When Dollar Tree (NASDAQ:DLTR) reports third quarter earnings on Tuesday, investors will be watching to see whether the deep discount retailer's Family Dollar chain can notch its fourth consecutive quarter of rising comparable sales.

The multi-price point discounter had been on the verge of being put on the chopping block because of its persistent woeful performance since it was acquired in 2015, but management convinced activist investors agitating for a separation to have a little more patience in the changes it was implementing. Waiting seemed to work.

Last quarter Family Dollar posted comps that rose 2.4% year over year, a modest gain for most retailers, but it was the highest same store sales the discounter had seen in five years and was progressively better than the comps seen in the first quarter of this year and the fourth quarter of 2018. So it will be worthwhile to see whether it can enjoy even higher comps this time around.

Woman with fistful of dollars giving thumbs up

Image source: Getty Images.

A new look

There have been a couple of factors influencing Family Dollar's turnaround, including renovating stores to a new layout, shutting down underperforming stores, and converting others to Dollar Tree stores. Almost 550 stores were renovated last quarter, 96 Family Dollars were closed, and 106 were rebranded as Dollar Trees.

Yet Family Dollar also benefited from marking down merchandise as it renovated, closed, or rebranded outlets so when inventory levels are finally right-sized with appropriate products, the sales-driving impact of the discounting will likely diminish.

However, it's doubtful the customers its drawing into Family Dollar now will completely abandon the chain because Dollar Tree is seeing double-digit comps increases in the renovated stores, of which it hopes to have around 1,150 completed this year. That's still a relatively small portion of the 7,800 Family Dollar locations it operates, but the benefits are lifting sales at all the stores.

Feeding the needs of consumers

Dollar Tree itself has also performed well, reflecting an environment where discounters are seeing success. It also put up higher comps in the quarter, the 46th straight time it has done so, benefiting from the addition of more freezer cases in the stores. Almost 6,000 of Dollar Tree's 7,300 stores now have freezers and coolers in them, which continues to drive store traffic for consumables.

Consumables carry lower profits margins than do other goods, but they bring more customers in. Still, merchandise costs rose 55 basis points last quarter due in part to more consumable sales, helping lower gross profit margin by 70 basis points to 33.8%. 

Rising freight costs are chipped away at margins, though Dollar Tree expects those expenses to flatten out in the back half of the year, at least domestically, but international freight costs are now expected to rise. Overall, however, such costs should be less.

Rising costs weighing on margins

The other major expense Dollar Tree faces is, of course, tariffs, which remain fluid as the U.S. and China seem to have on again, off again success in coming to a resolution on the issue. 

The deep discounter has largely been able to mitigate many of the higher costs associated with the trade war by negotiating with its vendors, but depending upon what tariffs are imposed and when, Dollar Tree is expecting them to impose an additional $26 million in costs between Sept. 1 and Dec. 15.

Another potential detractor: the discount chain was notified last week by the Food & Drug Administration it might be selling potentially unsafe over-the-counter drugs under its Assured Brand line. Its foreign manufacturers were found to have engaged in serious violations of federal law including not testing raw materials or finished drugs for pathogens and quality.

Even though Dollar Tree was warned the companies were on an import alert list that was supposed to prevent businesses from importing their goods, it continued to use them and now has two weeks to explain how it plans to correct the violations.

Still a good outlook

Analysts are expecting a 3.5% increase in revenue this quarter to $5.73 billion, with earnings of $1.12 per share expected, a 5% decline from the year ago period. Management itself expects sales will be in a range on $5.66 billion to $5.77 billion, slightly below Wall Street's outlook at the midpoint.

Dollar Tree gave a broad range for earnings, $1.07 to $1.16 per share, allowing for just about anything to happen, but going against year-ago earnings of $1.18 per share, even the retailer is expecting the weight of various costs and expenses to weigh on results.

While its FDA drug issue is a forced error that stings, it shouldn't impact how Dollar Tree performs in the third quarter or for the rest of the year. And if Family Dollar pulls through with yet another quarter of rising comps, it should be in a good place to finish the year strong.