The Company Pro Investors Are Buying

Aug.22.12 | About: Dollar General (DG)

In this article I will analyze both the business and financials of Dollar General (NYSE:DG), a stock I hold in my portfolio after following a great recommendation from the newsletter in the first week of March. I bought the stock at $43, then sold half the position at $55 and now I am waiting for a snap-back in the share price.

DG is a stock that prominent investors hold in their portfolios. For example, Warren Buffett, Eton Park, and Maverick Capital have allocated capital to DG shares. These investors, among others, have a bullish view on the company's future.

DG is the largest discount retailer in the U.S. by number of stores, with 9,961 stores located in 39 states as of March 2, 2012, primarily in the Southern, Southwestern, Midwestern and Eastern United States. The company offers a broad selection of merchandise, including consumable items such as food, paper and cleaning products, health and beauty products, and pet supplies, as well as non-consumable products such as seasonal merchandise, home decor and domestics, and apparel.

In the beginning of 2008, management defined four operating priorities, which the company remains keenly focused on executing. These priorities are to:

  1. drive productive sales growth,
  2. increase gross margins,
  3. leverage process improvements and information technology to reduce costs, and
  4. strengthen and expand DG's culture of serving others.

I believe management is executing very well, but the overall driver of the business comes from its commitment to drive sales growth. Management is driving productive sales growth by increasing shopper frequency and transaction amount, and maximizing sales per square foot. In 2011, same-stores sales increased by 6.0%, due to increases in traffic and average transaction and, to a lesser extent, the impact of inflation. Same-store sales were aided by continued enhancements to management processes, which help determine the most productive merchandise offerings for DG's customers. Specific sales growth initiatives in 2011 included improvement in merchandise in-stock levels; the completion of the final phase of raising the shelf height in the stores to 78 inches, which impacted health and beauty aids; further emphasis on the $1.00 price point; the expansion of the number of coolers in approximately 500 existing stores; and the impact of 575 remodeled and relocated stores during the year.

In addition to same-store sales growth, the company opened a record 625 new stores in 2011. DG convenient small-box stores offer consumable items, including packaged and refrigerated foods, to communities that might not otherwise have convenient access at value prices.

There are two things I would like to highlight from DG's reported financials:

1. The company is reporting record sales growth. DG reported a same-store sales record increase of 6.0% in 2011 compared to 2010. The increase in sales reflects increased customer traffic and average transaction amounts, which is the result of the continued refinement of the company's merchandise offerings, the optimization of category management processes, further improvement in store standards, and an increase in sales prices resulting primarily from passing on certain cost increases and increased utilization of square footage in the stores. Increases in sales of consumables outpaced non-consumables, with sales of packaged foods, snacks, beverages and perishables, contributing to the majority of the increase throughout the year.

2. Cash Flow from operations is growing significantly. A significant component of the company's increase in cash flows from operating activities in 2011 compared to 2010 was the increase in net income due to increases in sales and gross profit, and lower SG&A expenses as a percentage of sales. The company reported a record 27% growth in cash flow in operations in 2011 over 2010.

The company operates in the basic discount consumer goods market, which is highly competitive with respect to price, store location, merchandise quality, assortment and presentation, in-stock consistency, and customer service. DG direct competitors include Family Dollar (NYSE:FDO), Dollar Tree (NASDAQ:DLTR), Fred's, 99 Cents Only, and various local, independent operators, as well as Wal-Mart (NYSE:WMT), Target (NYSE:TGT), Walgreen (WAG), CVS (NYSE:CVS), and Rite Aid (NYSE:RAD), among others.

I think DG differentiates itself from other forms of retailing by offering consistently low prices in a convenient, small-store format. I believe that company's prices are competitive due in part to the company unmatched low-cost operating structure and the relatively limited assortment of products offered. The combination of a necessity-driven product mix and the company' s attractive value proposition, including a well-balanced merchandising approach, provides a strong basis for increased sales. It is remarkable that DG's average sales per square foot increased to $213 in 2011, from $201 in 2010 and $195 in 2009. I am sure the company will continue to have additional opportunities to increase store productivity through improved in-stock positions, price optimization, and space utilization, as well as additional operating and merchandising initiatives, including further expansion of its frozen and refrigerated food offerings.

Disclosure: I am long DG. 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.