Why Dollar Tree Inc's Stock Buybacks Don't Make Sense
Over the past decade, Dollar Tree shares have surged from under $10 to over $55. While fundamental growth and a bullish market have aided this performance, management's shareholder-friendly stock buybacks have played a big role in driving shares higher. However, the pending acquisition of Family Dollar might suggest buybacks are not in the company's best interest right now.
How do buybacks help Dollar Tree shareholders?
Over the past 12 months, Dollar Tree has bought back $1 billion worth of its own stock. Dollar Tree has been especially aggressive in stock repurchases during the past two years, and the company has reduced its shares outstanding by more than 39% over the past decade.
A good illustration of how buybacks benefit shareholders can be seen in the disconnect between market capitalization and stock performance. The chart below shows that Dollar Tree's market capitalization increased 271.6% during the last decade. Meanwhile, the company's stock increased 512.8% during the same 10-year span, as of Oct. 2.
Dollar Tree's stock has outperformed its market capitalization because of the reduced shares. Fewer shares multiplied by the same stock price equals a lower market capitalization.
On one hand, buybacks make sense for Dollar Tree
Companies often become more aggressive with buybacks when management feels shares are undervalued. That said, aggressive buybacks can signal a lack of investment options to grow the business larger. With nearly 5,200 total stores, Dollar Tree's expansion opportunities to spark growth are much more limited than they were in the early 2000s. Also, Dollar Tree already has the highest operating margin (12.2%) among the top dollar stores.
With Dollar Tree selling everything in its stores for just $1, the fact that its margins are higher than Family Dollar and Dollar General , which have more than one price point, is remarkable, but rising costs also mean there is likely little margin upside in its existing business. As a result, and given the state of Dollar Tree's mature business, it might seem logical that large buybacks are the best way for the company to return money to shareholders. However, at this point in time, I think Dollar Tree is best served by limiting, or even postponing, any future buybacks.
On the other hand...
The reason for this line of thinking involves Dollar Tree's $8.5 billion buyout offer for Family Dollar, which is 16 times greater than Dollar Tree's 12-month free cash flow and about 6.5 times greater than its total equity. Therefore, Dollar Tree is using more than $1.7 billion in stock as part of the buyout package for Family Dollar. While Dollar Tree's buybacks essentially offset the dilution that Family Dollar's acquisition will create, the acquisition itself will more than double Dollar Tree's 12-month revenue and gross profit. In other words, Dollar Tree should focus all of its resources on acquiring Family Dollar in order to create shareholder value. .
Not to mention, Dollar General's competing takeover effort for Family Dollar could increase the price Dollar Tree must pay to secure the acquisition. Dollar General has offered $9.1 billion in cash for Family Dollar, which so far has sided with Dollar Tree. According to an analyst with Deutsche Bank, both Dollar Tree and Dollar General might be preparing new bids for Family Dollar. If so, it makes even less sense for Dollar Tree to buy back stock.
Investors will be better served if Dollar Tree can make investments to grow its business and produce higher free cash flow. This notion can be proven with the fact that buybacks had nothing to do with the 271% increase in Dollar Tree's market capitalization over the last decade. Instead, that was driven by fundamental improvements, such as a 452.9% increase in EPS and a 168.9% spike in revenue.
Acquiring Family Dollar would be a good way for Dollar Tree to more than double its annual revenue and gross profit. Also, according to Dollar Tree management, the combined synergies would save an estimated $300 million in expenses by the end of the third year after the deal. This is a transformational merger that cannot be achieved with $350 million of capital expenditures or $1 billion in buybacks. Instead, Family Dollar would allow Dollar Tree to implement its best-in-class operating efficiencies and move beyond "everything's $1," and into higher margin goods, a move that should take Dollar Tree's stock and market capitalization significantly higher.
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The article Why Dollar Tree Inc's Stock Buybacks Don't Make Sense originally appeared on Fool.com.Brian Nichols 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.
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