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Shares of Dollar General (DG) continue to march higher setting fresh all-time highs in the wake of its second-quarter results.

As the valuation continues to increase, while I see few reasons for an acceleration in earnings growth, I remain very cautious and stay on the sidelines.

Second-Quarter Results

Dollar General generated second-quarter revenues of $4.39 billion, up 11.3% on the year before. Sales were supported by a solid 5.1% increase in same-store sales. Analysts were looking for revenues of $4.36 billion and comparable-store sales growth of 4.2%.

Net income rose by 15% to $245 million, while GAAP earnings per share increased by 17% to $0.75 per share. Adjusted earnings totaled $0.77 per share and beat consensus estimates of $0.74 per share.

CEO and Chairman Rick Dreiling commented on the past quarter's performance, "We remain focused on driving our sales and profitability, capturing high-return growth opportunities, returning cash to our shareholders through share repurchases and creating long-term value."

Looking Into The Results

As mentioned before almost half the growth was explained by same-store sales which rose 5.1% on both an increase in traffic and average transaction values. Growth was driven by introduced tobacco products and solid sales of snacks and candy.

Yet Dollar General has seen some pressure on gross margins, which fell by 65 basis points to 31.3% of total sales. Pressure was explained by greater sales of lower margins items, such as the tobacco products. "Inventory shrinkage" or simply theft kept increasing as well.

The company saw some leverage in selling, general and administrative expenses, which fell 23 basis points to 21.9% of total sales. The improvement is solid, keeping in mind that Dollar General also took an $8.5 million legal settlement during the quarter.

..And Looking Ahead

For the current fiscal year of 2013, Dollar General sees total sales growth of 10-11%, driven by a 4-5% increase in comparable sales. Gross margins are seen down roughly 90 basis points on the year before.

Adjusted earnings per share are seen between $3.15 and $3.22 per share.

Full-year store openings are seen around 650, up from a previously guided 635 openings. Another 550 stores will either be remodeled or relocated.

Valuation

Dollar General ended the second quarter with $169.2 million in cash and equivalents. The company operates with $2.87 billion in total debt and capital lease obligations, for a large net debt position of $2.7 billion.

Sales for the first six months of the year came in at $8.63 billion, up 8.5% on the year before. Net income rose by 8.9% to $465.6 million. Given the full-year outlook, Dollar General sees annual revenues to come in around $18 billion on which the firm will report earnings of around $1.0 billion.

Trading around $56 per share, the market values Dollar General at $18.5 billion. This values the business at 1.0 times annual revenues and 18 times earnings.

The company does not pay a dividend at the moment.

Some Historical Perspective

Shares of Dollar General were sold to the general public at $21 per share back in November of 2009. From that moment in time, shares have seen steady returns, setting fresh all-time highs of $57 in recent weeks.

Between the fiscal year of 2009 and 2012, Dollar General has increased its annual revenues by a cumulative 36% to $16.0 billion. Net income almost tripled to $952.7 million in the meantime.

Investment Thesis

Despite the economic recovery, the outlook for discount stores like Dollar General remains upbeat as large portions of society continue to struggle under the economic conditions. While middle-class and upscale consumers appear to be cutting back a bit, spending at Dollar General's stores remains solid.

Competitors that focus on more middle-class customers like Target (TGT) and Wal-Mart (WMT) have been struggling in terms of revenue performance lately, so have a range of apparel retailers.

The introduction of tobacco products in its stores has been a great move and is a driver behind the strong results. While the recession has ended, consumers continue to go shopping at dollar stores as they focus on their budgets given low wage growth and increased social security taxes.

Back in June of this year I last took a look at Dollar General's prospects. At the time I concluded that payroll taxes were strapping budgets, as people increasingly opted to steal products at the stores instead of paying for them.

While "inventory shrinkage" continues to be an issue, the strong tobacco sales have brought a needed boost to the results, as well as the introduction of national brands. Another promising side effect, two-thirds of customers buy other products when they buy tobacco products.

The company furthermore acknowledges at its earnings call that it relies for 5-6% of total revenues on Food Stamp Programs, but that this percentage has remained stable despite more elaborate programs in recent years.

The company now reiterates the guidance after cutting it slightly last quarter. Still the current valuation is too high far to my taste. Store openings growth of around 5% and a similar percentage in same-store sales growth won't last forever. In combination with an 18 times earnings ratio, this makes me quite hesitant to invest.

I remain very cautious on Dollar General's prospects given the fairly rich valuation despite the solid operating performance.

Source: Dollar General - Discounted Merchandise, Premium Valuation