By The Valuentum Team
There's something about the business model of a well-run dollar store that just hits at the heart of the American consumer. For starters, dollar stores sell a variety of inexpensive bargain goods, items that generally won't make sense economically to be distributed via e-commerce given the shipping costs. The ease at which consumers can visit their local dollar store (and the collection of low-priced goods in one place) is also a big advantage, and many of the dollar-store shopping demographic may not easily afford an Internet connection, or a subscription to Amazon (AMZN) Prime to reap the rewards of free shipping. We think these dynamics make the dollar-store space quite resilient in the face of e-commerce proliferation as well as the broader economic cycle. Big box retailers Walmart (WMT) and Costco (COST) have been around for decades, too, and they still can't stop the dollar-store trend.
But Why Dollar General?
Image Source: Dollar General's 2016 Investor Day
Dollar General (DG) has a tremendous track record of same-store sales performance. The chart above is from the company's Investor Day presentation from 2016 (it's a little dated now, but it's still a good one). Fast forward a few years, and now, fiscal 2018 has marked the 29th consecutive year in which it reported positive same-store sales growth (same-store sales advanced 3.2% in the most recently completed fiscal year). Not only is this a business model that speaks to unmatched operational consistency, but the measure has come in below 2% only twice over that 29-year stretch (1990 and 2000). Dollar General has a fantastic counter-cyclical business model, too, as performance often improves in times of macroeconomic pressure. For example, look at the results from the Great Recession of 2008 and 2009 when same-store sales leapt 9% and 9.5%, respectively. Dollar General’s business is what we'd call recession-resistant.
In addition to impressive same-store sales growth, the largest discount retailer in the US in terms of store count also has substantial room for store unit growth, which has been strong in recent years as well. Its current store base is approximately 15,370 across 44 states, as of February 2019, and management anticipates adding as many as 975 new stores in fiscal 2019 alone (ends January 2020). Given the rapid pace of store additions, we think Dollar General has the potential to roughly double its store count over time. The majority of these new stores may be smaller format stores, but this may be okay. Such a shift will enable the retailer to optimize merchandise mixes and reduce occupancy costs. Dollar General is working on 1,000 mature store remodels and 100 store relocations. It is not resting on its fantastic historical track record.
As a result of these expectations, Dollar General is targeting net sales growth of roughly 7% for fiscal 2019, with same-store sales expansion providing 2.5 percentage points of the growth. Although operating profit growth may not match that pace of an increase, management is still expecting it to grow 4-6% in the year, with diluted earnings per share targeted in the range of $6.30-6.50. Shares are facing pressure somewhat over concerns about this pace of operating-profit expansion, mostly because weakness on the gross margin line, which came in at 31.2% in the most recently-completed quarter versus 32.1% in the year-ago period. The company pointed to higher markdowns, more lower-margin consumables as a part of the mix, increased transportation costs, and some accounting adjustments (a higher LIFO provision).
We're not as concerned about this as the market may be. Same-store sales are still expected to be solid, and operating income expansion isn't that bad. In fact, during the fourth quarter of fiscal 2018, Dollar General put up the highest two-year same-store sales stack in the past 21 quarters. What this means is that business strength in organic same-store performance hasn't been this good in about 5 years, and what's more, this is coming at a time when arguably the US economy has never been stronger. If we start seeing inevitable weakness in economic activity, Dollar General's same-store sales performance may experience a boost, as it has in the past when economic conditions tend to turn sour.
Debt, Free Cash Flow, and the Dividend
If there may be one thing that we're not too big of fans of at Dollar General, it would be its balance sheet. But we might be a little nitpicky here. Net debt stood at ~$2.6 billion at the end of fiscal 2018. Granted, Dollar General’s balance sheet health is not what we would like it to be for a retailer in the midst of such growth plans (we always prefer a net cash position), free cash flow generation should be sufficient in handling the debt load and expansion plans, in our view. Net cash from operations jumped to $2.1 billion in fiscal 2019 from $1.8 billion in fiscal 2018, while free cash flow leapt to $1.41 billion from $1.16 billion over the same time period, an increase of roughly 21.5% on a year-over-year basis. Such free cash flow generation and an impressively-consistent track record give us confidence in management’s ability to effectively execute its growth plan.
As for the dividend, we think it is on sturdy ground. Free cash flow of $1.41 billion in fiscal 2018 covered cash dividends paid of $306 million a multiple of times. This gives it a rather large cushion to raise the payout, and that's exactly what management did. In its fourth-quarter report, released March 14, the board raised the company's dividend to $0.32 per quarter, a nice 10% increase over the prior quarterly payout. The company's forward dividend yield is now a modest but strong yield of ~1.2% ($1.28 per share). We would only expect management to keep raising the payout and buying back shares, though we would like to see some deleveraging a bit. During fiscal 2018, Dollar General returned $1.3 billion to shareholders through share repurchases and cash dividends, and it just increased its buyback authorization by $1 billion.
The Value of the Equity
Image shown: The summary of our enterprise discounted cash flow process for Dollar General
Image shown: The breakdown of how we ascribe value to shares of Dollar General within our enterprise discounted cash flow process
There are a few ways of looking at the value of Dollar General. The net debt position doesn't make the P/E ratio as informative, given that net debt is often ignored in the calculation of the P/E. That said, on a forward basis, diluted earnings per share are expected to be $6.50 at the high end of the targeted range for fiscal 2019, so that puts shares at about 16.7 times forward earnings, if management comes in at the high end of its earnings per share guidance. That's not too pricey for the consistency that Dollar General has put up. Our enterprise free cash flow derived process comes in with a similar conclusion, too. We value shares at ~$106 each at the moment, about in line with where they are currently trading. All things considered, Dollar General is a fantastic, recession-resistant business trading at a "fair" price with many years of dividend growth ahead of it. We like it.
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.
Additional disclosure: DG is included in Valuentum's simulated Best Ideas Newsletter portfolio.
Disclaimer: This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.