Dollar Tree's Q2 Report Is Likely to Be Messy

Rich Duprey, The Motley Fool

While the turnaround that Dollar Tree (NASDAQ: DLTR) is engineering at Family Dollar is finally taking hold, investors shouldn't expect the dollar store's business to look appreciably better in the second quarter. 

As Dollar Tree readies its second-quarter earnings report for Thursday, Aug. 29, world trade tensions, weak sales and margins, and an extensive store remodeling program will all likely weigh on the deep-discount retailer's results.

Scissors cutting dollar bill

Image source: Getty Images.

Several anchors are dragging on performance

No doubt Dollar Tree was relieved to learn President Trump relented on his threat to impose a new round of tariffs on products from China. The ensuing costs would likely have ripped away at the underpinnings of Dollar Tree's performance because the retailer imports such a large percentage of goods from the country.

Now that the rhetoric has temporarily de-escalated, China at least says it is still committed to holding trade talks with the U.S. next month. A resolution could be a big boost for retailers. But even a reprieve on trade likely won't be enough for Dollar Tree this quarter because it has other pressing issues.

Last quarter, higher fuel and transportation expenses ate away at profit margins. And though gas prices have fallen in recent weeks, there is still a shortage of drivers in the trucking industry, and companies there are going bankrupt. Costs are probably going to remain elevated for this expense for the immediate future, and payrolls will be higher as dozens of states have raised their minimum wage this year.

But the biggest drag on Dollar Tree this quarter could be Family Dollar. That discount chain's first quarter was its second consecutive period of higher same-store sales -- also the biggest increase in comps since Dollar Tree bought Family Dollar in 2015. But despite that, Dollar Tree will shutter nearly 400 Family Dollar stores this year, with most closing in this quarter.

Dollar Tree suffered a decline of 90 basis points in gross margins in Q1 due to closing down 25 stores (only 16 of which were Family Dollar stores), so if 200 or more stores will close this quarter, it's likely to have a significant impact on margins.

Strategies for improvement

Helping to offset that could be the Dollar Tree store remodelings. The deep discounter says that renovated stores have enjoyed substantial double-digit increases in comps. Having redone 350 Family Dollar stores in the first quarter, it wants to renovate a total of 1,000 locations this year, meaning there could be a large number of remodels in this quarter. That will also hurt sales even though the retailer should be better off in the long run.

There are a lot of moving parts to Dollar Tree during this turnaround. It is introducing alcohol sales at Family Dollar -- which, according to an employee at my local store, will primarily occur in the South -- and is experimenting with higher price points at Dollar Tree in a relative handful of stores.

Although Dollar Tree began testing above-$1 pricing even before activist investor Starboard Value began agitating for the change, it took on a new impetus after that. It could end up completely reshaping the company if it decides to finally "break the buck" for good.

Starboard Value had also called for Dollar Tree to sell off the Family Dollar chain because of ongoing depressed results, but the private equity firm was impressed enough with the changes it's seen in performance to back off that demand. 

Coming out stronger on the other side

Analysts at J.P. Morgan have upgraded Dollar Tree to an overweight rating because they see better earnings in the future and the ability for the dollar store to generate over $1 billion in free cash flow by 2020. And ratings agency Moody's says the chain has strong credit metrics, an "excellent liquidity profile, and balanced financial policies."

While this might not be the best quarter to judge how Dollar Tree is doing because of all the balls it has up in the air, investors should still get a sense of whether the Family Dollar makeover is continuing to gain traction, a path that will lead Dollar Tree itself to higher sales and profits.

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Rich Duprey has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

This article was originally published on Fool.com