleased" with Dollar Tree's decision to test "multiple price points" at its namesake stores, and that its management "appears to have conviction" that its turnaround plan at Family Dollar "is finally gaining traction."

Image source: Getty Images.

Starboard noted that there was still "substantial opportunity for further value creation," and that it looked forward to "a continued dialogue and monitoring of the company's progress." Let's take a closer look at what Starboard initially wanted, and why it backed down.

What happened to Dollar Tree?

Dollar Tree and Dollar General (DG -0.33%) are the two biggest "dollar store" chains in America. However, the two companies employ different strategies.

Dollar Tree sells all of its products for $1. It acquired Family Dollar, which sells most of its products for under $10, to broaden its price range in 2015. Dollar Tree and Family Dollar's stores are mostly based in urban and suburban areas.

Dollar General, which also sells most of its products for under $10, opens most of its stores in rural or smaller communities. Dollar General repeatedly posted stronger comparable store sales growth than Dollar Tree over the past year:

Source: Company quarterly reports.

Dragged down by Family Dollar

The albatross around Dollar Tree's neck is Family Dollar. Dollar Tree still attracted shoppers with its decision to remain a true "dollar" store, but Family Dollar faced tougher competition from Walmart and Amazon. As a result, it consistently reported weaker comps growth than Dollar Tree:

Comps growth. Source: Dollar Tree quarterly reports.

Many investors, including Starboard, looked at those results and concluded that Dollar Tree's $8.5 billion takeover of Family Dollar was a mistake.

Image source: Getty Images.

However, Dollar Tree recently unveiled some aggressive turnaround plans for Family Dollar. It plans to close 390 Family Dollar stores this year and renovate about 1,000 locations. Its newly renovated Family Dollar stores will sell alcohol and include a $1 Dollar Tree section. It will also expand the freezer sections in select stores.

Last quarter Dollar Tree claimed that its newly renovated Family Dollar stores generated more than 10% comps growth. Starboard stated that those improvements at Family Dollar convinced it to abandon its proxy fight.

A riskier plan for Dollar Tree

Starboard's focus on Family Dollar makes sense, but its proposed strategy for Dollar Tree is riskier. Dollar Tree likely fared better than Family Dollar in the past because it sold everything for a dollar.

Straying away from that concept could alienate the banner's core shoppers. Moreover, Dollar Tree consistently reports higher gross margins than Family Dollar even as it sells cheaper products -- so it doesn't seem necessary to test higher price points.

Source: Company quarterly reports.

However, selling Dollar Tree's products at slightly higher prices could significantly boost the banner's comps growth and margins. It could also insulate the banner from higher tariffs if trade tensions with China escalate again.

Investors shouldn't worry too much about this strategy for now, since Dollar Tree will likely scrap it if initial tests alienate shoppers.

Should investors buy Dollar Tree today?

Dollar General remains a better overall stock than Dollar Tree. It generates better comps growth, isn't burdened by a weaker banner like Family Dollar, and trades at the same forward P/E ratio as Dollar Tree, 17. Dollar General also pays a dividend, and Dollar Tree doesn't.

However, Starboard's decision to back down from a proxy fight highlights some key improvements at Family Dollar. If its renovated stores can consistently generate double-digit comps growth, its weak link could become a pillar of growth in the near future.