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Introduction

The dollar store sector can be boiled down to a commodity business, but if one looks closely there are ways to differentiate between companies. Dollar General (NYSE:DG) is in the middle of a transformation that we believe makes it one of the most attractive plays in the discount retail industry. The company is moving toward more consumable products, which have historically lower margins associated with them. While this seems bearish at first glance, this transformation will eventually lead to larger total transactions made by customers, as the store becomes a one-stop-shop destination. This is the main reason that we think DG is a strong BUY with an implied price appreciation of about 30% according to our DCF analysis. Other bullish factors that support a BUY rating include, but are not limited to, DG's value proposition it provides consumers, new efforts to reduce costs, historical operating income, and valuation.

Profile

Dollar General attracts its customers with the idea that most of its goods are a buck, given its name. DG only offers approximately 25% of its selection at $1 or less. DG is the largest discount retailer in the United States, owning over 10,000 locations in 40 states.

The firm offers products from America's most trusted brands. This selection includes Procter & Gamble, Kimberly Clark, Unilever, Kellogg's, General Mills, Nabisco, PepsiCo and Coca-Cola ... to name a few. The company also offers private label brands at lower prices and comparable quality. DG is based in Goodlettsville, Tennessee, and was founded in 1939.

Thesis

Valuation -

DG shares trade at about 17x trailing twelve month (TTM) EPS and more importantly 15x forward EPS. DG's peer group trades at 20x TTM and 17x forward. This peer group includes other discount retailers like Target (NYSE:TGT), Wal-Mart (NYSE:WMT), Family Dollar (NYSE:FDO), and Dollar Tree (NASDAQ:DLTR). DG being cheap to its peer group is an opportunity to accumulate shares.

DG's most relevant comps include other dollar stores like DLTR and FDO. DLTR trades at 16.5x forward and FDO at 14.4x forward. DG trades right in-between its most relevant competition at 15x and is thus fairly valued when compared to its dollar store rivals.

Fundamentally, DG is putting up impressive numbers that should support a higher valuation. DG increased net income 34% year over year in the most recent quarter. This put net income up well over one half of a billion. For context, DLTR only had 30% net income growth over the same period. DG outperformed the competition by 400 bps, which should be noted. Additionally, FDO saw slight deterioration in net income over the same period, down less than 0.1%. DG outpaces its closest competition, yet shares show no signs of it.

In the category of profitability, DG performs below its immediate peers with respect to gross margins. DG has 31.6% margins, but DLTR and FDO have 35.8% and 34.7% margins. In the category of operating margins, DG (at 10.3%) performs in-between its competition. FDO comes in lower at 7.1% and DLTR comes in higher at 12.1%. While DG is mediocre when compared to its peers, DG is actually better than 83% of its larger peer group in the operating margins category. This relates to the ability of DG to control its expenses.

On a related note, management effectiveness with respect to ROE (return on equity) is impressive. DG is able to reinvest its earnings very efficiently. DG has a higher ROE than 82% of its larger peer group. This makes DG more attractive to investors when compared to its peers. However, when compared to its direct competition, DG immensely underperforms. FDO's ROE is 33.8% and DLTR's is 38.7%, while DG struggles at 19.96%.

Another metric to look at is DG's PEG ratio. A PEG ratio puts forward EPS and growth into prospective. PEG ratios under one are generally accepted to be attractive and the opposite for over one. This ratio is highly a function of and dependent on forward estimates, which can be a weakness, but is still an interesting metric. Wall Street is expecting EPS to grow at 18.5%. Taking DG's forward PE of 14.8x and dividing it by 18.5 (which represents 18.5% EPS growth) yields a PEG ratio of 0.8x. This means that forward earnings may be "cheap" with respect to growth expectations. Our model conservatively assumes roughly 4% annual income from operations growth. We think DG can beat these figures easily considering the company has averaged 23% operating income growth since 2004.

It is also interesting to note that the average PEG ratio in DG's peer group is 1.14. DLTR and FDO have a PEG of 0.9 and 1.10. DG's EPS growth makes the company very attractive and considering its low PEG ratio, relative to its immediate and larger peer group, there is room for forward multiple expansion.

Catalyst -

Management has outlined a few trends to increase shareholder value. The plan is to drive sales growth by increasing shopper frequency and transaction amount. They want to do this by improving merchandise in-stock levels, testing larger store formats (including adding perishable foods), and by offering tobacco products this year. The company also plans on increasing gross profits by expanding private label selection, increasing foreign sourcing, and maximizing transportation and distribution efficiencies. Another item that will improve margins will be new efforts in improving the pricing model for markdowns.

Not all catalysts have been good however. In recent years, sales growth in consumables, which generally have lower gross profit than non-consumables, has outpaced that in non-consumables. This is mostly due to economic challenges faced by customers, but this also presents an opportunity later discussed in the "Economic Moat" section.

Another catalyst for DG includes store management. DG's store openings have been flat YoY, but remodeling and relocating stores are up about 9%. This indicates that management is selective in their store selection process and is careful of saturation. During 2012, DG opened 479 new stores and remodeled or relocated 591 stores. During 2011, DG opened 482 new stores and remodeled or relocated 544 stores.

Economic Moat -

The economic moat for DG is pretty shallow. The company is in a commodity business and has been appropriately discounted by the market, but recent announcements for future efforts may turn this around.

New store expansion, remodels and relocations will be a new and vital part of DG's store portfolio. While the current portfolio focuses on traditional stores, the future will be far more integrated as priority may shift due to the aforementioned consumable trend. Offering more products in-line with demands will make DG a one-stop-shop destination, which is the goal of the company and will greatly enhance their moat, for it will increase transaction size and top line revenues.

Revenue and EPS Outlook -

The company last issued guidance on December 11, 2012. This was the day where the company beat street expectations by 5% on EPS, but on the same day they beat, the company lowered its guidance for the remainder of the year. Historically speaking, DG usually beats Wall Street expectations. Over the last six quarters, DG has beaten expectations every time on average of 6.6%.

Another key metric to watch for is DG's sales per square foot. The retail arena, and even more so "dollar store" competition, is very intense. Stores are constantly competing for sales, but whom does it best. Sales per square foot analysis puts the competition into prospective. Of the three big "dollar store" chains, (DG, DLTR, and FDO) DG has the highest sales per square foot. DG comes in at $213 sales PSF (per square foot) while DLTR and FDO clock in at $182 and $152. But all is not favoring DG, for example FDO pays a dividend and over a ten-year period, FDO and DLTR have on average decreased the number of shares outstanding by 32%, while DG has increased their float by 1%. Not a large amount by any stretch, but the industry seems to be more shareholder friendly than DG.

DG credit rating has also improved. In April 2012, Standard & Poor's upgraded DG's corporate rating to BBB- from BB+ with a stable outlook, and Moody's upgraded the corporate rating to Ba1 from Ba2 with a positive outlook. This increase could further bring in investment dollars and push out growth. While many folks ignore the credit rating agencies after the financial crisis, they still serve an important purpose.

Price Target Analysis

The following price target was configured through a 5-year projected discounted cash flow analysis. The model projects operating income, taxes, depreciation, capital expenditures, and changes in working capital. Using that information, we can project what the company is worth. We can then use that projection and compare it to current prices. Here is how to calculate price targets using discounted cash flow analysis:

Step 1.

Project operating income, taxes, depreciation, capex, and working capital for five years. Calculate cash flow available by taking operating income - taxes + depreciation - capital expenditures - working capital.

2012 Projections

2013 Projections

2014 Projections

2015 Projections

2016 Projections

Operating Income

1542

1626

1671

1725

1790

Taxes

571

602

618

638

662

Depreciation

293

285

290

295

313

Capital Expendit.

-605

-545

-560

-575

-675

Working Capital

2

2

2

2

2

Available Cash Flow

657

762

781

805

764

Step 2.

Calculate present value of available cash flow (PV factor of WACC * available cash flow). You can calculate WACC, but we have given this number to you. The PV factor of WACC is calculated by taking 1 / [(1 + WACC)^# of FY years away from current]. For example, 2016 would be 1 / [(1 + WACC)^4 (2016-2012). WACC for DG: 3.36%

2012

2013

2014

2015

2016

PV Factor of WACC

0.9434

0.89

0.8396

0.7921

*

PV of Available Cash Flow

620

679

656

637

*

Step 3.

For the fifth year, we calculate a residual calculation. This number is calculated by taking the fifth year available cash flow and dividing by the cap rate, which is calculated by taking WACC and subtracting out residual growth rate. Residual growth rate is typically between 2-6%. 4% is average growth for industry. Companies with high levels of growth have higher residual growth, while companies with lower growth levels have lower residual growth. This is why higher growth companies tend to have higher PE ratios. We will give you cap rate. Cap Rate for DG: 3.00%.

2016

Available Cash Flow

$763

Divided by Cap Rate

3%

Residual Value

25,456

Multiply by 2016 PV Factor

0.7921

PV of Residual Value

$20,164

Step 4.

Calculate Equity Value - add PV of residual value, available cash flow PVs, current cash, and subtract debt:

Sum of Available Cash Flows

$2,591

PV of Residual Value

20,164

Cash/Cash Equivalents

143

Interest Bearing Debt

3,023

Equity Value

$19,875

Step 5.

Divide equity value by shares outstanding:

Equity Value

19, 875

Shares Outstanding

328

Price target

$60.59

Profit/Value Industry Comparisons:

Dollar Store Gross Margins (DG, FDO, DLTR) (click to enlarge)

The chart above displays gross margins over time in the dollar store sector. DG and its main competition are graphed together. DG has underperformed its peers over time with respect to gross margins and lost pricing power during the great recession while its completion stood strong. The future however may bring higher revenues at the expense of margins given their recently announced efforts as they adopt a new model.

Variant

DG does not have a significant online presence. This is a huge potential risk for the company, especially given the massive numbers other businesses are putting up. WMT is the third biggest online retailer - perhaps it is too late to take a significant share away from the big players. Efforts may be rewarded however, given the added growth potential (look at AMZN's valuation).

In recent news, with respect to the discount retail group, Costco paid a massive special divided. The firm returned $7.00, or roughly 7% to share holders. A mere one-month after the announcement, the dollar stores (FDO, DG, and DLTR), were down over 13%. Capital fled the dollar stores for chase COST. A risk to the BUY thesis on DG is that other competition, like WMT for example, pays a similar dividend and rotation continues. Neither DG nor DLTR pays a dividend.

The Bottom Line

DG shares are a solid BUY given new efforts from management. While the company is facing lower margins with these efforts, there are overwhelming more positives like valuation and historical operating income growth. The company has also historically beaten EPS and management is also rather efficient with shareholder capital. DG shares are a Buy.

Source: Dollar General Top Buy In Discount Arena, More Attractive Than Family Dollar And Dollar Tree