Thesis summary
Dollar General is a small-box discount retailer that has carved out a niche. Having built a substantial presence in rural America, the company provides a convenience choice for many Americans across various regions. Even though it has 19,000+ stores across the whole country, I don’t think the company has already reached a state of saturation. The new store format allows for a larger assortment including fresh produce and health product. The expansion abroad is still in its very early innings. The management can still find considerable amount of new store opening opportunities with an expected IRR of 20%+.
However, the company has been facing challenges from various directions: their core customers are financially challenged; the understaffing needs to be tackled; they issued much debt in 2022, paying more interest when interest rate rises; as for other retailers, inflation and supply chain disruption had negative impact on the business in the past few years. But please be aware that most of those challenges are short term. Many of other retailers are faced with strong headwinds as well. I believe that Dollar General’s basic business model remains powerful.
My valuation model assumes that Dollar General’s business has not been permanently impaired, and the company has not reached its saturation point. Then I assume net sales grows at 6% in the next five years, terminal net margin is 5% (lower than historical average), terminal PE ratio is 12-14x. All-in, I expect to have an annual return in the teens in the next 2-5 years. If the business turns out to be flawed or saturation is near, sell the stock. Personally, I don’t take this as a buy-and-hold investment. I take it as an undervalued stalwart that is faced with headwinds and short-term operating issues. Consider selling when the business normalizes, or the stock appreciates 30%-50% in a relatively short time.
Price: $108.14
Market Cap: $24.09B
EPS (Forward): 7.96
P/E (Forward): 13.58
P/FCF: 124.65
Dividend Yield (Forward): 2.18%
Sep 24, 2023
Introduction
I am always interested in retail industry: it is easy to understand; the core idea can be replicated many times; customers have an edge. What piqued my interest in Dollar General was DG’s nosedive in May. I considered this as a classic story of dumping in the period of negative outlooks. I didn’t initiate a position at a price of ~$150 because I saw no signs of getting better. Their core customers took a hit and inventory level skyrocketed, which then contributed to higher inventory shrink and damage. With the stock still trading at a PE ratio in the high teens, I don’t think we have enough margin of safety. I don’t want to buy in the hope and become homeless later.
After the company published its Q2 results, worries pervaded among institutional investors and sell side analysts. The aforementioned problems remained. The company missed the estimates and lowered guidance, again. Though the short-term headwinds and operating problems still haunted the company, there are not as terrible as many might think. The company even gains market share in consumables and non-consumables against the industrial headwinds. At today’s price of $108.14, the stock starts to get more attractive.
Background
Company and business: Dollar General Corporation is the largest discount retailer in the United States by 19000+ stores located in 47 U.S. states and Mexico as of 2023. The stores generally feature a low-cost, no frills building with limited capital requirements, low operating costs, and a focused merchandise offering within a broad range of categories, allowing the company to deliver low retail prices while generating strong cash flows and capital investment returns. The stores currently average approximately 7,500 square feet of selling space, with 80%+ of stores located in towns of 20,000 or fewer people, whereas the primary new store format currently averages approximately 8,500 square feet of selling space.
Dollar General generally targets low- and fixed-income households often underserved by other retailers and grocers. They offer a broad selection of merchandise, including consumable items (79.7% in 2022), seasonal items (11.0% in 2022), home products and apparel (9.3% combined in 2022). The merchandise includes national brands from leading manufacturers, as well as their own private brand selections with prices at substantial discounts to national brands. They offer the customers these national brand and private brand products at everyday low prices (typically $10 or less) in our convenient small-box locations. The bread and butter of the chain is to sell consumable items in the rural areas, drawing frequent visits from the customers to meet their essential needs.
Source: FY2022 10k, Annual Report
Dollar General has a rather impressive history of profitable growth. From 1990 through 2020, Dollar General achieved 31 consecutive years of positive same-store sales growth, interrupted by the COVID anomaly. The company has doubled its store counts in the past 10 years. It has grown its top line figures at a ~10% average annual growth rate and compounded its EPS by 17%+.
Competition: First, I think it is crucial to compare Dollar General to other dollar store chains, such as Dollar Tree and Family Dollar (acquired by Dollar Tree). 1) Pricing. Dollar Tree has set a standard rate of $1.25 for most of the merchandise, whereas it also provides some “Dollar Tree Plus” products in the $3-5 range over the last year. Dollar General and Family Dollar aren’t “real dollar store” in that they do not stick to the pricing of ~$1. They are in essence general merchandise deep discount stores. 2) Selection. Dollar General has more recognized name brand than Dollar Tree and Family Dollar, but it also invests more in $1-or-less merchandise and private-label brands to lure consumers. 3) Dollar General has a stronger online presence with an easy-to-use website and plenty of digital deals. However, I hold the opinion that the three chains share more common grounds than difference in terms of what they provide to customers. The previously underserved markets seem to be large enough for them to prosper without fighting for life and death. Before the recent struggles, Dollar General outperforms Dollar Tree (NASDAQ: DLTR) in terms of organic growth and comparable sales growth.
Second, consider the competition and big-box retailers such as Walmart, Kroger and Target. Since ~80% of the Dollar General stores are located in towns of 20,000 and fewer people, with many of those places underserved by big-box retailers, I consider the majority of Dollar General stores less prone to the competition pressure from big-box retailers. For those stores in Urban areas and some parts of Suburban areas, the competition they experience is indeed getting fiercer. But I believe that when the convenience factor is into consideration, the presence of Dollar General stores is justified. Generally speaking, we won’t walk two miles away to the big box retailers only for some party hats, drinks and snacks, provided that there is a Dollar General or Dollar Tree just around the street corner.
What caught my attention is the potential competition from Aldi. Even though the German grocery stores chain is still in its early innings of U.S. expansion, it could present a threat to Dollar General stores in suburban and even rural areas. By rough comparison, Aldi offers more private brands that carry even lower prices than Dollar General. But this threat, if any, would not fully materialize in the years to come.
What happened: Dollar General had a rather enviable operating history, until recently it has met its speed bumps. The stock became a 10-bagger after its IPO in 2009 from KKR. If you are lucky enough to buy after IPO and sell in 2022, you might think you are a stock genius. What came as a surprise is that the stock dropped from its all-time high of $261.59 (Oct. 28, 2022) to its all-time low of $108.14 (Sep. 23, 2023). Of the 30 wall street analysts that made their ratings for Dollar General in the past 90 days, 2 analysts provided a “sell” rating and 17 analysts issued a “hold” rating, which is essentially a “sell” in wall street parlance. What is even more interesting is that an analyst issued a “strong sell” after the stock dropped below $110.
Source: Tikr terminal
Dollar General has been suffering from many issues since the beginning of 2023, most of which are short-term in my opinion. On the one hand, the investor sentiment to both retail sector and Dollar General stock is negative. With many retailers experiencing an exceptional year in 2022, strong headwinds are blowing against them in 2023. Worries of an economic recession and worsening of consumer sentiment also contribute to the challenges those retailers are faced with. According to Michigan consumer confidence index, the consumer sentiment in the U.S. is still at a depressed level. At the same time, many U.S. households find themselves hard to get access to loans. Against such a background, Dollar General missed the estimates by a large amount and significantly lowered the guidance in FY2023 Q1 & Q2, leading to two vast stages of stock dumping. But the reality might not be as doomed as many institutional investors and analysts might think. The management has seen improvement in in-store traffic and stability, and the market share of both highly consumable and non-consumable product sales actually grows in FY2023 Q2. What is satirical is that the stock still took a nosedive after the earning call. In my opinion, Mr. Market appears to overreact and panic, with much of the focus on short-term addressable issues.
On the other hand, Dollar General is still faced with a bunch of challenges from their core customers, their operation, supply chain and economic conditions in general. 1) The core customers, those low-and-fixed income households, have been hit hard by the highly inflationary environment. What even aggravates the case is that the tax refunds are lower than usual in the past filing season and the SNAP (Supplemental Nutrition Assistance Program) benefits have reduced. As a result, more of those people are living paycheck to paycheck. Therefore, Dollar General has seen the consumption mix switching from high-margin discretionary non-consumables to low margin consumables. 2) Dollar General also has some operating issues itself. The management piled up the inventory level in 2022, only to find the excessive inventory hard to get rid of in a market downturn. Another operating issue is that they were understaffed. In many stores, cartons and merchandise are placed on the store aisles, and the shelf placement can be chaotic sometimes. The company experienced larger than expected inventory shrink and damage in the past year. 3) As many other retailers, Dollar General was once disrupted by supply chain issues as well. Now the management has made satisfactory progress on this front. The stabilized supply chain led to enhanced stability inside the stores. 4) “It is economy, stupid.” This seems to be a cliché excuse overused by management in many companies. I won’t elaborate on this.
It seems to me that Dollar General hasn’t reached the state of saturation yet, but I won’t be surprised if somebody thinks so. With more than 19,000 stores, the company operates more stores than any retailer in the U.S. and are located within five miles of approximately 75% of the U.S. population. However, I don’t see salient evidence of cannibalization and management can still find many new store opening opportunities with 20% expected IRR and cash paybacks of less than two years. What’s more, the company is trying to break into Mexico market. If it turns out to be a success, why can’t it be replicated in some other countries?
Source: FY2022 Annual Report
Ongoing initiatives and strategic moves: The management have made several initiatives to address the current issues. 1) They accelerate the rightsizing process of the inventory position by expanding promotional markdowns, primarily in the non-consumable products. This will cause a short-term operating profit headwind, but I think is the right thing to do. 2) They make labor investment and deploy what they call “smart team” (Dedicated teams that are at the disposal of a district manager to deploy where they need to be deployed most) in every single district in the company. The management has seen sales accelerating where the teams have been able to touch and claimed that the smart teams “haven’t plateaued”. The initiative is expected to be permanent. I think this initiative will lessen the understaffing problem to some extent. 3) They cease the share buyback in 2023 (after buying back a whopping $2.7B in FY2023 at market exuberance), modestly reduced its plans for new real estate projects and store openings. 4) They plan to invest up to $25M in some other areas such as improved inventory demand forecasting tool to streamline the merchandise flow and lower cost to serve. This is important given the large store base, and I believe that better inventory optimization will contribute to a higher customer satisfaction.
On the strategic front, the management is focused on four keyways. 1) They continue pushing forward the high-return, low-risk real estate model especially in the rural areas. This is the fundament of DG’s business model. The store counts increase by ~5% year over year. They are now opening and remodeling stores in two larger formats (approximately 8,500 square feet and 9,500 square feet, respectively), and expect the 8,500 square foot format to serve as the base prototypes for most new stores (the traditional format is 7,300 square feet). The larger formats allow for expanded high-capacity-cooler counts (as a part of DG Fresh strategy), and more beauty and health products. In the long run, I think, an expanded product assortment will drive more in-store traffic, and in turn increase the sales of other products, despite the fact that the fresh produce business is generally characterized by time sensitivity and thin profit margins. I genuinely think it will greatly benefit rural areas, where customers often need to cover significant distances to access fresh produce. 2) They are constantly testing new formats and channels. For example, they started their digital initiative complement their substantial brick-and-mortar footprint, and they’ve made great progress so far. They also extended their reach beyond the border for the first time by opening the first Mi Súper Dollar General store in Monterrey, Mexico. The Mexico expansion is still in its very early innings, so it is hard to evaluate the odds of success, even though the CEO Jeff Owen claimed to have received great results. It worthy of monitoring though. 3) They have been extending their reach through the pOpshelf format for three years. This format provides a stress-free, guilt-free shopping experience designed around non-consumable shopping occasions. I am afraid that this draws more competition from Amazon (NASDAQ:AMZN), Five Below (NASDAQ:FIVE), and some local “treasure hunt shopping” retailers. 4) They also strive to serve the rural underserved communities through their health initiative branded as DG Well Being. Their in-house customer research team shows that not only are rural communities underserved with basic staple offerings, but they also have trouble accessing healthcare goods and services.
Source: CNBC
Competitive advantage
Dollar General has successfully carved out a niche. They target low-and-fixed income households mostly in rural areas. The main competitive advantage of Dollar General is its locations of the stores. As I mentioned above, they have a substantial presence in rural communities (approximately 80% of stores serve rural communities with fewer than 20,000 residents). This strategy reminds me of Casey’s General Stores, which have approximately 50% of the stores opened in areas with populations of fewer than 5000 persons. It has become the most dominant grocery retailer in rural America. In many areas it operates, there are essentially no other alternatives within 10 miles. What’s more, it is just uneconomical for most other retailers to jump into those rural markets to directly compete with Dollar General. For those Dollar General stores opened in Urban and Suburban areas, they are still doing a good job. Convenience is key.
Compared with many other retailers that were hit hard by Amazon in the past, Dollar General has fared pretty well. This has a lot to do with its niche. I suspect that even in the future, if Amazon permeates into rural areas, Dollar General could still be the delivery pickup point thanks to its positioning.
Financials
Debt level: The debt level is rather stable before 2020. After the outbreak of COVID, the long-term debt level surges to 2.4x the pre-COVID debt level. In general, this is a warning sign for me, because this often indicates that the business is experiencing constant cash outflow if there is no significant acquisition. However, this is not the case for Dollar General. For 2022 and 2023, the free cash flow drops mainly because of the substantially higher capex level. I suppose that the management issued long-term debts to conduct share buybacks. The good news is, in spite of the higher interest rates and significant business headwinds, the LTM Interest Coverage Ratio (EBIT/Interest expenses) is still 10x+.
Source: Tikr terminal
Inventory level: The inventory level outgrew net sales by a large margin in FY2022. The management has been working on the rightsizing of inventory, but the constant deterioration in inventory turnover is worrisome. A glut of inventory could have negative impact on customer satisfaction and lead to a high level of inventory shrink and damage. I expect the inventory level to gradually improve over the next few quarters in that the store traffic improves and inventory growth has significantly decelerated in FY2023 Q2. Of course, I can be wrong. Anyways, the inventory level and inventory turnover are crucial indicators of the business. In the long term, the company plans to invest in inventory forecasting tools, which may largely improve the operating efficiency.
Expenses: On the COGS front, Dollar General utilizes LIFO (Last In First Out) inventory method. Under LIFO, the costs of the most recent products purchased (or produced) are the first to be expensed. In the inflationary environment, the current COGS would be higher under LIFO because the new inventory would be more expensive. As inflation rate trends down from last year’s 9%, the earning headwinds caused by inflation will ease up if inflation level stays relatively low.
Source: U.S. Inflation Rate, U.S. Bureau of Labor Statistics
On the SG&A front, increasing store personnel and worker hours as well as raising wages will contribute to higher expenses. 1) As of 2022, approximately 92% of their workforce earned less than $15 per hour, a wage that has become a sticking point recently. The company said that there will be wage hikes. 2) As the company roll out the larger store formats and push forward DG Fresh and DG Wellbeing, more staff are needed.
Return ratios: First I want to touch on ROIC. Between 2015 and 2019, Dollar General’s ROIC increased from 13%+ to 18%+ according to Morningstar. After the outbreak of COVID, ROIC decreases but is still higher than 10%. Dollar General constantly outperformed Walmart (NYSE:WMT) and Dollar Tree (NASDAQ: DLTR) in terms of ROIC, which is a good sign. Then ROE. Dollar General’s ROE rose from 19.2% to 40.9% between 2015 and 2023. The main reasons underlying such a rising trend are higher leverage ratio and massive share buybacks.
Management
Incentive: I want to stress three points. First, the executive compensation program sets adjusted EBIT as metric for 100% of the short-term incentive and 1-year adjusted EBITDA as metric for 50% of PSUs awarding. This excludes the impact of interest expenses. Second, the program sets stock price as metric for option granting (50% of the long-term incentive). This and the first point combined might explain why the management issued more debt to buy back stock massively in the past two years. Third, the program evaluates 3-year adjusted ROIC, which, I think, is a reasonable metric.
Source: 2023 Proxy Statement
They utilize key performance indicators (“KPIs”) in the management of the business. The KPIs include same-store sales, average sales per square foot, and inventory turnover. Those indicators combined provide a good evaluation of the operation.
The former CEO Tod Vasos retired in November 2022. The new CEO Jeffery Owen, who has served Dollar General’s COO since 2019, is a Dollar General veteran. He began his career as a Dollar General store manager trainee in December 1992, which is impressive thanks to Dollar General’s strong internal promotion culture. He is clearly not like those parachute CEOs in many other retailers. He knows the corporate culture and the business well, and he is on the right track for tackling with business headwinds and operating issues. This is a positive. The negative is that he just took over the CEO position less than one year ago. There isn’t much track record to speak of.
Capital allocation
The new CEO will also stick to the capital allocation priorities that have been set up for years:
Our first priority is investing in our business, including our existing store base as well as high return organic growth opportunities such as new store expansion and our strategic initiatives. Next, we remain committed to returning cash to shareholders through a quarterly dividend payment and, over time and when appropriate, share repurchases, all while targeting a leverage ratio of approximately 3x adjusted debt to EBITDAR in order to maintain our current investment-grade rating.
Source: 2023 Q2 Earning Call
Capex: Before 2021, capex had been aligned very well with Depreciation + Amortization. After 2021, capex exceeds Depreciation + Amortization by a considerable amount. DG is aggressively pursuing store construction, remodeling, and distribution projects at the moment, all while construction costs have significantly increased. This has led to a huge decrease in free cash flow, which in turn may break the upward dividend payout trend. Fortunately, such an abnormally high capex will not persist in the long term. I expect capex as a percentage of net sales to peak in 2023 or 2024.
Dividend: Currently, Dollar General’s dividend payout ratio is 23.2%, which is sustainable if the free cash flow doesn’t experience significant outflows. The forward dividend yield is 2.18%.
Share buybacks: The management doesn’t plan to buy back shares in 2023. The company reduced shares outstanding by 35% between 2012 and 2023. What annoys me is that they conducted an even more massive buyback after 2020 at the PE ratio of 20-25x. At high multiples like this, issuing debt to buy back stock like crazy doesn’t strike me as a sensible strategy, especially given the fact that they suspend the share buyback in 2023 when the multiples are significantly lower. Buying at exuberance and being left with no ammunition at troughs conflict with the principles of value investors. On top of the decelerating growth rate, this is the main reason why I won’t consider Dollar General as a buy-and-hold type investment for now. But since the stock is getting much cheaper now, it might be a good idea to restart share buybacks and curb capex when the business shows signs of normalizing.
Source: Microtrends
Acquisitions: The company doesn’t make any acquisitions in the past five years.
Amateur’s edge (opt.)
Insider trading: In the past six months, we saw two directors and new CEO buying Dollar General stocks at a price much higher than today. Though insider selling doesn’t necessarily mean the outlooks/fundamentals are bad, it is concerning to find that the previous CEO Todd Vasos sold a massive amount at ~$155. When I checked his trading record, however, I found that he has been selling his holdings in the company for two years. His selling in June seems like a hiccup. (Perhaps this is the real reason why the company issued much debt to buy back shares at a historically high level: boosting share prices for his selling. This is only my guess)
Source: Dataroma
Superinvestor buying: Seth Klarman and Tom Gayner have initiated their holdings recently. Christopher Bloomstran from Semper Augustus has raised his holdings to 5.86% of his portfolio. Christopher Bloomstran touched on Dollar General in his recent interview with William Green, and I believe the basic story remains intact.
Valuation
When it comes to valuation, it would be better to consider the case in which the business normalizes. Historically speaking, Dollar General’s EPS growth came from 1) ~5% of store expansion 2) 2-4% comparable sales growth 3) buyback yield of 3-6%. In this way, the company grew its EPS at a 10%+ rate (with 1)and 2) magnified by operating and financial leverage). The management expected to sustain a 10% EPS growth over the long haul. I won’t take management’s opinion at face value, so I will consider two conservative cases:
1) The basic business model hasn’t been impaired; the headwinds and operating issues are largely short term. What will the business be like five years out? The abnormally high capex will come back to normal in the long run, and the free cash flow will be much higher. Assume a 4% store expansion rate, a 2% comparable sales growth, and a 5% 5-year terminal net income margin (mostly 6%+ in the past decade), the terminal earnings will be $2.532B. Assign a 12x-14x terminal PE ratio to the stock and take dividend into consideration, the stock will at least bring a low-to-high teens annual return.
2) The basic business model has been impaired; the recent problems reflect fundamental issues to some degree. Watch out for the telltale signs such as 1) the comparable sales don’t turn into negative territory for too long 2) the company starts to lose market share in consumables and non-consumables 3) the inventory becomes out of control and the inventory turnover further deteriorates from here. To be honest, I don’t think chances of this happening are high. Even if this is indeed the case, the downside is not unacceptable at today’s multiples (forward PE ratio 13.58x; TTM PE ratio 11.08x).
Why this opportunity exists
- Retail apocalypse: dumping retail stocks out of fear and worries
- Retailers are faced with strong headwinds
- Dollar General’s operating issues
- Abnormally large capex worries some investors
- The fear of Amazon prevailing over brick-and-mortar retailers
Risks
- Inventory becomes out of control
- Competition from Dollar Tree: the previous CEO of Dollar General, Rick Dreiling, was appointed as CEO of Dollar Tree.
- Understaffing remains a problem for a long period
Catalysts (opt.)
- The low-and-fixed income households might become less economically challenged in the near future
- The new CEO resumes stock buybacks at low multiples