I still rate Dollar General as a Strong Buy despite the almost 30% rally seen in shares since I last wrote about the stock.
The discount variety retailer has managed to grow total net sales as a result of new store openings while total COGS have remained flat YoY. Small increases in SGA expenses and a 1.3% decline in same-store sales have however continued to weigh on the company’s share price.
However, I believe most of the pressures currently facing DG have arisen as a result of a difficult macroeconomic environment rather than due to any inherent flaws in the firm’s business model.
Therefore, I am still a believer in the firm’s long-term (2-10 year) turnaround story and have retained my position in the stock.
Dollar General is an American chain of low-end variety stores who operate more than 19,100 stores across the U.S. and Mexico. Since the firm’s creation in 1939 the chain has grown into one of the largest and most profitable store brands in the U.S.
DG has achieved this massive growth and profitability through targeting consumers in rural America often placing stores in towns with less than 1000 people. This allows DG to operate monopolistically within these localized markets due to the complete lack of competitors within these tiny towns.
The chain also targets lower-income regions of larger cities where food-deserts have been created due to the reluctance of larger retailers or grocers such as Target (TGT), Walmart (WMT) or Kroger (KR) to place outlets within these areas.
With Todd Vasos back at the helm, I continue to believe in Dollar Generals recovery. The company’s core business model remains strong in my opinion, with great leadership and an easing macroeconomic environment primed to support future growth.
Economic Moat – Q3 FY23 Update
Dollar General has what I consider to be a medium-width economic moat. This moat is built primarily upon their unique sales model, competitive pricing and extensive geographic reach. To read an in-depth analysis of their moat, please read my previous article here.
From a fundamental perspective, little has changed with regards to DG’s economic moat. The firm continues to be the leading discount retailer in the U.S. with a streamlined stocking strategy continuing to define the firm’s business model.
DG also continues to focus on expanding their store footprint to underserved “food deserts” where consumers are being underserved by both big box stores and larger grocers. This allows DG to act as a monopoly within each respective business region which significantly increases the sales per store achieved by the retailer.
This strategy of targeting consumers in underserved regions and through the virtue of being a discount retailer has resulted in Dollar General primarily serving a low-income demographic of peoples living in America.
As pandemic savings were rapidly eroded post late 2021, DG has seen their core consumer base become increasingly income stressed which has led to falling net sales and visitor numbers. Higher interest rates often impact lower-income households first as their financial flexibility is significantly lower compared to higher income individuals.
While this has resulted in decreasing margins and returns, little fundamental damage has been done to Dollar General’s economic moat. Their business strategies remain sound while total net sales should rebound in a lower interest rate environment as consumers pocketbooks become less stressed with monthly payments and as wages catch-up to inflation.
Still, the saturation of dollar stores within the U.S. may continue to place some pressure on DG’s margins as new store openings may be less profitable than in the early 2000s. While DG’s overall scale and reach should allow the firm to outearn rivals such as Family Dollar, it is undeniable that total returns on both invested capital and assets may decline in the coming years by a percentage point or two.
Financial Situation – Q3 Update
Dollar General has earned massive returns over the last five years compared to the relative performance of other retailers. The firm’s 5Y average ROA, ROE and ROIC are 9.68%, 33.82% and 13.14% respectively. A 13.14% ROIC in particular is great to see especially when considering that Walmart has only managed a ROIC of 9.73% over the same period.
For the same previous 5Y period DG has managed to operate on gross, operating and net margins of 31.18%, 7.99% and 6.77% respectively. While not quite as impressive as their returns, I believe their robust gross and operating margins reflect the efficiency DG aims for in their operations structure.
To read an in-depth analysis of DG’s financial situation, please refer to my previous article here. In this update I would like to cover their most recent Q3 earnings report which highlights some of the progress DG has made since mid- calendar year 2023 with regards to their profitability and margins.
Q3 saw DG grow total net sales by 2.7% to just under $9.7B. This growth came primarily as a result of positive sales contributions from newly opened stores while being partially offset by a 1.3% decline in same-store sales YoY.
The decline in same-store sales suggests DG’s core consumers are still feeling financial pressure from the higher interest rates which is supported by research conducted by the FED reporting that lower-income individuals are already in a recessionary market cycle.
DG also notes that the primary product groups resulting in declining same-store sales are the “home”, “seasonal” and “apparel” which all happen to be non-essential categories. This supports the hypothesis that DG’s lower-income customer base is cutting back on non-essential spending which also happens to be the largest source of revenues and margins for the firm.
While this is regrettable, it should really come as no surprise given the increasingly contractionary macroeconomic policy pursued by the Fed. Businesses and their customers all experience a natural degree of revenue and income fluctuations as a result of the business cycle.
In the case of Dollar General, I do not view a 1.3% decline in same-store sales in the third quarter as a metric particularly indicative of the business’ core viability, but rather as an indicator of the amount of disposable income their core customers have to spend at present time.
COGS as a percentage of revenues remained flat YoY at 70.1%. This illustrates just how hard DG has been working to ensure their supply chain remains efficient even amidst a difficult macroeconomic backdrop.
The length of many of DG’s supplier contracts also helps to curb any sudden increases in product procurement prices with DG’s massive scale and economic moat helping to diminish some of the effects of significant cost inflation.
Q3 also saw the firm’s SGA expenses increase by a whopping 183pp to a total of 24.5% of revenues compared to just 22.7% in FY22. This significant YoY increase was primarily due to wage inflation outpacing revenue growth while depreciation and amortization, repairs, rent and professional fees continued to rise.
Once again, DG is most likely simply a victim of the current macroeconomic backdrop. The firm is known for their fiscally responsible attitude and I believe Vasos is most likely doing everything he can to maintain costs to a minimum.
However, every 10-15 years or so, a recessionary environment tends to impact consumer cyclical companies such as DG with the current variables of rising inflation and declining consumer purchasing power suggesting this very environment may already be in place.
Seeking Alpha’s Quant continues to assign Dollar General with a “B” profitability rating. I believe this to be a relatively realistic overview of the firm’s current profitability considering the falling sales figures and operating profits.
The firm’s balance sheet and cash flows continue to look mostly healthy with the firm exhibiting sound liquidity and sufficient cash flows to support and enable continued growth of their business.
One note that I would like to highlight in this update is the significance of lease payments for the firm’s retail stores. DG (unlike Walmart, Target or Costco) has expanded their business through leasing real estate rather than purchasing it outright.
This has allowed DG to remain incredibly flexible with store locations while simultaneously enabling the firm to rapidly expand their presence across the U.S.
The consequence of this growth strategy is that DG must continue to generate sufficient cash flows from the continuing business processes to support these lease obligations. At present time, DG has around $1.3B in current lease obligations while the weighted-average remaining lease term stands at around 9.3 years.
DG generated $1.4B in cash flows from operating activities in Q3 FY23 which represents a $193.8M in increase compared to Q3 FY22. These massive cash flows from operating activities already reflect the current lease liabilities due and illustrate just how much cash DG continues to generate from the business despite the difficult macroeconomic environment.
Dollar General continues to receive an “Baa2″ credit rating from Moody’s for their senior unsecured notes and a “Prime-2” commercial paper rating. The outlook remains stable. Baa2 is classified by Moody’s as credit obligations which are of “medium grade” representing a “medium investment risk” grade.
The firm’s dividend has remained at $0.59/share since early 2022 with the firm’s dividend yield of 1.74% and annual payout of $2.36 remaining even amidst a disappointing FY23.
With a payout ratio of 26.70%, a 5Y growth rate of 15.47% and a growth streak of 6 years, I believe DG’s dividend while not inherently impressive should illustrate management’s confidence in the business model and ability for the firm to bounce back from a difficult macroeconomic environment.
From a financial perspective, DG remains a healthy organization despite the drop in profitability experienced since late 2021. The firm continues to be excellent at generating huge cash flows while margins and overall returns have remained mostly stable for the firm throughout a difficult FY23.
Seeking Alpha’s Quant still assigns Dollar General with a “D+” Valuation rating. I believe this is an excessively pessimistic representation of the intrinsic and future value present within Dollar General’s shares.
The firm currently trades at a P/E GAAP TTM ratio of 15.59x along with a P/CF FWD of just 12.11x. These metrics are both 26.5% and 35.4% below DG’s 5Y averages respectively.
Their TTM EV/EBITDA of 13.13 is a little elevated but not overly concerning given the positive macroeconomic impacts that should benefit DG in FY24. DG’s EV/Sales TTM and FWD are both just 1.22x and 1.23x which represent 30% reductions compared to the firm’s 5Y running average. This should begin to illustrate just how well-priced DG stock currently is.
To emphasize the firm’s EV/S metrics, DG is still currently valued at just 1x their sales over the trailing twelve months despite the 33% rally since I last wrote about the stock in Q1 FY23. The sector median in the retail category is 1.68x with DG historically trading at around 1.70x.
From an absolute perspective, DG shares are still trading at a significant discount relative to previous valuations. Over the last 5Y the firm has produced just -17.0% returns with a 2023 -53% selloff resulting in huge drop in valuations for shareholders.
This has led to a significant souring of sentiments among investors regarding the potential that lies in DG which I believe to mostly be speculation and unfounded pessimism.
Such negative sentiment is also compounded by the 80% returns generated over the past 5Y by the S&P 500 tracking index fund SPY (SPY) which has left many DG shareholder lamenting the recent poor performance of DG stock.
While the relative valuation provided by simple metrics and ratios along with the absolute comparison help to create a baseline of understanding regarding the value present in DG shares, an intrinsic value calculation is still absolutely necessary in order to gain a more reliable quantitative valuation figure.
By utilizing The Value Corner’s Intrinsic Valuation Calculation, we can better understand what value exists in the company from a more objective perspective.
Using DG’s current share price of $135.76, an estimated 2024 EPS of $7.45, a conservative “r” value of 0.10 (10%) and the current Moody’s Seasoned AAA Corporate Bond Yield ratio of 4.74x, I derive a base-case IV of $197.10. This represents a still substantial 31% undervaluation in the firm.
Even when using a very pessimistic CAGR value for r of 0.06 (6%) to reflect a scenario where Dollar General sees increasing losses due to their core demographic struggling to purchase even consumables items as a result of an acute recession impacting the U.S. in 2024, shares are still valued at around $141.80 representing a fair valuation in shares.
Considering the valuation metrics, absolute valuation and intrinsic value calculation, I believe Dollar General is still trading in what can be deemed real value territory.
In the short term (3-12 months), it is still entirely possible that DG shares drop to the low $100 mark that we last saw in October 2023. Despite the continued undervaluation in shares, short-term volatility is always possible as a result of the markets acting more as a voting machine than a fact-based weighing scale.
Still, even if the U.S. entered an acute and deep recession, it is difficult to see how much further share prices could realistically go given the massive undervaluation and at worst case fair valuation present in shares.
In the long-term (2-10 years), I continue to see a bright and prosperous future for DG. I believe they will be able to continue growing their overall footprint of stores while a recovering low-income consumer base should cause net sales per store to increase significantly in the coming 1-5 years.
Risks Facing Dollar General – Q3 FY23 Update
Little change has occurred regarding the risk profile accompanying Dollar General’s business model. To read an in-depth analysis of these threats, please see my previous article here.
To summarize the current situation, DG still faces real threats from increasing variety store competition and the continued expansion discount supermarket chains.
While most competitors to DG will struggle to match the firm’s store economics as a result of the firm’s massive scale, an increasing number of alternative discount variety retailer such as Family Dollar or even emerging discount supermarkets like Aldi will most likely result in a slight margin contraction at DG.
Equally, DG continues to face some pressure from online retailers with the likes of Amazon working hard to increase the availability of rapid same-day or next-day delivery options in order to harness a larger consumer base for their day-to-day product sales.
From an ESG perspective, DG still faces tangible social and governance risks arising from their monopolistic business practices and the allegations of worker mistreatment. DG also must contend with the rising rates of merchandise loss happening in the U.S.
In short, I still believe DG is a great business with healthy margins, massive cash flows and a solid balance sheet defining their operations.
The firm remains laser focused on keeping costs to a minimum to ensure they can accurately target their increasingly income stressed customer demographic. While DG’s consumer base appears to still feel significant pressure on their pocketbooks, I believe this macroeconomic environment is transitionary with future gains almost certainly on the horizon as interest rates decrease, at least in my opinion.
When DG’s promising future prospects are combined with the potential for a substantial 30% undervaluation to still be present in shares, the firm’s stock starts to look like a real GARP opportunity.
Therefore, I still rate Dollar General a Strong Buy and maintain the position I commenced with an APP of $103.2. While I will not personally be adding more DG stock at present time as a result of my portfolio already having 8% exposure to DG as a percentage of total portfolio value, I still believe the stock is up for grabs at a bargain compared to the intrinsic value of shares.