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Discount Retail Stores: The Family Dollar Deal Makes Dollar Tree An Excellent Short Candidate

From a fundamental standpoint, the post-merger Dollar Tree has absolutely nothing to do with the pre-merger Dollar Tree.

Pro-forma the deal, the company's financial health has significantly deteriorated amid increasing competition as new players enter the discount retail industry.

Nevertheless, at the current price of $82.54/share, DLTR's post-merger key metrics are much higher than its pre-merger ones.

In other words, by buying Dollar Tree now is like you are paying for a flawed product more than you were paying for the same product when it was flawless.

Don't bury the head in the sand, because no grossly overvalued company is immune to the fundamental approach.

When it comes to the business deals, 1+1 doesn't always equal 2. Often, it equals 1.5 or even less than that. And, this is the case with Dollar Tree, Inc. (NASDAQ:DLTR), whose deal with Family Dollar (NYSE:FDO) came at a very high cost.

In this factual and bearish article, I will try to present the big picture to those investors who are willing to see it. I will try to help them be proactive and make decisions, because investors who are in denial and do nothing will get hurt the worst. "Sheep get slaughtered," never forget this.

The Deal

In January 2015, Dollar Tree won the battle for Family Dollar, a multi-price discounter focused on urban and rural areas. Family Dollar accepted Dollar Tree's offer of 74.50/share while rejecting Dollar General's (NYSE:DG) offer of 78.50/share. Family Dollar's shareholders chose to merge with Dollar Tree over much larger competitor Dollar General primarily due to antitrust fears. Family Dollar had estimated regulators would force 3,500 to 4,000 store closings under a Dollar General merger versus the 500 closings that Dollar Tree projected for the completion of the deal. Finally, Dollar Tree needed to sell 330 stores to Sycamore Partners to avoid monopolizing the markets.

On July 6, 2015, Dollar Tree completed its acquisition of Family Dollar Stores, Inc. Since that date, the company has been executing its integration plan.

However, the deal impacted negatively Dollar Tree's financial health, given that the net debt skyrocketed from approximately (-$100 million) in January 2015 to $6.6 billion in January 2016. And according to the company's projections, the recovery of its financial health will take approximately five years, as presented in detail in the next paragraphs.

Key Fundamental Details

For FY 2015, consolidated net sales increased $6.90 billion, or 80.2%, to $15.50 billion from $8.60 billion in the prior year, and Family Dollar's sales represented $6.16 billion of the increase. In Q4 FY 2015, consolidated net sales increased 116.7% to $5.37 billion from $2.48 billion in the prior year's fourth quarter. The increase was the result of $2.68 billion in sales from the Family Dollar segment.

And as expected, the company was profitable for another consecutive year. However, investors have to take into account the following three key points:

1) SSS significant slowdown is here and will continue in FY 2016: Dollar Tree's same-store sales growth has slowed significantly since 2015. Specifically, same-store sales increased 1.7% on a constant-currency basis for the Dollar Tree segment in Q4 FY 2015. In comparison, same-store sales on a constant-currency basis increased 5.6% in the prior-year period for the Dollar Tree segment. Adjusted for the impact of Canadian currency fluctuations, the same-store sales increase was 1.3%.

Obviously, a significant slowdown on a YoY basis is here. And according to the company's guidance linked above, the SSS will remain in the low-single-digit territory in FY 2016. However, this doesn't surprise me because Family Dollar's SSS was just 0.7% in Q3 FY 2015.

2) CF and Free CF in Q4 FY 2015: Given that the deal with Family Dollar closed in July 2015, I am not going to dig into Q2 FY 2015, but I will focus on some key details from Q3 and Q4 FY 2015 instead.

In Q4 FY 2015, the company generated $830 million CF from operating activities while CF from investing activities was $101 million. In other words, the company's free CF in Q4 FY 2015 was $730 million, which helped it reduce its net debt significantly compared to Q3 FY 2015.

However, if investors extrapolate these figures and assume that Dollar Tree will continue to generate this amount of free CF during the next four quarters, they will make a huge mistake given that:

A) In Q3 FY 2015, the first quarter post-integration, Dollar Tree burned almost $180 million.

B) The fourth quarter has traditionally been DLTR's strongest quarter over the last three years. During the fourth quarter, the company traditionally generates more than 50% of its annual operating CF. Specifically, it generated $538 million operating CF in Q4 FY 2014 and $927 million for the entire FY 2014. It generated $427 million operating CF in Q4 FY 2013 and $794 million for the entire FY 2013. And it generated $365 million operating CF in Q4 FY 2012 and $678 million for the entire FY 2012.

3) Net Debt and FY 2016 EBITDA: As linked above, the company estimates consolidated net sales for the first quarter of 2016 to range from $5.05 billion to $5.12 billion. For FY 2016, the company estimates consolidated net sales to range from $20.76 billion to $21.11 billion. Both estimates are based on a low-single-digit increase in same-store sales.

Based on this guidance, I will guesstimate the company's EBITDA in FY...


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