In the markets, a corporation's fortunes may turn on a dime; more often, they turn on a quarter -- a reporting quarter, that is. The narrative Dollar Tree (NASDAQ:DLTR) provided last quarter of improving health in its Family Dollar segment was completely forgotten as a reduced full-year outlook became the dominant story line. Shares of the consumer staples giant withered by as much as 17% on Tuesday following the company's release of fiscal third-quarter 2019 earnings. Let's unpack the last three months and trace the roots of investor displeasure, bearing in mind that all comparative numbers refer to those of the prior-year quarter.

Dollar Tree: The headline numbers

Metric Q3 2019 Q3 2018 Change (Decline)
Revenue $5.75 billion $5.54 billion 3.8%
Net income $255.8 million $281.8 million (9.2%)
Diluted EPS $1.08 $1.18 (8.5%)

Data source: Dollar Tree. EPS = earnings per share. 

Essential details from the quarter

  • Total comparable-store sales increased by 2.5%, as Dollar Tree segment comps rose by 2.8%, and Family Dollar segment comps increased by 2.3%. Management attributed the improvement in both segments to a higher average ticket and rising customer traffic.
  • While gross profit climbed $33 million to $1.7 billion, gross margin dipped by 50 basis points to 29.7%. As in recent quarters, higher freight and distribution costs weighed on gross profitability. Management also cited shrink (i.e. spoilage, wastage, and theft) and a higher proportion of lower-margin consumables sales in Family Dollar as factors behind the weaker gross margin.
  • Selling, general, and administrative expenses (SG&A) rose 30 basis points as a percentage of sales, to 23.5%. 
  • A slimmer gross margin and the higher overhead nudged operating margin down by 80 basis points to 6.2%.
  • Net of store closings, Dollar Tree added 123 stores to its base during the quarter. The company also rebranded 39 Family Dollar stores to the Dollar Tree name and renovated 247 Family Dollar stores in the new streamlined "H2" format. The organization is gunning for 1,000 Family Dollar H2 store renovations in fiscal 2020.
Illustration of a tree trimmed in the shape of a dollar sign, bending in heavy wind.

Image source: Getty Images.

The variety of factors dimming the 2019 outlook

Dollar Tree's fourth-quarter outlook anticipates a bit of stumbling at year-end. The company expects low-single-digit comps growth next quarter, resulting in expected revenue of $6.33 billion to $6.44 billion. At the midpoint of this range, the fourth quarter's top line will advance by just 2.8% over the prior-year period.

Management quantified the fourth-quarter impact of trade import tariffs under Sections 301-310 of the U.S. Trade Act of 1974, more commonly referred to as Section 301 tariffs. Dollar Tree estimates that Section 301 tariffs imposed on its imports from China will inflate its cost of goods sold by $19 million, or $0.06 per share, in the final three months of the year. Fourth-quarter diluted EPS, including this impact, is expected to land between $1.70 and $1.80.

At the midpoint of this range, EPS will fall below diluted EPS of $1.93 achieved in the fourth quarter of fiscal 2018 (after adjusting for a number of one-time charges the company incurred during that period). The expected tariff impact accounts for one-third of the drop of $0.18 between last year's fourth-quarter EPS and the midpoint of the current projected range. The rather weak fourth-quarter sales growth and some additional expected margin obstacles are supplying the rest of the differential.

The company characterizes these obstacles as "additional pressure on merchandise margin based on lower-margin consumables growing faster than originally forecast; payroll cost pressure in distribution centers; and increased run rates for repairs and maintenance, utilities, and depreciation."

The year-end weakness also affects Dollar Tree's full-year forecast. Management tightened its fiscal 2019 revenue expectation to a range of $23.62 billion to $23.74 billion from a previous range of $23.57 billion to $23.79 billion. Diluted EPS for the 12-month period is now projected to land between $4.66 and $4.76. This is well below the $5.45 in fiscal 2018 adjusted EPS. Moreover, just last quarter, management raised the EPS target to a range of $4.90 to $5.11 from an original projection of $4.77 to $5.07. 

One trend helps explain the big picture

How did Dollar Tree's profit picture erode so quickly? Slower retail shelf growth is a prime culprit. Essentially, as the company has focused on closing underperforming Family Dollar stores this year, its net store openings have curbed significantly. The organization expanded total selling square footage by 3% in fiscal 2018, but is on pace to increase retail selling space by just 1.1% this year.

Without brisk net store additions, Dollar Tree must rely on same-store sales for most of its revenue growth. But as comps have remained soft in the low-single-digit range, the dollar store specialist has lost the ability to easily absorb rising cost pressures. Of course, management has mostly stabilized the Family Dollar business in 2019, so the pace of net store openings should presumably rise again in the coming quarters, supporting revenue and providing much-needed operating leverage. But that's likely of meager solace to shareholders checking on their DLTR positions, awash in red, today.