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Here's Why Dollar Tree Is Worried About Rising Costs and Dollar General Isn't

It's curious: Management at discount retailer Dollar Tree (NASDAQ: DLTR), also parent to the Family Dollar chain, made a point of cautioning shareholders during the company's most recent quarterly earnings call that rising freight costs would be biting pretty deeply into profits, at least through the current quarter. Rivals Dollar General (NYSE: DG) and the much smaller Big Lots (NYSE: BIG) didn't express similar concerns during their latest earnings releases.

There's a good reason one of these organizations is issuing a warning in the form of lowered guidance, while the other two aren't. And it's not a conscious decision to ignore potential problems and hope for the best. Whereas Big Lots and Dollar General are mostly buffered from rising freight costs, Dollar Tree has considerably less wiggle room in terms of profit margin.

Image source: Getty Images.

No breathing room

Cutting straight to the chase, Dollar General is roughly 30% more profitable (as measured by margins) than Dollar Tree.

The graphic below comparing the historical operating margin rates for all four of the country's key discounters tells the tale. Dollar General's operating profit margin for the past four quarters averages out to 10.1%, but it's only a little less than 8% for Dollar Tree.

Similarly positioned Ollie's Bargain Outlet (NASDAQ: OLLI) is roughly twice as profitable as Dollar Tree, while Big Lots' bottom line is more or less in line with Dollar Tree's. But that's to be expected given Big Lots' smaller size -- in retail, more scale typically lowers relative costs. Perhaps most important, the chart illustrates just how unpredictable Dollar Tree's already-low margin rates have been since 2015.

Data source: Thomson Reuters. Chart by author.

Some investors already know it, but if you're wondering why Dollar Tree's profitability plunged so dramatically in 2015, blame the acquisition of Family Dollar.

When it was solely dedicated to the $1 price point, Dollar Tree boasted industry-leading profitability rates. Family Dollar didn't, reporting operating profit margin rates of only 4% and 6.6% in the two years before the deal was consummated. The cost synergies anticipated by bringing Family Dollar into the fold simply haven't panned out.

Now, six years into the project, it's unlikely they ever will.

Why isn't scale working out for Dollar Tree?

Still, the profit margin disparity is striking given how similar these four retailers' business models are. What gives?

As it turns out, these companies' respective business models aren't actually all that similar where it matters most. The two biggest differences in Dollar Tree's operation are the key reasons it's waving red flags now.

CEO Michael Witynski fleshed out one of these headaches in detail during last month's second-quarter earnings call. "Dollar Tree brings in nearly 90,000 40-foot [shipping] containers per year, predominantly for the Dollar Tree banner," Witynski said, adding "the Dollar Tree banner imports more containers per $100 million in sales than other large retailers."

He then explained, "The Dollar Tree banner is more sensitive to freight costs than others in the industry." And it is. Witynski pointed out that certain maritime freight routes Dollar Tree relies on now cost 400% more than they did in 2019.

End result: The company's previous per-share estimate of 2021 freight costs of $0.60 to $0.65 as of May has since swollen to an estimate of between $1.50 and $1.60 per share. Given the details of Dollar Tree's supply chain logistics, the anticipated doubling of freight costs isn't likely to be a setup to underpromise and overdeliver, either.

Image source: Getty Images.

The other impasse disproportionally impacting Dollar Tree and its Family Dollar division is that Dollar Tree isn't able to procure inventory the way that Ollie's, Big Lots, and Dollar General do.

Again, it's the sort of nuance that would be easy to overlook if you aren't looking for it. It's evident upon closer inspection, though. Dollar General offers a lot of private-label goods designed and priced specifically for its target customer. Ollie's and Big Lots offer plenty of closeout goods: merchandise that other U.S. retailers have given up on selling and are willing to pass along to another retailer for pennies on the dollar.

That's not to suggest Dollar Tree doesn't offer any private-label goods or buys all of its inventory from overseas suppliers. But it is seemingly not making the same house-branding and value-offering connections with consumers that its rivals are.

A problematic distinction

The big takeaway for investors is, don't dismiss Dollar Tree's concern. But also don't assume that Dollar Tree's warning universally applies (or at least applies to the same degree) to seemingly similar discount retailers.

All discounters are certainly feeling the impact of rising fuel costs and other inflation factors. Only one of the aforementioned names, however, is specifically less investment-worthy because of it.

That's Doller Tree. And while it might try to adapt, it's tough for retailers to simply find new suppliers and/or new delivery routes. There are hundreds of such partners, and they tend to serve existing, proven customers before taking on new ones that might not be interested in a more permanent relationship with vendors and logistics service providers.

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James Brumley has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Ollie's Bargain Outlet Holdings. The Motley Fool has a disclosure policy.


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