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Morningstar | Family Dollar's Challenges Damp Our Moat Assessment for Dollar Tree

Reflecting struggles at Family Dollar and soft second-quarter results, we are changing our moat rating for Dollar Tree to none from narrow and reducing our fair value estimate to $89 per share from $98. While we believe the firm's competitive standing is under threat and near-term results are stressed, we still project mid-single-digit top-line growth against 9% adjusted operating margins, on average, over the next decade.

Family Dollar has struggled to generate traffic and profitability growth, most recently posting a 0.5% same-store sales decline and 30 basis points of operating margin degradation through the first half. While the chain caters to lower-income customers who often do not have other convenient shopping alternatives, we believe Family Dollar will require ongoing investment to recover lost momentum, particularly as it meets an influx of competition from convenience stores, hard discount grocers, and digital retailers. Still, while the chain was acquired in 2015, we believe management has ample room to improve results and expect operating margins to rise from around 3% forecast in fiscal 2018 to roughly 6% by the end of our 10-year explicit forecast.

The situation is more favorable for the Dollar Tree banner, in our view. The fixed-price format allows the chain to cater to a wider variety of customers, particularly middle-income bargain hunters. With per-item prices and transaction sizes low, we believe the unit is better protected than most from digital retailers, considering their need to absorb shipping costs. While the landscape is becoming more challenging for Dollar Tree stores as well (as digital retailers develop scale-based economies and brick-and-mortar rivals dedicate store space to similar low-priced items), we expect the banner is in a better position than its corporate counterpart. However, with sales divided equally between the chains, we believe that Dollar Tree's strength is insufficient to offset Family Dollar's challenges.

We continue to believe the competitive environment for both banners is becoming less favorable, leading to our continuing negative moat trend rating. Customer expectations are changing rapidly, and rival retailers are working to meet Dollar Tree's combination of low prices and convenience. Furthermore, as digital retailers build their distribution networks, we expect the cost of reaching farflung shoppers and those looking to buy a small number of items to decline, eroding key elements of Dollar Tree's value proposition. As Family Dollar relies on branded items that are readily available from a number of outlets (as opposed to Dollar Tree's greater private-label orientation), we suspect that chain is more vulnerable, though new efforts to revitalize its unbranded offering should help somewhat.