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Where the wave of turmoil engulfed many industries during the recessionary phase in the US, discount retailers were able to make the escape and continued to register positive growth. Keeping in view the changing consumer preferences, the low price strategy adopted by discount retailers helped their businesses flourish in such difficult times. Even within this category of retailers, the dollar retailers were able capture a large proportion of the growth in demand. These small box retailers have posted revenue growth at an average rate of 9.75 percent per annum over the last 5 years, generally outpacing the rest of the market players.

The decline in the median household income has led to a change in the spending habits of US consumers. Due to the increasingly uncertain economic conditions, more and more shoppers in the US are now actively searching for bargains and discount deals before making their purchases. They are no longer willing to pay an extra dollar unless it balances their equation of "value for money". As per the Kantar Retail report, this change in consumer shopping habits is expected to persist in the long term and this is expected to greatly benefit discount retailers, particularly dollar retail stores.

Due to this potential for high growth, I have chosen Dollar General (NYSE:DG), the largest dollar retailer in the US, to analyze its historic performance and the future prospects of the company. Dollar General, as per the latest report, operates 10,866 stores across 40 US states with sales topping $16 billion. The company was able to beat the consensus estimates for its second quarter's financial results, 2013. Adjusted EPS was $0.77 as compared to the analyst estimates of $0.74 per share while revenues rose to $4.39 billion as compared to the consensus estimates of $4.35 billion.

Recent Results

Revenues grew by 11.3 percent and earnings were up 17.2 percent, as compared to last year. The fastest growing category for the company was its consumables which grew by approximately 13 percent and accounted for 75.1 percent of total net sales as compared to 74 percent last year. The growth in revenues was achieved primarily due to an increase in the comparable store sales by 5.1 percent and an increase in the store count by 6.5 percent. The company's selling square footage increased by 7.5 percent and its net sales per square foot increased by 3.6 percent over the same period last year.

Despite the high growth achieved by the company in the last quarter, the company's gross margins have fallen to 31.3 percent as compared to 32 percent last year. This reason being that there has been a change in the sales mix, a larger proportion of sales are now being derived from the sale of consumables which are low margin products, and also due to the higher shrink rate. This decline in gross margin was more than offset by a decrease in the operating expenses as a percentage of net sales.

Growth Trends

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Source: DG Annual Financial Statements

The company has continuously improved its same store sales over the last 5 years. In fact, fiscal year 2012 was the 23rd consecutive year that the company has been registering an improvement in same store sales. What seems surprising is that the largest same store sales growth experienced by the company had been during the financial crisis of 2008 and 2009. Dollar General's net sales have increased at a CAGR of 11.3 percent over the last 5 years. Initially, growth was achieved through rapid improvement in the same store sales and in the latter years, the company grew its store network.

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Source: DG Annual Financial Statements

The company has gradually expanded its network of stores in the US and currently operates more than 10,000 stores in 40 states. The store count has increased by approximately 6 percent or 462 stores each year over the last 5 years. The selling square foot has increased by approximately 7 percent per annum with a 1 percent increase in the average store size. The slowest expansion was done in 2008 and 2009, with the company adding only 168 and 466 stores, respectively. In each of the next three years the company has added around 550 stores to its network.

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Source: DG Annual Financial Statements; US Energy Information Administration

The gross margin of the company has generally improved over the 5 year period from 29.3 percent in 2008 to 31.7 percent in 2012. Although several factors affect the company's gross margin which include markdowns, shrink rate and sales mix, yet here transportation cost seems to be the one main factor that has been affecting the gross margins significantly. Transportation cost is directly related to the average fuel prices during the year. As exhibited in the graph above, the gross margin and fuel costs share a negative relationship, where a large change in fuel price causes a considerable change in the company's gross margin. The only odd year was 2010, in which the company recorded better markups resulted primarily from higher purchase markups and increased sales volumes which have contributed to the company's ability to reduce purchase costs from
its suppliers.

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Source: DG Annual Financial Statements

The company has almost doubled its operating margin, from 5.6 percent in 2008 to 10.3 percent in 2012, as the improvements in gross margin trickled down. The company has also reduced its operating cost as a percentage of sales. The selling, general and administrative cost came down to 21.4 percent of net sales in 2012 as compared to 23.4 percent in 2008. Dollar General was able increase its operational efficiency through better sales generation and store utilization over the years. The company's sales per square foot have increased at a CAGR of 4.7 percent over the last 5 years and this has enabled the company to substantially increase its margin and return on equity.

Amongst the merchandising categories, consumables have always been the biggest contributor to the company's top line, making up to approximately 74 percent of the total net sales in 2012. As mentioned above, this ratio has increased further in the most recent quarterly results reported by the company. The company plans to increase its merchandise offerings within the consumables category which is likely to increase the contribution of merchandise in the coming years. As consumables generally sell at a lower margin, I expect the company's gross margin to reduce in the next few periods.

Growth Opportunities

Slow economic growth in the US, persistent high unemployment level and economic uncertainty were the major factors that spurred the growth of discount retailers. These circumstances have led US consumers to turn into bargain-hunters. This new consumer behavior is expected to persist in the long term and will aid in the continued growth of discount retailers in the coming years.

According to Kantar Retail and PWC, the discount retailers are expected to be the fastest growing store based retail category, growing at an annual rate of more than 7 percent through 2020. This high level of growth will allow the company to further increase its sales revenue. As the company's store network covers only 40 states of the US, it can expand its network not only within these states but also by opening stores in other states. Thus, I think the company will outperform its peers in the coming years.

Another long term growth opportunity can be to pursue international expansion, particularly in the Canadian market. The future outlook for discount retailers in the Canadian market is also very promising. They are expected to perform better than other retail formats. The entry of a few American chains in the Canadian retail market provides a reconfirmation of the great retail opportunity that the country can provide for Dollar General. All in all, there are several growth opportunities for the company through which it can further enhance its performance and generate superior returns for its shareholders. Hence, I will give a buy recommendation for Dollar General.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Is Dollar General A Strong Buy?