Dollar General: Wait To Buy

About: Dollar General Corporation (DG)
by: William Lum

Dollar General's aggressive expansion plans are credible as dollar store market is still far from saturated.

At the same time, DG's strong cash generative ability means that more cash can be returned to shareholders.

DG is currently fairly valued compared to its peers based on TTM and Forward P/E.

I find Dollar General (NYSE:DG) to be a unique stock that investors should consider having in their portfolios, as it has a surprisingly strong growth runway for a mature company with solid cash generation ability. My belief is driven by two main observations. Firstly, Dollar General's aggressive future growth will be driven increasingly by sales from new stores as compared to same-store sales growth. Fortunately, my saturation analysis finds that the dollar store market is still far from saturated. Secondly, Dollar General generates a ton of cash for its shareholders and has more than enough to increase its return of cash to shareholders even after capital expenditures.

Dollar General's 2016 top-line growth of 7.9% was achieved in spite of a paltry 0.9% same-store sales growth, implying that sales from the 900 new stores opened in the same year drove the top line. Going forward, I expect this trend of sales driven by new store openings to be the new normal for Dollar General. In fact, it is currently in the process of converting 322 stores it acquired from a small-box, multi-price point retailer in April and has plans to open another 1,290 new stores for 2017. But how credible are these ambitious store expansion plans? We see other retailers, especially departmental stores, consolidating and shutting down stores. Moreover, Dollar General's competitors such as German discounters Aldi and Lidl have also announced aggressive expansion plans. Aldi, which has about 1,600 stores in the US currently, wants to increase the number of its US stores to 2,500 in the next five years while Lidl, a new entrant to the US grocery market, plans to open 100 stores along the east coast by mid-2018. In light of all this, it is important to take a closer look at how many more dollar stores can be opened feasibly going forward. In other words, how many more stores can be opened till the dollar retail market becomes saturated?

To estimate the market opportunity for dollar stores going forward, I looked at the total number of dollar stores in each state - Dollar General, Dollar Tree (NASDAQ:DLTR) and other independent comparable stores (assumed to be one-third of the total number of Dollar General and Dollar Tree stores) and the US Census Bureau data on the total number of households with annual income of less than $45K per state. I use the latter as an input for the saturation measure - the number of households per dollar store - as they are the core consumers for dollar stores. A state would be deemed to be more saturated with dollar stores if the aforementioned measure was lower. The most saturated state currently, Mississippi, was used as the benchmark, and to be conservative, the number of potential stores was capped at the current highest number of dollar stores in a state, which was 3,812 in Texas.

State Total Dollar Stores Total number of HH with HH income <45K HH/$ Store Potential Stores Increase
Alabama 1,419 946,551 667 1,669 251
Arizona 496 1,092,518 2,203 1,927 1,431
Arkansas 860 610,450 710 1,077 217
California 1,152 4,781,707 4,151 3,812 2,660
Colorado 328 756,565 2,307 1,334 1,006
Connecticut 195 446,633 2,294 788 593
Delaware 133 127,703 958 225 92
Florida 2,455 3,473,928 1,415 3,812 1,357
Georgia 1,975 1,646,645 834 2,904 930
Idaho 103 279,604 2,723 493 390
Illinois 1,264 1,911,156 1,512 3,371 2,107
Indiana 1,059 1,150,705 1,087 2,030 971
Iowa 381 526,115 1,380 928 547
Kansas 417 480,253 1,151 847 430
Kentucky 1,064 872,976 820 1,540 476
Louisiana 1,327 863,239 651 1,523 196
Maine 171 255,247 1,496 450 280
Maryland 444 644,140 1,451 1,136 692
Massachusetts 307 881,246 2,874 1,554 1,248
Michigan 1,347 1,764,398 1,310 3,112 1,765
Minnesota 375 776,320 2,072 1,369 995
Mississippi 1,072 607,804 567 1,072 0
Missouri 945 1,112,661 1,177 1,962 1,017
Montana 36 196,653 5,463 347 311
Nebraska 225 311,504 1,382 549 324
Nevada 161 440,213 2,729 776 615
New Hampshire 119 173,905 1,465 307 188
New Jersey 468 1,034,257 2,210 1,824 1,356
New Mexico 348 382,051 1,098 674 326
New York 1,285 2,891,944 2,250 3,812 2,527
North Carolina 1,911 1,820,088 953 3,210 1,299
North Dakota 47 119,825 2,568 211 165
Ohio 1,889 2,115,995 1,120 3,732 1,843
Oklahoma 819 701,656 857 1,238 419
Oregon 147 681,773 4,648 1,202 1,056
Pennsylvania 1,591 2,108,949 1,326 3,720 2,129
Rhode Island 77 167,593 2,167 296 218
South Carolina 1,159 899,426 776 1,586 428
South Dakota 95 146,121 1,544 258 163
Tennessee 1,572 1,247,248 793 2,200 628
Texas 3,812 3,918,306 1,028 3,812 0
Utah 163 324,716 1,996 573 410
Vermont 72 105,136 1,460 185 113
Virginia 1,036 1,073,321 1,036 1,893 857
Washington 156 985,720 6,319 1,739 1,583
West Virginia 500 394,401 789 696 196
Wisconsin 521 969,806 1,860 1,710 1,189
Wyoming 59 86,846 1,480 153 95
Potential Industry Opportunity if Penetration equals Mississippi 75,638 38,085

From the analysis, I derive an estimated total market opportunity for dollar stores in the US to be about 75,000 stores. As there are currently about 37,000 stores, it means that the dollar store market is only 49% saturated now. With still that much room for growth in the dollar store market, it appears that Dollar General's ambitious store expansion plans are pretty credible after all.

Dollar General is also a large, stable and defensive company that generates a lot of cash. According to its 10-K, the company produced $1.054 billion in free cash flow in fiscal 2016, representing a 10.4% increase since 2015. In the chart below, we see the seasonal trend in free cash flow by quarter. For Q1 2017, Dollar General had about $367 million of free cash flow compared to $304.98 million a year before.

Clearly, Dollar General has strong cash generation ability. It is thus able to grow the business through store expansions while rewarding shareholders at the same time. Management has chosen to achieve this through a combination of share repurchases and dividend payouts. In the first quarter of 2017, Dollar General repurchased $89 million or 1.3 million shares at an average price of $70.86 per share. As management has forecasted total share repurchases for fiscal 2017 to be approximately $450 million, this implies that about $360 million worth of shares will be repurchased for the remainder of 2017. On top of that, Dollar General paid a dividend for the first time in 2015, and since then, its dividend per quarter has been inching up, as seen below:

In Q1 2017, DG paid a quarterly dividend of $0.26 per common share outstanding. Altogether, this amounted to $71 million in dividends paid out that quarter. Dollar General's dividend payout of 25.4% and a dividend yield (TTM) of 1.5% is generally lower than its more mature and larger competitors such as Wal-Mart (NYSE:WMT), which has a payout ratio of 45.52% and a dividend yield of 2.67%. If Dollar General's free cash flow continues to grow steadily, there might be more room to return value to shareholders through a judicious expansion in buyback and dividends even after accounting for spending on store expansion. Moreover, the share repurchases also have the added dimension of being a more tax-efficient way to reward long-term shareholders due to the ability to defer tax until the shares are sold, and it is noteworthy there has been a slight bias by Dollar General for share repurchases vis a vis dividends, as a means of returning cash to shareholders, when we consider the dollar amounts returned through each method.

Dollar General trades at 16 times TTM earnings and 14 times forward earnings. Its closest competitor, Dollar Tree, trades at 19 times TTM earnings, but is slightly cheaper on a forward earnings basis at about 13 times forward earnings. Still, both dollar stores actually compare favorably with the market at large given that the PE for the S&P 500 stands at about 25 currently.

Costco (NASDAQ:COST) is the most expensive of the group as it is a perennial retail favorite, counting even Warren Buffett's Berkshire Hathaway (BRK.A, BRK.B) as its shareholder. One reason for that is because its membership structure has led to sticky customers and robust same-store sales growth even as other retailers struggle to maintain same-store sales growth.

Excluding Costco, with the market at 12-16 times forward earnings, Dollar General seems fairly valued at the moment. When compared to its own recent past, DG seems to be on the cheap side at $70, but I think it is still not a compelling enough price for investors to go in now. I will be waiting for a bit more of a dip before buying in.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in DG over 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.