Image Source: Dollar General Corporation – IR 2016 Presentation
By Callum Turcan
Dollar General Corporation (DG) is one of the holdings in the simulated Best Ideas Newsletter, and shares yield 1% as of this writing. The company had ~15,500 stores situated across 44 states as of March 1, 2019, making Dollar General the largest discount retailer by store count. Its business model is built around selling low-cost items that e-commerce firms couldn’t economically ship without being part of a much larger order. Around three-quarters of Dollar General’s stores are located in towns with populations of 20,000 or less, giving it another edge on its competitors like Amazon Inc (AMZN) due to the logistical problems that arise when selling very small volumes of low-cost items outside of major demand regions (namely metropolitan areas).
Great Growth Story
We like Dollar General’s growth trajectory (as it plans to continue expanding its small-box store footprint via new stores) and its impressive same-store sales performance, with 29 consecutive years of growth as of fiscal 2018. Furthermore, we see Dollar General’s promising free cash flow potential and strong payout coverage (Dividend Cushion ratio stands at 2.9x) culminating into a great dividend growth story (earning the firm both an Excellent Dividend Growth and Dividend Safety rating). While its net debt load is a concern, we expect Dollar General’s free cash flows over the next five years will handily cover its forecasted dividend obligations. Moody’s Corporation (MCO) rates Dollar General’s unsecured debt at an investment grade credit rating of Baa2 with a stable outlook.
At the end of 2018, Dollar General’s management thought the company could possibly add another 12,000-13,000 stores to its footprint in markets all across America (there could be a lot of room for upside in northwestern American markets and states that it doesn’t already have operations in). While its current stores on average have roughly 7,400 square feet of selling space, some of these new stores will be even smaller with less than 6,000 square feet to keep occupancy costs low. Small and nimble is Dollar General’s way of capitalizing on strong US consumer spending growth prospects without directly competing with its big box peers, preferring to use geographical proximity and convenience to its advantage. Consumables represent the vast majority of Dollar General’s business, representing ~77.5% of its net sales in FY2018. Note that Dollar General’s fiscal year generally ends in early-February or late-January (FY2018 ended on February 1, 2019).
During the first quarter of FY2019, Dollar General continued to perform well. Same-store sales growth came in at 3.8% year-over-year, driving growth across the board. Net sales rose by over 8% while its GAAP diluted EPS rose by $0.12 to $1.48, good for almost 9% year-over-year growth. However, note that its gross margins weakened by almost 25 basis points year-over-year due to rising transportation costs and greater consumable sales, which generally carry lower margins. Going forward, Dollar General plans to continue scaling back promotional price cuts to bolster its profitability. That’s the right call in our view as Dollar General has witnessed a material increase in traffic to its stores as well. Management had this to say about Dollar General’s first quarter FY2019 performance during the earnings conference call:
“Turning now to our first quarter performance. We delivered comp sales growth of 3.8%, additionally net sales grew 8.3% to $6.6 billion compared to net sales of $6.1 billion in the first quarter of 2018. This strong net sales performance in the first quarter of 2019 showed once again that we can continue to drive sales growth from both new stores and mature stores. Additionally, during the first quarter, we continue to gain market share and highly consumable product sales, which was a key driver of our strong and balanced performance. Syndicated data indicated we had mid to high single digit growth in both units and dollars over the 4, 12, 24 and 52 week periods ending May 4, 2019.
Our 3.8% comp growth rate for the first quarter of 2019 resulted from both an increase in average basket size as well as our highest customer traffic growth in over a year. Driving profitable traffic to our stores remains a priority, and we’re pleased to see our efforts delivering during the quarter. We saw another very strong quarter of growth in sales of consumables. Our non-consumable sales growth was driven by strong results in both seasonal and home.”
The apparel business is one that’s hard to earn an economic return in, which is why management also stated that Dollar General has been reducing store space allocated to selling apparel in favor of better opportunities. Having a small in-store inventory and limited selling space makes managing limited offerings crucial to Dollar General’s financial performance. We are supportive of Dollar General shifting towards items that it has more of a competitive advantage in selling, such as consumables, and away from products that are better left to traditional retailers and the e-commerce industry. That includes moving into the produce space, with Dollar General adding produce offerings to 50 additional stores during the first quarter, bringing its store count with produce offerings up to 480 with plenty of room to grow.
Financials Overview
Dollar General’s net operating cash flow climbed by 34% from FY2016 to FY2018 while its capital expenditures rose by 31% during this period, enabling its free cash flow to expand from $1.0 billion to $1.4 billion, good for 35% growth. Consistent and growing free cash flow is one of the things we really appreciate about Dollar General. As of May 3, 2019, Dollar General was sitting on $0.3 billion in cash & cash equivalents versus $2.7 billion in long-term obligations and a negligible amount of its current portion of long-term liabilities, resulting in a net debt position of ~$2.45 billion.
While that net debt is concerning in the sense Dollar General is undergoing significant expansion (management intends on adding 975 stores to the firm’s asset base this fiscal year on top of 1,000 planned remodels and 100 relocations), its strong free cash flow makes that net debt position very manageable. As does its investment grade credit rating and stellar track-record when it comes to same-store sales growth. Dollar General opened 240 stores, remodeled 330 stores, and relocated 27 stores during the first quarter so it appears the firm is on-track to meet FY2019 guidance.
Management’s guidance for FY2019 calls for 7% annual net sales growth, annual same-store sales growth of 2.5%, annual operating profit growth of 4% – 6%, and diluted EPS of $6.30 – $6.50 (up sharply from $5.97 in FY2017 on a GAAP basis). Capital expenditures are expected to climb further to $0.8 billion while management intends on repurchasing $1.0 billion additional shares, effectively utilizing the firm’s remaining share buyback authority (which stood at $1.1 billion at the end of the first quarter). Keep in mind this guidance includes the expected impact from the additional tariffs the Trump administration placed on Chinese imports in May 2019, as those cost increases will filter into Dollar General’s financials (core price increases and lower levels of promotional price reductions will help offset potential negative impacts to a degree).
What We Think
We like the multiline discount retail space. Here’s a concise summary of our thoughts on the industry from our 16-page Stock Report:
The retail discount store industry provides consumable basic needs to customers primarily in the low- and middle-income brackets. More than one third of the industry’s customers live in households that earn less than $20,000 per year, making the group’s results counter-cyclical–as more households generate lower income due to poor economic conditions, store growth and same-store-sales opportunities increase. Still, competition is fierce among constituents and with many other retailers, including grocery stores. But given the niche low-price strategy of participants and their counter-cyclical nature, we like the group.
Here is how we view Dollar General’s key strengths from our two-page Dividend Report:
Dollar stores sell a variety of inexpensive bargain goods, items that generally won’t make sense economically to be distributed via e-commerce given the shipping costs. The ease at which consumers can visit their local dollar store (and the collection of low-priced goods in one place) is also a big advantage. Dollar General has a tremendous track record of same-store sales performance. The company has a fantastic counter-cyclical business model, too, as performance often improves in times of macroeconomic pressure. For example, results from the Great Recession of 2008 and 2009 showed same-store sales leaping 9% and 9.5%, respectively.
Equity analysis always requires investors to monitor the downside risks as well, which we cover here (also from our two-page Dividend Report):
If there may be one thing that we’re not too big of fans of at Dollar General, it would be its balance sheet. But we might be a little nitpicky here, as its debt load is quite manageable. Its balance sheet health is not what we would like it to be for a retailer in the midst of such growth plans (we always prefer a net cash position), but free cash flow generation should be sufficient in handling the debt load and expansion plans, in our view. Free cash flow covers the dividend nicely. We would only expect management to keep raising the payout and buying back shares, though we would like to see some deleveraging a bit. The dividend is solid, nonetheless.
Concluding Thoughts
Shares of Dollar General are trading near ~$130 per share, which is near the very upper end of our fair value range, indicating shares are richly priced as things stand today. However, the resilience of DG in the face of ongoing trade turbulence and the related declines in major indexes has been quite impressive. We are holding onto Dollar General in the Best Ideas Newsletter portfolio for the time being, and we continue to like the story as the stock is supported by a great growth trajectory (same-store sales growth combined with new store openings and moving into new product offerings). Management likes to reward investors with significant payout growth, with Dollar General’s low yield a product of strong capital appreciation. Dollar General’s quarterly dividend rose from $0.22 per share in calendar year 2015 to $0.32 in 2019, and we expect there’s plenty of room for upside in the years ahead.
Retail – Discount: BIG, DG, DLTR, FRED, PSMT
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Callum Turcan 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.