Dollar General: Testing The 'Unshakeable' Thesis

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About: Dollar General Corporation (DG)
by: D.M. Martins Research
Summary

Dollar General's 4Q18 sales numbers impressed, but pricing softness and an expectation for higher SG&A in 2019 knocked the stock down.

The key area of concern over Dollar General's financial performance in 2019 seems to have been given a name: margin contraction.

Despite the short-term headwinds, I believe Dollar General continues to be a well-performing retailer led by a competent management team.

About a year ago, I called Dollar General (DG) an "all-weather" stock. A quick glance at its performance this decade helps to understand how resilient the retailer's shares have been, even through corrections like the one experienced late last year: -1% in the fourth quarter vs. the S&P 500's (SPY) -14%. More impressively, the company managed to grow revenues, gross profits, and store footprint at a solid pace even during the Great Recession of 2008.

But then came the 4Q18 results, delivered on March 14, and DG took a 7.5% hit on a single day - the most pronounced daily loss of the past 10 months.

Is DG no longer the unshakable stock that I once thought it was? Or will the recent share price dip prove to be nothing but a small window of opportunity for potential investors to buy near November 2018 levels?

Credit: WWAY

To try and answer these questions, I turn to the results of the quarter first. Dollar General delivered a satisfying $43 million revenue beat. Strength was observed across the different lines of business, with the crucial consumables segment (76% of total revenues) advancing 9% and keeping up with the recent growth trend.

Eye-catching were comps of 4.0% that accelerated the growth pace of same-store sales in 2018. This was an impressive feat, considering the company's strong year-ago results that made comparisons tougher in 4Q18. According to the management team, in fact, this was the "highest two-year same-store sales stack in 21 quarters" - see same-store and total sales trends below.

Both foot traffic and average transaction amount were reported to have increased in the quarter. But glass-half-empty investors may discount the achievement as it was boosted by the early distribution of government-sponsored nutrition assistance benefits, quantified by Dollar General as having added 70 bps of upside to comps. This could result in revenue headwinds of similar magnitude in 1Q19.

Source: DM Martins Research, using data from company reports

The robust top-line performance, however, came accompanied by a five-cent EPS miss not witnessed since 2014 at least. Therefore, it seems obvious that the company's struggles in the quarter happened not in loss of sales momentum, but further down the income statement instead.

As the summarized P&L below depicts, gross margin dipped 91 bps YOY, a sizable deterioration not seen in recent quarters. The culprit appears to have been an increase in discounted activity that, while serving as a tool to boost sales growth and capture market share, is rarely seen by retail investors as a good sign. I estimate that the gross margin decrease caused 18 cents of drag to per-share earnings in the YOY comparison (holding all other variables constant), a mere one-third of which would have been enough to push Dollar General's reported EPS above consensus expectations.

No other item seems to have been of major concern in 4Q18. Opex as a percentage of revenues dipped by 34 bps YOY and could have been better (about four cents in EPS terms, by my estimates) if not for disaster-related expenses incurred in the quarter. Dollar General benefited from a lower effective tax rate once again, the last time that the 2017 tax reform should have a direct impact on the company's earnings growth.

Source: DM Martins Research, using data from company reports

Looking forward and my take on the stock

The key area of concern over Dollar General's financial performance in 2019 seems to have been given a name: margin contraction. In virtually all other aspects of the business, the Tennessee-based retailer appears to be executing very well, with strategic initiatives like DG Fresh and Fast Track (to be rolled out later this year) likely to provide further support to sales and earnings growth in the long run.

That said, DG's recent price drop may have been properly justified by the uncertainties regarding the new year. In my view, not only pricing softness will pressure margins in 2019, but so might unfavorable developments on the trade and tariff fronts and the opex investments required to kick off DG Fresh and Fast Track.

Chart Data by YCharts

With valuations having been trimmed a bit (see graph above) to account for the short-term margin headwinds, DG is now priced a bit more attractively for those who have been sitting on the sidelines. I believe that Dollar General continues to be a well-performing company led by a competent management team. And, I continue to hold my views that the retailer will continue to produce consistent financial results even through tougher economic conditions, which I think is a valuable and desirable feature for investors to consider.

Disclosure: I am/we are 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.