Dollar Tree, Inc. Q1 FY2021 Earnings Call

Good day, and welcome to the Dollar Tree, Inc.'s First Quarter Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Mr. Randy Guiler, VP, Investor Relations. Please go ahead, sir.

Thank you, Shannon. Good morning, and welcome to our call to discuss Dollar Tree's performance for the first quarter of 2020. Joining me today are CEO Gary Philbin, Enterprise President Mike Witynski, and CFO Kevin Wampler. Before we start, I want to remind everyone that the remarks we will make regarding future expectations, plans, and prospects for the company are forward-looking statements under the Private Securities Litigation Reform Act of 1995. Actual results may differ significantly from those indicated by these forward-looking statements due to various important factors mentioned in our most recent press release, 8-K, 10-Q, and annual report, which are filed with the SEC. We are not obligated to update our forward-looking statements, and you should not expect us to do so. After our prepared remarks, we will open the call for your questions. Now, I will turn the call over to Gary Philbin, Dollar Tree's Chief Executive Officer.

Thank you, Randy. Good morning, everyone. First, from all of us, our report today is against the backdrop of the COVID-19 impact across our country. Our hearts go out to all those affected. Today's Q1 report reflects a number of accomplishments and challenges during a quarter that was impacted, unlike any other, due to the effect of COVID-19. First, our results around the core businesses of both banners speak to the resiliency and strength of both Family Dollar and Dollar Tree in the communities we serve. The investments we have made in our Family Dollar business in our H2 stores and assortment have been highlighted during this critical time. Second, we took quick action to protect individuals with enhanced cleaning protocols to keep the facilities clean and sanitized. We encourage social distancing guidelines as recommended by the CDC and provided PPE supplies, including masks and gloves. Additionally, we have installed more than 60,000 plexiglass shields in store checkouts. Third, our efforts to get the right products to the distribution centers and stores have been the key priority for merchants across both banners. We worked closely with vendor partners to support and streamline shipments of needed essentials. And finally, all of this could not be accomplished without the leadership of our teams across 48 states and 5 Canadian provinces. Their efforts have been remarkable, and it is humbling to see the dedication they have with their teams and for their communities. I could not be more proud of all of these and the many other accomplishments against the COVID-19 crisis that's impacted our country and company. Family Dollar's comparable sales of 15.5% reflected the initial impact of households stocking up on basic goods in March related to the disease. The consumable side of the business delivered a 17-plus percent comp and was strong throughout the quarter. On the discretionary side, comps were positive up to Easter. And then we saw an acceleration through the end of the quarter around the home and other discretionary categories, resulting in a discretionary comp of just under 9% for Q1. Operating income for Q1 improved 230 basis points. But despite the impact of selling record volumes of lower-margin consumables and incurring the additional costs related to COVID-19, Dollar Tree's comp decreased 90 basis points, driven by the impact on Easter selling and our party business in general, from the executive orders for shelter-in-place mandates. The combined impact of the party, candy, and Easter categories negatively affected Dollar Tree's overall comp by 490 basis points. Following Easter, discretionary comps were nearly flat for the remainder of the quarter. Operating margin was 9.2%, reflecting a negative top line comp and a heavier consumable mix along with COVID costs. All related COVID costs incurred for our wage premiums and for front-line associates, guaranteed sales bonuses for field management, and supplies for keeping our facility safe totaled just over $73 million. Now I'll turn the call over to Mike.

Thank you, Gary, and good morning. Before I get into the details regarding our Q1 performance, I want to share a little bit about the associates and their remarkable work and dedication. I want to thank our teams for all they've accomplished each and every day for the last 9 weeks. Our entire leadership team is inspired and very much appreciative of their individual commitments and their collective team efforts across Dollar Tree and Family Dollar. In our stores, in our distribution centers, and in our store support center, I am very proud of the dedication of our associates. Regarding Dollar Tree's response to COVID-19, our company took aggressive and decisive actions early on to protect our teams and our shoppers. In early March, we activated our business response team led by risk management and human resources with representation from each functional area in the company. The group worked around the clock to assess the situation, develop policies and procedures, and take action where necessary. I would like to recognize the leadership and efforts of our business response team to support our front-line workers. Steps we’ve taken to provide clean and safe environments include: our store associates are practicing social distancing as recommended by the CDC, and we continue to ask that customers also follow these guidelines. We dedicated the first hour each morning to serve at-risk customers. We continue to provide store teams with hand sanitizer and cleaning supplies, for high-frequency enhanced cleaning protocols. We closed stores at 8 PM to provide associates adequate time for cleaning the store and restocking shelves with essential high-demand products. We supply personal protective equipment, including nonmedical face masks and gloves for associates to wear during their shifts. We have implemented associate health screenings to ensure that we are minimizing the potential for exposure. We’ve installed plexiglass guards at the checkout lanes in all stores to assist in protecting shoppers and our cashiers. Stores are now equipped with contactless payment through tap-to-pay with Visa, MasterCard, Apple Pay, and Google Pay. We are committed to meeting or exceeding all relevant local and state requirements. By taking these steps, we have been able to keep all stores open as an essential business. Also in March, we announced our plans to hire 25,000 new associates, a target which we have exceeded. Our stores play a valuable role in the communities we serve, and we are dedicated to both serving customers and being an employer of choice, especially in this critical time of need. Now to our first quarter performance. Sales grew 8.2% to $6.2 billion. Consolidated same-store sales increased 7%, and we delivered an EPS of $1.04. For the Dollar Tree segment, our 90 basis point decline in sales was materially impacted by weakness in party, candy, and Easter seasonal categories. We were well prepared for the Easter season with products in stores and set during February, following our strong Valentine season. As stated in our March 31 business update, Dollar Tree had a 7.1% comp increase for the first 8 weeks of Q1, but was beginning to see a material drop-off due to traffic and the initial shelter-in-place as we approached Easter. In March, seemingly overnight, there was a hyper focus on stocking up consumables as concern spread; schools were closed, shared services, weddings, and parties were canceled and widespread stay-at-home orders were mandated. We saw a material decline in demand for many of the seasonal and discretionary products related to celebrations and large gatherings. As Gary mentioned, the combination of party category and Easter seasonal product negatively impacted Dollar Tree's Q1 comps by approximately 490 basis points. For the quarter, the consumables delivered a positive 9% comp and the discretionary side of the business was down nearly 9%. Prior to the slowdown, our Valentine seasonal category comped over 4% with a strong sell-through. Categories that performed well included household consumables, food, personal care, and crafts. We continue to see great traction in our stores with the new Crafter Square program. We added the Crafter Square assortment to more than 2,400 Dollar Tree stores in Q1. Our customers are responding to the new offerings and the great values. For the quarter, Dollar Tree's comp transaction count was down 11.7%, while comp average ticket increased 12.2%. As consumers in general have been shopping less but buying more, a trend that has been seen across retail. Interestingly, our consumables versus the discretionary mix. Through Easter, it was 55% consumables. For the period following Easter through quarter end, there was a 50-50 balance. And for the first 4 weeks of Q2, we've seen a shift to 55% discretionary. Regarding Family Dollar segment sales highlights for the first quarter, the team delivered a 15.5% same-store sales increase on top of a 1.9% comp a year ago in Q1. This was comprised of a 17.1% increase in average ticket, partially offset by a 1.4% decline in transaction comp. The sales strength was broad across geography, each zone delivering a comp increase of 13% to 19%. Regarding cadence of comps in the quarter, February was slightly positive. We had an extremely strong March with customers stocking up on consumables. As provided in our business update, the Family Dollar comp was 14.4%. Through the first 8 weeks of the quarter, the team delivered great results in April with strength in many of our discretionary categories. The consumable side of the business delivered a 17-plus percent comp, and discretionary comp was just under 9%. We continue to be very pleased with the performance of our H2 stores, with comps continuing to outperform the chain average by 10-plus percent. Regarding real estate for the enterprise during the quarter, we completed more than 350 projects, including 99 new stores, 21 new locations, 220 Family Dollar H2 renovations early in the quarter and then 14 store closings, primarily at the end of lease term. We ended the quarter with 15,370 stores.

Thank you, Mike, and good morning. Consolidated net sales for the first quarter increased 8.2% to $6.29 billion, comprised of $3.21 billion from Family Dollar and $3.08 billion from Dollar Tree. Enterprise same-store sales increased 7%, and on a segment basis, comps from Family Dollar increased 15.5% and Dollar Tree decreased 0.9%. Overall gross profit increased 3.9% to $1.79 billion, gross margin of 28.5% compared to 29.7% in Q1 2019. Gross profit margin for the Dollar Tree segment decreased to 31.9% compared to 34.5% in the prior year's quarter. Factors impacting the segment's gross margin performance for the quarter included merchandise costs, including freight, which increased approximately 140 basis points. Dollar Tree saw a 4.2% shift in mix to lower margin consumables from higher-margin discretionary merchandise related to the soft Easter selling season and pandemic demand. Higher costs from the impact of an incremental $18 million of tariff costs and higher freight costs were partially offset by improved markup. Markdown costs increased approximately 40 basis points, resulting from increased seasonal markdowns due to the lower Easter sell-through. Distribution costs increased approximately 30 basis points, primarily due to higher payroll costs and depreciation. Dollar Tree payroll costs included approximately $3.5 million or 10 basis points of hourly premium pay for all hourly Dollar Tree associates for hours worked since March 8, as well as guaranteed sales bonuses. Occupancy costs increased approximately 30 basis points due to loss of leverage on the comp sales decrease in the quarter, and shrink increased approximately 25 basis points based on unfavorable inventory results and an increase accrual rate. Gross profit margin for the Dollar Tree segment improved 60 basis points to 25.4% during the first quarter. The year-over-year improvement was due to the following: Occupancy costs decreased approximately 105 basis points as a result of leverage from the comp sales increase and the increased expense in the prior year related to the acceleration of amortization of right-of-use assets from store closures. And shrink decreased approximately 30 basis points resulting from an increase to the accrual rate in the prior year quarter and improved inventory results in the current year. These benefits were partially offset by merchandise costs, including freight, increasing approximately 55 basis points, primarily due to a 1.6% mix shift to lower margin consumable merchandise as a result of pandemic demand and higher freight costs, partially offset then through initial markdown. Distribution costs increased approximately 15 basis points due to increased payroll costs at Dollar Tree. These costs include approximately $2.7 million or 10 basis points related to the hourly premium pay for all hourly distribution center associates for hours worked since March 8 and guaranteed sales bonuses. Consolidated selling, general and administrative expenses improved 40 basis points to 22.7% of net sales. For the first quarter, the SG&A rate for the Dollar Tree segment as a percentage of net sales increased to 22.7% compared to 21.2% in Q1 of 2019. The increase was primarily due to approximately 145 basis points in payroll costs, which included an increase of store hourly payroll of approximately 120 basis points due to the store hourly premium paid to all hourly associates beginning March 8. The premium paid totaled $30 million for the quarter. Field management payroll increased approximately 15 basis points due to loss of leverage from the decrease in comparable store net sales and $800,000 of guaranteed bonuses paid. Store sales bonus expense increased approximately 10 basis points as a result of $2.7 million of guaranteed fund payout. Store supply costs increased approximately 10 basis points due to the result of the installation of plexiglass guards and incremental costs for PPE. Inventory service expense decreased approximately 10 basis points due to the postponement of inventories from March 15 through the end of the quarter. The SG&A rate for the Family Dollar segment improved approximately 170 basis points to 19.9% compared to 21.6% for the first quarter of 2019. The improvement was primarily due to the leverage on stronger same-store sales. Payroll expenses improved by 65 basis points, driven by leverage from the strong comp. Store hourly premium pay totaled $22.3 million and guaranteed bonuses totaled $1.6 million. Occupancy costs improved by 55 basis points. Operating expenses decreased by approximately 40 basis points, resulting primarily from reduced advertising and travel as a percentage of sales. Depreciation and amortization expense decreased approximately 10 basis points. Additionally, corporate and support shared service expenses as a percentage of sales improved 20 basis points, primarily related to leverage on stronger sales in the current year and cycling store support center consolidation costs from the prior year. Operating income was $365.9 million compared with $385 million from the same period last year, and operating income margin was 5.8% compared to 6.6% in last year's quarter. The current year's quarter included $73.2 million in COVID-19-related expenses. Nonoperating expenses totaled $40.7 million, primarily comprised of net interest expense, and our effective tax rate was 23.9% compared to 22.1% in the prior year's first quarter. The company had net income of $247.6 million or $1.04 per diluted share, which included $73.2 million or $0.23 per diluted share of incremental operating costs for COVID-19-related expenses. This compares to net earnings of $267.9 million or $1.12 per share in the prior year quarter. Combined cash and cash equivalents at quarter end totaled $1.76 billion compared to $539.2 million at the end of fiscal 2019. Outstanding debt as of May 2, 2020, was approximately $4.3 billion, which included $750 million drawn on our revolving line of credit. Inventory for Dollar Tree at quarter end increased 4% from the same time last year, while selling square footage increased 7.2%. Inventory per selling square foot decreased 3%. The team is actively managing the mix of inventory to rebuild essential goods while controlling categories such as party, which saw a decrease in demand in the first quarter. Inventory for Family Dollar at quarter end decreased 10.6% from the same period last year, while selling square foot decreased 3.9% based on store closures in the prior year. Inventory per selling square foot decreased 7%. Our Family Dollar inventory reflects higher than normal out-of-stock in certain categories. Our merchants, supply chain, and vendors are working diligently to improve our positions to meet increased product demand going forward. Capital expenditures were $235.8 million in the first quarter versus $209.2 million in Q1 last year. For fiscal 2020, we're now planning for consolidated capital expenditures to be approximately $1 billion compared to our original guidance of $1.2 billion. Changes to our capital expenditure plan include expectations to open 500 new stores compared to our original plan of 550. These will be comprised of 325 Dollar Tree and 175 Family Dollar, which includes a reduction of 25 planned stores for each banner. Due to the COVID-19-related suspension of our H2 renovation program, we are now planning for 750 Family Dollar H2 renovations for fiscal 2020 compared to our original plan of 1,250. Additionally, we've seen a reduction in our capital mix for supply chain based on the finalization of projects for the year. Depreciation and amortization totaled $165.5 million for Q1 compared to $151.2 million in the first quarter last year. For fiscal 2020, we now expect consolidated depreciation and amortization to range from $670 million to $680 million. While we are not providing sales and EPS guidance, I do want to provide a few data points for your modeling. Net interest expense is expected to be approximately $39 million in Q2 and $160 million for fiscal 2020. The tax rate is expected to be 23.2% for the second quarter and 22.7% for fiscal 2020. Weighted average diluted share counts are expected to be 238 million shares for Q2 and 237.9 million shares for the full year. As reported in our March business update, the company withdrew our prior Q1 and fiscal year guidance. Due to the continuing uncertainties, we have limited visibility to our future business trends, which results in a wide range of potential outcomes for our 2020 financial performance. We're in a strong financial position and remain confident in our business and ability to drive long-term shareholder value. I will now turn the call back over to Gary.

Thank you, Kevin. The current macro environment was obviously not contemplated in planning our business for fiscal 2020. Our performance in Q1 validates that Dollar Tree and Family Dollar are important to shoppers in times of need, especially for their daily essentials. With more than 38 million Americans filing unemployment claims in just the past 9 weeks, we believe families need value and convenience more now than ever before. We have a resilient business model, a very strong balance sheet, an experienced leadership team, and tremendous opportunity to continue serving customers with those values and conveniences they seek. I cannot say enough about our store and distribution center teams. They have been up to the challenge in being nimble and agile in a quickly changing work environment and committed to running the business through an unprecedented time. To recognize our efforts, we have rewarded our hourly store and distribution center associates with wage premiums going back to March 8. This investment in our front-line associates has totaled approximately $95 million to this point, $63 million incurred in the first quarter. We were also pleased to welcome more than 25,000 new associates to the organization during the quarter. Q1 is in the books. We finished the quarter strong. The momentum has carried into our second quarter. While we are still less than 4 weeks into the quarter, I am pleased to say that business is as good at this point. At Dollar Tree, we have seen an improvement on the discretionary side of the business. In fact, with the exception of party-related categories, discretionary categories are comping positively in Q2. Categories performing well include crafts, kitchenware, lawn and garden, hardware, and toys. They're all performing well. We had a strong Mother's Day and school graduation sales. The Crafter Square offering, like Mike discussed, continues to gain momentum and is now available in more than 3,000 Dollar Tree stores. In the balloon business, which was hindered in 2019 by the helium shortage, has bounced back nicely. The comp performance at this early stage in the quarter has returned to a level we are accustomed to seeing from Dollar Tree. At Family Dollar, we believe the current environment with families staying close to home has provided us an opportunity to showcase improvements we have been working very hard on in recent years. Our investment in the Family Dollar store base with our H2 renovations has been a key driver since we accelerated our renovations a year ago. Now, with customers and communities needing us more than ever, we are being introduced to a format that has a better shopping experience when they need it most. I'm also pleased with the work of the merchant team and the traction we are seeing on the discretionary side of the business. Our customers have moved from all things essential to more purchases to support their at-home and outdoor living needs. The discretionary momentum we saw late in Q1 has certainly continued into the second quarter as well. Q2 is off to a very good start at Family Dollar. That said, we do expect this to continue to be an extremely volatile consumer environment. Factors impacting retail will continue to include the evolution of macroeconomic factors, including unemployment rates, variability in vendor supply chains being able to meet product demands, volatility in consumer demand related to the crisis, the value and timing of government stimulus, the duration, degree, and geographic breadth of shelter-in-place mandates, the evolving competitive landscape across retail and restaurants, and our incremental costs related to managing the business during the COVID crisis. We continue to focus on making meaningful progress to grow and improve our business for both brands. We believe we are well positioned in the most attractive sector of retail to deliver continued growth and increase value for our shareholders. The combination of more than 15,300 Dollar Tree and Family Dollar stores provides us the opportunity to serve more customers in all types of markets. Operator, we're now ready to take questions.

We'll take our first question from Edward Kelly of Wells Fargo.

I wanted to ask you about the comp cadence. Could you talk a little bit more about the trends that you saw in April, both leading up to Easter and then after Easter? And then what have you seen so far for each banner? And then you provided some qualitative commentary. I'm curious if you could provide some more specific color on May and what you have seen to date from a comp perspective.

Ed, this is Gary. Let me characterize it this way. Obviously, on the Dollar Tree side, Easter was the first week of April. So we really saw the impact of shelter-in-place mandates going in, traffic dropped and Easter was not on anyone's mind going into the holiday. So the bigger seasonal impact to Dollar Tree was the Easter holiday basically evaporating. But post-Easter, traffic was negative but moderated, and maybe more importantly, what we saw people buying also changed too, from the hoarding of essentials to some of the other elements of what people were buying around staying at home, which meant children were out of school, so more stationery, more back-to-school items, and toys for kids. Family Dollar was maybe slightly a little different, not as big of a holiday effort for Easter at Family Dollar and at least around pure Easter. But the things that get impacted at Family Dollar are things like people grilling out, it's a family celebration, and apparel. But I would describe it the same way. Post-Easter holiday, we saw folks get back into buying more of what they needed around home living and outdoor celebration, I would call it. And with more folks at home, obviously, we’re experiencing the essentials spiking for both banners. So as we go into May, while we see some traffic down, we see basket sizes go up and we see the breadth of what folks are buying being expanded beyond clearly beyond the essentials. So we like what we see going into the end of April, and it's carrying on into May.

Alright. And then maybe just a follow-up from the margin perspective, particularly around the core Dollar Tree business. This has been a 35%, 36% gross margin business for a very long time. You've had some headwinds recently. A lot of it seems like it could just be transitory. Is there any reason to think you can get back to that range? And can you get back there soon, meaning Q2, Q3 or sometime this year?

Well, I don't have a crystal ball that says what's going to happen exactly to the macro environment. There's no reason Dollar Tree can't get back to 35% and 36% with what we see on how we're selling our assortment. Even now, I like how the mix is occurring at Dollar Tree. The impacts that we're experiencing from COVID, it's everything from how we need the distribution centers to run on the priorities of getting key vendors into the DCs and out to stores, which we're spending extra on. When we are buying low-value essential products, that impacts the freight costs coming in and out of our margin as well, and obviously, we think the current wage premiums. Long term, there's no reason. I don't know that I see it in Q2 or in the back half of the year, and I dare not make a guess on how the retail environment will be. But what we're buying in for the value for Dollar Tree is as great as ever. Mike called out Craft. I mean, here's a category that really didn't even live in Dollar Tree last year to any extent. And our customers have welcomed it wildly in the stores that we put it in, and that's the nature of Dollar Tree. We find something, we build it. You're on the new thing, and that's really the underpinning for what's going to drive margin. The thing that we've got to handle on the expense side, I've always said, given enough time, we'll scurry around the rocks, but the key to Dollar Tree's magic is keeping the magic of incredible value in front of our customers on the product we're selling.

Our next question will come from Chandni Luthra of Goldman Sachs.

This is Chandni on behalf of Kate McShane. Could you elaborate on the improvements in trends following Easter? Have those trends continued? We're starting to hear that some customers are just beginning to receive payments. Can you explain how you've seen stimulus affecting the business? Also, is there a relationship to be made with tax refunds? We heard a retailer mention this, so do you see any similar benefits in terms of their duration?

Chandni, we're getting a lot of echo on your first question. Was it around how we're seeing customers with the stimulus check?

Yes, that is correct. So basically, my question is, is there a parallel between stimulus checks and tax refunds?

Yes. So yes, we are seeing some impact as the stimulus gets released into the market and the tax refunds, especially on the Family Dollar side. And as Gary described, we saw some nice momentum in our discretionary side of the business with our home and outdoor categories. So we can see a correlation of the stimulus dollars being released and an increase in our basket size.

Got it. And then if I could get a follow-up. I'm sorry, go ahead.

Yes. We were just wondering what your second question was?

Yes. So in terms of your global supply chain, in light of the disruption this year we've seen and then with tariffs last year, are there any efforts to realign sourcing globally?

Well, the ripple effect of the COVID impact, obviously, started in Asia and then has moved into the U.S. side. Initially, when we saw the disruption in Asia, the parallel was just the short-term effect of factories shutting down right after Chinese New Year. I would say that rebounded fairly quickly to the point that, other than being measured a few weeks late on some shipments, that was moderated and now is not an issue for us. On the domestic side, however, the spike in demand for domestic essentials is something that all retailers are chasing and it varies by vendor, it varies by geography, and anything that's related to cleaning supplies, toilet paper, and paper towels. While they're all getting better and we're selling record amounts, it's still something that we're probably going to be chasing, I think, into June, and I would guess maybe July with some vendors. But it's getting better week by week, and we see it in our sales. But it's almost shifted more to the discretionary side now. Some of the things that folks are buying are imports. We're having to go back and take a look at orders on inbound supply and up those. It's been a changing shift in dynamics from when it got started, going back to the impact to China. On supply chain, U.S. domestically, and now what people are buying. So I think about it almost in those three stages: how we're running our business and where the priorities are.

And our next question will come from Michael Montani of Evercore.

I just had two questions. The first was on the tariff front. I think initially, there was discussion of around $45 million plus of impact in the first half of this year. So I wanted to see if $20 million to $25 million is probably about right for Q2. And then on the COVID expense side, you called out some of the initial labor costs to expect into Q2. I was hoping to understand if there's additional kind of PPE safety equipment run rate that we should be factoring in here and how normal and ongoing that would be?

Sure, Michael, it's Kevin. Regarding the tariffs, at the start of the year, we mentioned that tariffs would add an extra $47 million this year, mainly affecting Dollar Tree. This was partly due to the annual effect of List 3 at 25% and also List 4. Initially, we projected $25 million, but it came in around $23 million, with $18 million attributed to Dollar Tree and $5 million to Family Dollar. Looking at Q2, we now anticipate it to be slightly less than we initially thought. We expected around $20 million, but it might be closer to $15 million due to timing as we manage our supply chain. I believe it will be about $15 million in Q2. Regarding COVID-related costs, we incurred significant expenses in Q1 as we increased our PPE supplies. As Gary mentioned, we also installed 60,000 plexiglass shields in our stores, which was likely a larger expense than the supplies themselves. Looking ahead, we expect to face additional supply costs to ensure our stores are stocked with PPE, including masks and gloves, as well as cleaning supplies and sanitizers to meet safety mandates and enhance our cleaning protocols. It's challenging to predict the costs for Q2, but they will continue. This uncertainty is one of the reasons we cannot provide guidance moving forward.

Michael, I would just add that the majority of the costs, once you account for the initial expenses, is primarily due to the wage premium. Our employees are paid biweekly in advance of each pay period. We inform them that this wage premium is ongoing. Currently, we are committed to this wage premium for our associates until mid-June, allowing them to plan accordingly. So that's our current situation.

Our next question will come from Paul Trussell of Deutsche Bank.

Good execution in a volatile and challenging marketplace. First question is on Family Dollar. Maybe just touch a bit more detail on what you're seeing there. Should we think that Q2 is more or less in line with Q1 results? Also, what's the feedback been from customers as they return to the format potentially, for some, for the first time in a few years and how you plan to keep those customers there? Also, just curious about any updates on the H2 front and how you feel about your inventory and overall merchandise assortment, especially on the discretionary side, which we were planning to change over this year.

Let me start and have Mike share some insights on various categories. Family Dollar has performed even better than we anticipated, especially given the uncertainty we faced. Customers have come in and shopped vigorously because of the convenience and value we offer. Our early efforts to create a safe shopping environment have also been recognized, as reflected in our internal assessments. Additionally, we've seen an increase in sign-ups for our Family Dollar app, which is a positive indicator that we're attracting new customers. Initially, there was a strong demand for our services, which has transitioned into recognition of our early work on product variety and stock levels. Our supply chain is generally effective globally, but we are experiencing stress domestically, particularly related to essential items. Supplies that used to last about 2 hours are now lasting between 1.5 to 4 days, depending on demand. Our team has stepped up to meet the needs of their communities, and we have received numerous expressions of gratitude from customers. They genuinely rely on the Family Dollar brand during this period. I'll let Mike provide more details on the sales by category.

Yes. Gary mentioned that during the initial three weeks, there was a significant demand primarily for consumables, cleaning products, and paper goods. After Easter, the focus shifted to at-home items, with strong sales in our apparel sector as well as soft home goods, decor, toys, and hardware. It's encouraging to note that we entered the year with a robust inventory in those areas, allowing us to keep a strong stock for the latter part of the first quarter. As Gary noted, we're successfully replenishing those sales. Additionally, as I shared on March 4 regarding Family Dollar, we are focusing on turning around our discretionary business with essential products at competitive price points, ensuring they reach our stores and displays in the second half of the year. Our inventory has been moving well, and our current purchasing and replenishment adjustments are receiving positive customer feedback. Another unexpected development is the increasing activity in the closeout business, and we anticipate significant value opportunities at Family Dollar and Dollar Tree for closeouts in the upcoming months.

And if I may mention, Paul, you inquired about H2. It’s tough to analyze March due to the pandemic impact. However, I can say that after Easter, H2 has continued to see a slight increase even during this period. Interestingly, as we approached April post-Easter, our rural H2 locations, where we have the majority, outperformed the urban ones. This isn't entirely surprising considering the hotspots that affected urban areas more than rural communities. We’re still satisfied with H2 performance; it's timely. Reflecting on 2008, while it was a different situation, that was when Dollar Tree was refining our prototype as desired. I think this experience is comparable to the 1,500 H2 locations we currently have, which are now driving our business effectively.

That's really helpful color. My follow-up is just to get any other comments that you can provide as it relates to guidance. I know that you're not giving anything specifically, but anything else that we should keep in mind as it relates to Q2 for the balance of the year on some of the items you've mentioned were impacted in the first quarter, things like the merchandise costs, markdowns, and other pressures.

Yes, Paul, it's Kevin. As we consider the situation, Gary's remarks indicated that the Dollar Tree business mix has become more normalized. I believe that looking ahead to Q2, this could be a positive change compared to Q1. Another factor to keep in mind is the diesel fuel costs. In Q1, they were down approximately 12% year-over-year, and at the start of Q2, they dropped by 25%. While this is a small part of the overall freight rates, it is beneficial. Additionally, we began the year expecting to see increases in our import freight with our contracts starting in May, but those increases were not as significant as we anticipated. I think this will provide some advantages in the latter half of the year. There are many moving parts to consider. Distribution costs will face ongoing pressures, particularly in our buildings where we are currently experiencing high throughput as we work to replenish our essential inventory alongside normal operations. This may create some pressure as we continue forward. The company is engaged in numerous initiatives, and we managed to control expenses effectively in Q1. We will maintain a strong emphasis on expense management throughout the year, aiming to keep SG&A growth at a reasonable level.

We'll take the next question from Peter Keith of Piper Sandler.

Gary, you'd commented that Dollar Tree is now running, I guess, in May, at a level you're accustomed to seeing. So the two questions on that is, would that imply kind of an up-low single-digit run rate for the quarter? And then secondly, just thinking about the exposure sort of party and celebrations, is Dollar Tree being negatively impacted at this point because there are still fewer get-togethers and potentially fewer celebrations?

Well, let me answer the second one first. Clearly, we did see the impact of shelter-in-place. Obviously, parties took the biggest hit, but I think the resiliency of our customers and just their creativity that we've seen out there with the drive-through workday parties, what's been happening in graduation. We actually comped on graduation balloons last week, which I thought was just remarkable for our business. Now party is a big category for us; we split it into our celebration and party paper. So the celebration is actually doing quite well right now. Party paper, as we called out before, is the piece that's lagging. On the other hand, Crafts, a category that we didn't talk about a year ago, is now a significant category in dollars. The comp is something that customers have responded to. I think it speaks to families figuring out how to entertain themselves with the magic of products that you can buy for a dollar at Dollar Tree and even at Family Dollar with toys and some of the home essentials there, too. I sort of put it into those buckets. So that's how I think about it. And then we're early into the quarter. I think what we want to call out on what we see in Dollar Tree is that it's a new normal. But it certainly, at least in terms of the categories that we are seeing respond, feels a lot more like we're used to. We don't have any huge category or maybe celebrations, holidays until we get to the back half, really, right? We go from Memorial Day, the outdoor grilling, to back-to-school, whatever that's going to trend to be in the early fall. After Easter, we like what we see. We're not having the same kind of impact on the seasonal side that we had all focused on 1 week in April with Easter. So I think that also lets us spread our opportunity out there in the store on what we merchandise and what we put on display. I think what we're encouraged with is the things that our customers needed, they have found in both stores and have bought at elevated levels now, really, Family Dollar, starting with the April time frame, and now it seems like Dollar Tree is getting back to its normal cadence.

Okay. I want to ask a separate question and maybe ask you and the team to put on your economist hats on, which I know can be a little bit dangerous. But it's on the federal unemployment benefit that's being paid out right now of $600 per week, which, at present time, is set to expire at the end of July. And obviously, no one can predict what will happen. But if that were to expire, do you view that as a notable negative to the business and maybe to the spending power of your core customer? Or conversely, does it allow you to pick up some share with your value offering?

This is Mike. We think about it that as that goes away, we will be in a great position as a value retailer when people are unemployed and they don't have that source of income. They will need value more than ever. And we should be in a great position to provide that for them.

Yes. It's not 2008 for all the obvious reasons. What our customer has right now is money in their pocket. That's obviously a tailwind for anybody that has their doors open. In 2008, folks lost jobs too, and they needed us and they found this. I think that’s some of what we're planning for as we take a look into our crystal ball here for the back half of the year into '21.

Gary, what percent of Dollar Tree sales relate to gatherings? Presumably, party is a big piece of that, but it extends also across seasonal and discretionary as well. Would you say it's 10% of sales? 20% higher than that?

That’s a challenging question. If we consider Easter, the major impact was seen in the Easter products, which contributed 490 basis points to that holiday. However, after this significant holiday, effects seem to be more dispersed. We've prioritized the party category, which has become essential. While birthday parties are still taking place, they occur differently now, and graduations are happening virtually. We're beginning to see sales return to nearly previous levels for items associated with these events. The situation with party supplies varies; it relates to gift-giving and other areas that will gradually improve. It’s a slow recovery. For instance, in the stationery category, kids are learning from home, resulting in increased demand for school supplies. Craft items are also seeing upticks, and while discretionary spending is still ongoing, it aligns with routine shopping habits. What we’re noticing is that shoppers are coming in with specific needs. They aren’t just browsing; they are focused and looking for necessary items, and currently, Dollar Tree and Family Dollar are meeting those needs.

And my follow-up is on the Family Dollar gross margin. It is up year-over-year but against a really easy comparison, particularly on a 2-year basis. So how should we think about the trajectory of the gross margin at Family Dollar, understanding that mix might have had some issues in the first quarter? But what's it going to take to be able to get this business back to a 26% to 27% gross margin? And how quickly do you expect that to happen?

Yes, Mike, the timeline is perhaps the more challenging aspect of this situation. We are pleased with our progress. The renovations in the second half of the year are a significant factor. The work our merchant team is doing on the discretionary side of the business is also crucial. Our goal is to attract more customers to the store, showcase our product assortment and reassortment, and generate excitement about the Family Dollar experience. There is definitely an opportunity here. Increased volume will certainly help, but changing our product mix could have an even larger impact overall. We are eager to sell more consumables, while recognizing the importance of the discretionary categories as well. Additionally, there are areas where we need to improve. We've discussed shrink in recent years, and it hasn't met our expectations in Family Dollar stores. Our team is putting in the effort, but there’s more to do, even though we saw some improvement in the first quarter. Regarding other aspects, markdowns have been significant over the last few years, but we feel more optimistic as we progress through this year. Initially, we anticipated higher markdowns for Q1 due to our discretionary reassortment efforts, but we believe we've managed that well with our sales performance. Looking ahead, we see this opportunity, and our team is committed to helping consumers recognize the new assortment and mix, which we believe will be exciting for them.

Can I just clarify one thing? One of your competitors reported this morning that they've seen a moderation in their cost trends in recent days. Have you seen the same thing?

I don't think that's something that we would comment on, Michael.

Our final question will come from Paul Lejuez of Citi.

Curious on the Family Dollar side, if you have any idea about the number of new customers that may have come into the network over the past several months. And then second, just to go back to the Dollar Tree gross margin. Curious, if we take mix out of the equation, if maybe you can talk about the gross margin within categories relative to themselves on a year-over-year basis, where you're seeing increases and decreases.

I can share that our team in the field has observed an influx of new customers. We track customer feedback from individuals who identify as new customers, and weekly, we monitor the number of first-time users of the Family Dollar app. We noticed an increase as people sought essentials. This provides us a chance to highlight our H2 stores and the improvements to our Family Dollar locations, which is encouraging. For Dollar Tree, on the margin mix, when you think about that 490 basis point shift, I mean, I guess there's a start there. I mean, that was the low point for us, losing that amount of business on a key holiday in the discretionary business. We're getting that back to normal now. I think if you're asking the question around if we think we'll get mix and mark-on. Well, mark-on is just fine, and when we look at categories like Craft now that are comping outside the norm, that's going to help. As we get back to a more normal mix, the mark-on's just fine, and then to Kevin's point, the thing down the line that still deserves our attention is, we have to do better on shrink. We're willing to spend more in our distribution centers right now to get essentials to our stores. That's probably going to be with us through at least Q2, if not past that.

And I'd like to turn the conference back over to Randy Guiler for any additional or closing remarks.

Thank you, Shannon. Thank you for joining us for today's call and especially for your continued interest in Dollar Tree and Family Dollar. Our next quarterly earnings conference call to discuss Q2 results is tentatively scheduled for Thursday, August 27, 2020.

That does conclude today's teleconference. Thank you all for your participation. You may disconnect.