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Featured Companies: Dollar General (DG) and Family Dollar (FDO)

Secondary Companies: Costco (COST), Dollar Tree (DLTR) and Wal-Mart (WMT)

Ratings:

DG - Maintain at Buy

FDO - Maintain at Sell

Price Targets:

(click to enlarge)

Thesis:

Dollar General continues to excel in the discount/dollar store space, and the company continues to be our favorite in the industry. The company has not received the valuation premium of the likes of Dollar Tree, but we are seeing better growth on margins for DG than many competitors like Family Dollar and Fred's (FRED). Family Dollar, however, is not far behind DG, but we still believe that prospects are limited for FDO without weakness in the shares first.

DG continues to look very solid after their latest report and based on recent developments. In the company's latest quarter, DG reported increased operating margins and net margins. Operating margin increased from 9.56% to 9.83% while net margins increased from 4.3% to 5.5%. What stood out most to us was the company's 5.1% increase in same-store sales. The company's restructuring of its stores to appeal more to speedier shoppers has worked well so far. The company increased its FY outlook as well with EPS from 2.77-2.85 from 2.68-2.78. Right now, we see DG as outperforming its competitors. While competition remains high, DG is remodeling nearly 600 stores this year, which is a great initiative that will help the company in the long-run. On top of that, the company has a lot of locations ready to be opened with around 600 new stores being opened this year. We believe that the company will actually increase its Y/Y revenue growth from around 8% to 10% in 2013 as these new stores start to generate sales. The only concern for us with DG is that macroeconomic conditions continue to remain soft, and the company's aggressive expansion could end up weak if the economy double dips into a recession.

Family Dollar completed its 2012 FY in August, and while we believe the company should see a solid FY 2013 with 11-12% growth in revenue, there are some problems that limit our upside potential. First off, margin growth is not as solid as DG. The company has noted that it expects to see gross margins decline in 2013 already and are expecting around $625M in capital expenditures, 85% of our operating income expectations. That compares to our expectations of DG to have 35% of operating income tied up in capex. To keep pace, FDO is remodeling a bevy of stores, opening a bevy of stores around 500-600. While we understand capital expenditures now mean growth in the future, we do not see these expenditures as giving the company any competitive advantage or creating any economic moat, and it drastically limits equity value in 2013. Future growth will create more revenue streams, but we have priced in around 40% growth in sales over the next four years. Those capital expenditures limit the success of shares though.

At this time, we see DG as executing slightly better to win over customers and deal with pricing as can be seen by the company's higher margins. FDO is still a good stock with solid fundamentals in an industry that can be successful in many market conditions, but we prefer to see some weakness before wanting to enter.

Profitability:

DG -

FDO -

Profitability is really the key to identifying the winners in this sector. What we are seeing is expanding margins in operating margin and net margin for DG. On the other hand, FDO is seeing some declining margins. FDO does have a very strong ROE, which does explain some of its value. At the same time, the company is seeing a decline in that margin as well. How do these companies compare to the competition?

Competitors for the companies include Dollar Tree, Wal-Mart and Costco. DLTR outpaces both companies with a 36% gross margin, 11% operating margin, and 35% return on equity. Dollar Tree is definitely the best company for executing its products at the best margin in the group, but the company has been plagued by overvaluation and investor concern. WMT operates with a 25% gross margin, 6% operating margin, and 22% ROE. With the size and scale of WMT, the company would expect to outperform small stores that are offering cheap goods only, but WMT does not. This trend shows you that WMT is indeed pricing very cheaply to attract customers and showing a move towards smaller stores for convenience. COST, as the ultimate stock in bulk buying, operates with 12% gross margin, 3% operating margin, and 14% ROE. As far as profitability, DG and DLTR outperform much of the companies' competition.

Value:

DG -

FDO -

Family Dollar and Dollar General both fit in our appropriate value ranges for acquiring. We like to see a sub-15 future PE for purchases and sub-22 PE. Both companies, though, are operating at slight premiums to the industry average. Given our conversation of profitability, this does make sense. Moving forward, we believe DG continues to improve profitability, increasing value. FDO, on the other hand, is not showing that same strength. How does these values stack up?

DLTR operates with a PE of 17 and future PE of 13. WMT operates with a PE of 15 and future PE of 13, and COST operates with 25 PE and 19 future PE. As we can see, DG and FDO are pretty even with its competition.

Financial Health:

DG -

FDO -

As far as financial health, large discount store chains tend to sit on the lower end of current ratios and debt-to-equity ratios as they typically have higher levels of debt for store expansion and accounts payable for large amounts of goods they buy to put into stores. Both companies sit above our 1.5 rate for health. DG is seeing debt-to-equity increasing, which is a negative. FDO is working off some debt and increasing equity.

DLTR operates with a current ratio of 2.3. WMT operates with a 0.8 ratio, and COST operates with 1.1 ratio. WMT's current ratio is slightly concerning as it's below the 1.0 level that shows adequate health. While there is no expectation of any bankruptcy or liquidity issues for WMT, the company has leveraged itself very strongly.

Source: Dollar General: Conviction Buy, Best In Discount Industry