Let's Talk About Dollar General

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About: Dollar General Corporation (DG)
by: Leo Nelissen
Summary

Dollar General reported strong earnings and sales growth in its third quarter.

The company benefited from a strong price/mix and continues its domestic store expansion.

Retail traders will likely face headwinds due to falling consumer sentiment which makes a spread trade with Dollar General very interesting.

Long only traders should ignore the stock for the time being.

Dollar General (DG) is one of the best retail stocks of the past few years. The stock price has rewarded investors with a 380% gain since the IPO in Q4 of 2019. However, the most recent earnings release caused the stock to crash more than 6%. My take on consumer stocks has been to stay on the sidelines given the pressure from peaking consumer sentiment and slower general economic sentiment. In this article I am going to things a bit differently. I am going to discuss the quarterly results as I usually do but I will end the article by showing you a way to benefit from Dollar General despite my negative view on the consumer. So bear with me.

Source: Wikipedia Commons

Good Isn't Good Enough Anymore

The Tennessee based retailer had a strong third quarter despite two hurricanes that challenged sales. Total net sales improved 8.7% to $6.4 billion compared to $5.9 billion in the prior-year quarter. These results were also slightly above expectations of $6.4 billion. The sales trend as displayed below continues without any major bumps in the road.

Source: Estimize

This massive sales trend is obviously not only the result of strong in-store customer traffic but the company's store expansion. The company started the third quarter with 14,534 stores and ended the quarter with a net gain of 693 stores which puts the count at 15,227. The total square footage is up 6.0% year-on-year.

The company's sales expansion is not only the result of additional stores. The existing stores reported same store sales growth of 2.8%. This surge was caused by strong consumables and non-consumables partially offset by slower apparel sales. Apparel saw by far the slower growth rate while consumables added 9.4%. Consumables are also by far the biggest part of the company's total sales. Note that customer traffic was unchanged which means that pricing and product mix were the sole providers of higher comps growth.

And speaking of consumables. Outperforming consumables in addition to an increase in LIFO provisions caused gross margins to drop to 29.5% from 29.9% in Q3 of 2017. And speaking of profitability, SG&A expenses as a part of total sales declined by 21 basis points to 22.6% which is due to lower incentives spending. Nonetheless, operating margins declined from 7.07% to 6.89%. Net income margins improved almost 100 basis points to 5.21% due to the lower tax rate of 20% compared to 35.8% one year ago. The graph below shows the bigger trend quite well. EBITDA margins continue to decline while net income margins got a much needed boost from lower taxes.

What's Next?

The company's forecast was not well-received by investors as key indicators got down revisions. The third quarter saw a number of hurricanes that caused expenses to be higher than expected.

The full year sales growth rate is expected to be 9.0% versus the previous range of 9.0%-9.3%. Same store growth is expected to be in the previous range of mid-to-high two percent.

Operating margins will be modestly below 2017 operating margins. This is slightly down from the previous outlook that expected margins to be unchanged.

EPS has been revised to $5.85-$6.05 from the previous range of $5.59-$6.15.

Unfortunately, this is not where the bad news ends. The graph below has been in every single retail/consumer article (like this one) I have written over the past few weeks. Simply because it is so important with regards to the health of the US consumer and the potential risk reward of retail investments. What we see below is that consumer sentiment is slowly rolling over after expanding since 2008. This move would make sense given that general economic sentiment is also slowly starting to roll over.

With that being said, I am not going to end this article with the usual 'stay on the sidelines'. I am working on an interesting mid-term trade and have encountered a few interesting things that I want to share with you. First and foremost we mist acknowledge that Dollar General is not just an average retailer. The company is targeting the lower income consumer. This is a market that is quite strong and is getting stronger when consumer sentiment starts to decline. In addition to that, there is no denying that the company's expansion is working quite well. The company is going to open roughly 975 new stores in 2019 and is not expected to quit its store expansion anytime soon.

The graph below shows that Dollar General is both outperforming the average retail stock (XRT) and retailers that focus on wealthier customers like Macy's (M).

Source: TradingView

Dollar General has a great ability to outperform its 'peers' on the long term and especially during times of market turmoil due to economic fears. I expect this trend to continue but I am not yet ready to add a long Dollar General vs. different retail short to my portfolio. Both because I am not sure if Dollar General is the best low-income retailer and because I am not ready to increase my short exposure at this point.

The main message of this article is therefore that Dollar General is not a lot cause despite dropping more than 6% after earnings. The long-term expansion and focus on lower income customers make it a very interesting trade. The question remains: what's the best short for a spread trade?

Over the next days, I will look at additional low-income retailers to determine the best stock for a successful investment. With regards to Dollar General (without hedges) I will have to pass. Mid-term traders will likely face difficulties due to falling consumer sentiment which will make trading profits very unlikely without proper hedges.

I'll keep you updated!

Thank you for reading my article. Please let me know what you think of my thesis. Your input is highly appreciated!

Disclaimer: This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.

Disclosure: I/we 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.