Is Dollar Tree (NASDAQ:DLTR) stock headed for a fall?
All the early momentum it gained from announcing last month it was buying rival deep discounter Family Dollar (UNKNOWN:FDO.DL) has been lost amid a competing bid for the chain by Dollar General (NYSE:DG) and an earnings report that, while reporting higher revenues and another quarter of positive same store sales, still came up short on profits.
While there's a lot to commend the deep discounter that could send its stock higher, it's still fraught with risk that could send shares lower still. Let's be clear, I'm not saying you ought to put your sell order in right away, but smart investors know it's worth keeping at least one eye on the things that are most likely to hurt the company's bottom line -- and its share price.
Here are three big concerns that could send Dollar Tree's stock lower.
It loses even if it wins
There's a lot of sense to its acquisition of Family Dollar, and beyond losing out to Dollar General as a risk that could sink its stock, Dollar Tree faces headwinds even if it comes out on top.
For one, it may have to get into a bidding war to eventually win the prize. The General topped Dollar Tree's $8.5 billion bid with a counteroffer of $8.9 billion. Although Family Dollar rejected the competing bid, saying it needed assurances it wouldn't run into antitrust problems, Dollar General waved off those concerns and said it's committed to staying in the race.
That means Dollar Tree may need to go a lot higher to eventually sway investors. Dollar General has the wherewithal and the need to up the ante even more as analysts believe a combination of those two chains makes even more sense as it creates a more effective competitor to Wal-Mart (NYSE:WMT), which has increasingly been doing even more discounting to woo shoppers to its stores to offset lagging sales.
Dollar Tree was already giving a 23% premium to Family Dollar shareholders. If it has to bid higher, the deal may not make as much financial sense.
Harder to justify will be paying up so much for a company that was faltering. The merger combines the best operating dollar store chain with the worst, and it has committed to keeping on Family Dollar's CEO, the individual who's presided over the company's decline. While that may have played a role in the company rejecting Dollar General's offer since it has made no such assurances, it erects a hurdle in front of Dollar Tree to seamlessly integrate the two organizations.
It could end up being a case of one step forward by leapfrogging to the forefront of the dollar store industry in terms of size, but two steps back as it needs to meld the organizations together without a hiccup all the while turning around a sinking ship.
Freeze out chills profits
Dollar Tree has been adding more refrigerators and freezers to its stores as a means of driving in traffic because they're stocked with consumables which generates a lot of return trips.
After adding 141 more of them to its stores this past quarter, it now has frozen and refrigerated products in 3,410 stores, or two-thirds of its total footprint, and has plans to build them out further.
Yet consumables tend to be products with lower margins than other goods, so the more it sells the more points it gives up in profits. Many companies make a good living making up in volume what they lose in price, and Dollar Tree is the most efficient dollar store operator with operating margins exceeding either Dollar General or Family Dollar. It has got room to work here.
However, freight costs from a growing truck driver shortage are causing expenses to rise and continue to chip away profits. This past quarter they moved nearly 40 basis points higher and Dollar Tree anticipates freight costs will continue to be a "meaningful headwind" to gross margins.
Couple that with increased margin compression due to selling more consumable products and the gap between it and Dollar General may be narrowed considerably. And if it's ultimately successful in buying Family Dollar, that company's poor profit picture will weigh heavily on future results.
The competition isn't getting any less intense
As mentioned, Wal-Mart is trying to reverse declining same store sales by being even more competitive on pricing than it already is.
For five straight quarters Wal-Mart has failed to achieve positive comps growth and store traffic fell once again in the latest quarter. Operating income for the mass merchandising discounter also fell 2.4% from the year ago period.
While that sounds like a positive for Dollar Tree, it actually hides the threat to its business.
Wal-Mart has been building out its smaller footprint stores like its Neighborhood Markets that are of a physical size closer to what Dollar Tree and the deep discounters run. Those stores, while as yet not on a scale of the dollar stores, are showing remarkable strength.
Neighborhood Markets saw comps jump 5.6% in the quarter, traffic grew 4.1%, and Wal-Mart is on track to open another 180 to 200 new units for the year.
Target (NYSE:TGT) also sees the value in getting big by going small, and recently opened its first TargetExpress store that at 20,000 square feet will be just 15% of the size of a typical Target store.
With both Wal-Mart and Target offering up more deals for consumers, along with tough competition in the dollar store space itself, Dollar Tree will need to be on top of its game and perform flawlessly.
Foolish investment takeaway
With any business there are a lot of moving parts, and a wrench thrown into any one of them can cause progress to grind to a halt.
Right now Dollar Tree is trying to figure out how it can keep its business growing, support its profit margins, and fend off the competition, all the while having to acquire a rival that, while bulking up its size, doesn't necessarily make the mission any easier.
The perfection needed in its game plan could be threatened by Family Dollar's weaknesses. Conversely, losing out on the acquisition will put it far, far behind its biggest competitor.
There's still a lot to like about Dollar Tree, which as was said before, remains the best-operating dollar store in the business, but investors need to watch out for those things that could cause its stock price to become as discounted as the products it sells.
Rich Duprey has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.