As part of Valuentum investing, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In the case of Dollar General (DG), we think the firm is fairly valued at $34 per share.
For some background, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Dollar General scores a 6 on our scale (reflecting its "fairly valued" assessment and bullish technicals).
But before we dive into the ins and outs of Dollar General's valuation, let's take a look at its most recent quarter:
On Monday, Dollar General reported solid fiscal third-quarter results and raised its fiscal 2011 earnings guidance range.
The firm’s total revenue increased 11.5% on the heels of same-store sales expansion of 6.3%, which represented its third consecutive quarter of accelerated growth (and up 2.1 percentage points from the year-ago period). The company noted strength in lower-margin consumable sales, with particular expansion in candy and snacks, perishables, packaged foods, health and pet supplies. Total merchandise inventories, at cost, only increased 5% on a per-store basis, reflecting decent inventory management.
Dollar General’s operating profit jumped 13% as its operating margin nudged up modestly in the period (8.6%), with weakness in the firm’s gross margin offset by reduced SG&A expenses as a percentage of sales. Adjusted net income advanced 29% to $0.50 per diluted share in the quarter--which came in higher than consensus expectations ($0.47)—thanks to profit strength (internal sales expansion and cost controls) and lower debt costs.
Though the firm indicated that discretionary apparel remained weak, Dollar General had some positive commentary about November sales, indicating that its Thanksgiving week and Black Friday sales were strong. As a result, Dollar General raised its full-year 2011 earnings guidance to the range of $2.29 to $2.32, up from the range of $2.22 to $2.30. Embedded in this yearly guidance are expectations for comparable same-store sales growth of 5.6% to 5.8% and the opening of approximately 625 new stores for the year.
For fiscal year 2012, the company plans to continue its rapid pace of new-store expansion and plans to open up 625 new stores during the year (implying a net square footage increase of about 7%). The firm also announced a $500 million stock-buyback program (including the repurchasing of $185 million worth of shares from Buck Holdings, L.P.), a move we are neutral on, given our valuation of the company.
Our Report on Dollar General
Click to enlarge images.
Investment Considerations (terms defined below)
DCF Valuation: FAIRLY VALUED
Relative Valuation: NEUTRAL
Cash Flow Generation: MEDIUM
Financial Leverage: MEDIUM
Technical Evaluation: BULLISH
Relative Strength: STRONG
Money Flow Index (MFI): NEUTRAL
Upside/Downside Volume: BULLISH
Near-term Technical Support: $38.00
Dollar General earns a ValueCreation rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. We expect the firm's return on invested capital (excluding goodwill) to expand to 33.1%, from 25%, during the next two years.
The company looks fairly valued at this time. We expect the firm to trade within our fair value estimate range for the time being. If the firm's share price fell below $25, we'd take a closer look.
Dollar General's cash flow generation and financial leverage are at decent levels, in our opinion. The firm's free cash flow margin and debt-to-EBITDA metrics are about what we'd expect from an average firm in our coverage universe.
Although we think there may be a better time to dabble in the firm's shares based on our DCF process, the firm's stock has outperformed the market benchmark during the past quarter, indicating increased investor interest in the company.
The firm experienced a revenue CAGR of about 11.1% during the past 3 years. We expect its revenue growth to be better than its peer median during the
next five years.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Dollar General's 3-year historical return on invested capital (without goodwill) is 19.9%, which is above the estimate of its cost of capital of 9.6%. As such, we assign the firm a ValueCreation rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Dollar General's free cash flow margin has averaged about 3.4% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Dollar General, cash flow from operations increased about 43% from levels registered two years ago, while capital expenditures expanded about 105% over the same time period.
Our discounted cash flow model indicates that Dollar General's shares are worth between $25 and $43 each. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $34 per share represents a price-to-earnings (P/E) ratio of about 18.7 times last year's earnings and an implied EV/EBITDA multiple of about 9.6 times last year's EBITDA.
Our model reflects a compound annual revenue growth rate of 6.7% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 11.1%. Our model reflects a 5-year projected average operating margin of 11.3%, which is above Dollar General's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.2% for the next 15 years and 3% in perpetuity. For Dollar General, we use a 9.6% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $34 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Dollar General. We think the firm is attractive below $25 per share (the green line), but quite expensive above $43 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Dollar General's fair value at this point in time to be about $34 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Dollar General's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $46 per share in Year 3 represents our existing fair value per share of $34 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.