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Introduction

In this article, I'll have a closer look at Dollar General (DG), which has just reported its Q3 numbers. As Dollar General is one of the discount stores with approximately 10,000 stores in the USA, I'm curious to see how its business model is affected by the current economic situation. I will provide my view on the financial results and the balance sheet, and this will result in my investment thesis at the end of this article.

My view on the financial results

In the third quarter of this year, the same-store revenue increased by 4.4% compared to the same period last year, which obviously is an excellent accomplishment. During the quarter, total revenues came in at $4.38B which resulted in a net profit of $237.4M or $0.74/share, which is roughly in line with the expectations and is in fact a light beat. The net margin (net profit/total revenue) was a very healthy 5.42% and is actually higher than the 5.24% in the same period last year, despite a lower operating profit yield. As Dollar General saved approximately $6M in interest expenses, its bottom line was hugely influenced by this and this caused the increased net margin.


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Let's now move over to the cash flow statements, as these usually give a much better indication about the quality of the underlying business. In these statements we see that Dollar General generated $760.6M in operating cash flow and it spent just $443M on its investing activities, leading to a free cash flow of $217M in the first nine months of the year, and this will very likely result in a free cash flow of in excess of $300M for the entire year.


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The management decided to use this free cash flow to repurchase $420M worth of stock, which was partly financed by the free cash flow and for a smaller part by issuing more debt.

Even though $300M sounds like a high number, the company's free cash flow yield will very likely come in at less than 2%, and I'm aiming for a FCF yield of 1.8%, which is quite low.

My view on the balance sheet

Let's now move over to the company's balance sheet. At the end of the third quarter, Dollar General had a working capital position of $1.15B which is very decent for a company of this size, and almost $200M higher than at the end of Q3 last year. This very likely caused the management's decision to increase the share buyback (see next paragraph). Dollar's current ratio was 1.66, which is relatively healthy (keep in mind a current ratio higher than one means a company has sufficient current assets to cover its current liabilities, but if this ratio is too high, it could mean that the company is using its working capital inefficient).


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At the end of the quarter, the book value per share was $16.43, which is a 15% increase compared to the BVPS of $14.26 at the same period last year. Unfortunately the goodwill and intangible assets on the balance sheet are worth more than the entire equity position, so one will always have to consider impairments on those balance sheet entries and cannot see the $16.43 as the 'minimum value' of the stock.

Outlook

Dollar General announced it would sell some of its stores and lease them back, which would allow the company to book a net cash inflow of approximately $200M which will be used to fund further share buybacks. Just yesterday, the board of directors approved a new buyback program which brings the total amount the company can spend to buy back shares to $1.2B, and at the current share price this could reduce the amount of outstanding shares by approximately 6%.

I would however be careful with those share buybacks, as I'm not a very big fan to issue debt to purchase shares at in excess of 50 times the free cash flow and 3.5 times the book value, and I'd prefer it if the company would just use its free cash flow to buy back its stock (at a rate of 1.5-2% per year).

The FY guidance has been narrowed down to $3.18-3.22 from $3.15-3.22, and I'm aiming for a profit per share of $3.20 during this year, and $3.55-3.65/share next year as the company continues to expand and as the net income will have to be divided over less outstanding shares.

Investment Thesis

Dollar General is doing fine and as it will open several hundreds of new stores, the company continues to be one of the big growers in the industry. The shares are a bit pricey at this point, but the additional store openings will increase the free cash flow and the net profits year after year, and because of the continuous share buybacks, the FCF/share and EPS will increase at a faster rate.

Dollar General is a long-term growth story, and investors should be willing to ride this one for a few years. And whilst I admit the current FCF yield is quite low, an investment in Dollar General might bear fruit in a longer term. As such, I'm looking at the possibility to write a put option, and I'm particularly looking at the P50 May 2014 for $1.85 and a P50 January 2015 for $4.00. If I don't get the shares assigned to me by expiration day, I just keep the option premium which results in an annualized yield of respectively 8.1% and 7.7%.

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. I currently have no position in DG, but might be tempted to write a P50 January 2015, as explained in this article.

Source: Dollar General Is On The Right Track And Will Buy Back More Shares