Simulated Best Ideas Newsletter portfolio idea Dollar General continues to deliver consistent top-line performance, but higher than expected expenses in the second half of its fiscal 2018, including hurricane-related expenses and rising transportation costs, resulted in a reduction of operating margin and diluted earnings per share guidance. Net sales growth expectations were also tempered slightly.
By Kris Rosemann
Margin performance across the retail space has left a bit to be desired of late, “Retail Margins Weighed Down by Labor, Transportation Costs,” and simulated Best Ideas Newsletter portfolio idea Dollar General (DG) was unable to avoid some of the pressures as its fiscal third quarter report, results released December 4, brought with it slightly lower margin expectations for the full fiscal year. We’re sticking with our fair value estimate of $103 per share for the time being, and the company’s ~1.1% dividend yield as of this writing looks to be quite well covered by free cash flow generation.
The notably consistent dollar store operator expects to deliver its 29th consecutive year of same-store sales growth in its fiscal 2018 (ends January 31) with guidance coming in at the middle of its previous range of mid-to-high two percent growth, and net sales guidance was rolled back slightly to ~9% from previous guidance of 9%-9.3%. The company adjusted its operating margin target for the full fiscal year to modestly below levels realized in fiscal 2017 compared to flat margin guidance previously, and diluted earnings per share guidance was lowered to a range of $5.85-$6.05 from $5.95-$6.15 previously. Management cited a $0.09 per share impact to this guidance range resulting from hurricanes and other disasters, rising transportation costs, and year-to-date results as the driver for the reduction.
Net sales grew 8.7% on a year-over-year basis in Dollar General’s fiscal 2018 third quarter thanks to a 2.8% increase in same-store sales from the year-ago period and contributions from new stores. The solid same-store sales growth marked the company’s highest two-year same-store-sales stack in 11 quarters as the advance came on top of a 4.3% gain in same-store sales in the third quarter of 2017. However, customer traffic was approximately flat in the quarter as a higher average transaction amount with strength from the consumables, seasonal, and home categories drove the positive same-store sales results and offset weakness in the apparel category.
Dollar General’s gross margin took a 39 basis point step back in the quarter from the year-ago period due to higher markdowns, increased transportation costs, and negative mix shift, most notably related to consumables sales, in addition to an increase in its LIFO provision. Meanwhile, SG&A spending as a percentage of revenue declined 21 basis points as a result of lower incentive compensation, advertising and supplies, and repairs and maintenance expenses as a percentage of sales, which were partially offset by higher depreciation expenses. These factors resulted in an 18 basis point operating margin contraction from the comparable period of fiscal 2017, but diluted earnings per share leapt 35.5% on a year-over-year basis thanks in large part to a materially lower tax rate.
Free cash flow generation through the first three quarters of fiscal 2018 jumped ~47% on a year-over-year basis to $963 million, which easily covered cash dividends paid in the period of $231 million. Dollar General plans to continue its ambitious store growth plans moving forward with expectations for 975 new store openings, 1,000 remodels, and 100 store relocations expected in fiscal 2019 on top of its targets of 900 new store openings, 1,000 remodels, and 100 store relocations in fiscal 2018. The company holds a net debt position of more than $2.6 billion as of the end of its fiscal third quarter, but its solid free cash flow generation should be able to handle this load. We think management could cut back on share repurchases as it bought back $298 million of its common stock in the third quarter of 2018 at an average price of $107.55, which is just above our fair value estimate for shares.
All things considered, we would have liked to see a bit more resilience in Dollar General’s bottom-line in the near term, but the cost pressures it is facing are not a material surprise given recent trends seen from other retailers. We’re going to keep highlighting the company as an idea in the simulated Best Ideas Newsletter portfolio as it remains a model of consistency with a same-store sales growth track record that spans decades and multiple economic cycles. Nevertheless, we’re keeping an eye on the impact transportation costs are having on the retail space, and the tight capacity that is driving transportation rates may be one of the first impacts the proliferation of e-commerce has had on the dollar store discount space. Fuel prices may also be worth watching both in terms of additional transportation expenses and as it relates to the amount of disposable income among Dollar General’s core customer base.
Retail – Discount: BIG, DG, DLTR, FRED, PSMT
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Kris Rosemann does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.