Description

Dollar General Corporation (NYSE: DG)

Per Share Price of $57.90 / Market Capitalization of $18.7 billion

October 2, 2013 

Thesis:

1)      Low-cost provider of essential items.  75% of Dollar General net sales are of essential, consumable items (branded and private-label): food, dairy, cleaning supplies, health and beauty items, beer/wine and tobacco that DG sells at competitive every day low prices (EDLP) (25% of products retail for $1.00 or less, almost all retail under $10.00).  Pricing studies show DG’s prices significantly undercut conventional grocers and drug stores (DG is 21% and 41% cheaper on average, respectively) and are also competitive with Wal-Mart (DG prices are often in line with WMT on a per-unit/per-ounce basis, but are almost always cheaper on a per-package basis due to smaller-sized packages).  DG is able to offer competitive EDLP on merchandise due to its no-frills, low-cost operating model:

• Cheap build-out of new stores ($255,000 average total investment per new store; cash-flow-positive in first year with overall payback period of less than two years)
• Efficient small-box footprint (7,300 sf versus 47,000 sf for conventional grocery chains and 125,000 to 200,000 sf for WMT Supercenters)
• Cheap staffing costs (typical store staffed with two to three personnel at given time; no unionized labor or legacy pension liabilities as with many conventional grocers)
• Limited, focused offering of essential SKUs (fewer than 10,000 at DG versus 50,000 at conventional grocery; limited number of SKUs provides DG buying power/pricing advantage in dealing with suppliers)
• Increasing private-label penetration (approximately 20% of sales in 2012; room to increase over time)

With a large number of Americans living under continued financial strain (the Economist reports the American real median household income was $51,000 in 2012, flat to 2011 and below pre-recession levels), it is a good bet that dollar stores like DG will continue to play an increasingly important role in shopping routines regardless of how the economy plays out.

2)      Gaining market share / Best operator in growing dollar store category.  Given the no-frills business model and offering of essential products, DG/dollar stores are well positioned over long term to continue to take share from a number of structurally disadvantaged companies in staples retail.  DG is winning share from conventional grocers and drug stores primarily due to its significant EDLP advantage.  DG has a location/convenience advantage relative to WMT for regular small-basket or “fill-in” trips (a majority of customers live within a three to five miles of stores; a large percentage of DG customers walk to stores; the small-format box allows shoppers to get in and out quickly).  DG is the best operator of the dollar store companies (higher sales productivity and more efficient cost structure relative to Family Dollar and Dollar Tree) with greater scale (10,900 DG stores compared to 7,800 and 4,700 for FDO and DLTR, respectively).  The U.S. market can conservatively support an additional 10,000 dollar store doors and DG is well positioned with its distribution network and financial wherewithal to capture the largest square footage gains among dollar store players over the next several years.

3)      High-ROIC retail model / Significant opportunity for re-investment in business.  As noted, DG builds out new stores in an extremely cost-effective manner ($255,000 average investment) and realizes an average payback in only 1.6 years, which implies a return on new store investment well in excess of 50%.  There are very few businesses out there that can generate similarly exceptional returns on invested capital and even fewer that offer a significant opportunity for continued re-investment in such high-ROIC projects (potential for DG to 600 to 700 new stores for next 10-plus years).

4)      Secure financial position / Shareholder-friendly capital allocation.  DG is capitalized conservatively relative to its earnings power / free cash flow generation (Net debt leverage of only 1.30x Ebitda; 3.00x Rent-Adjusted Debt/Ebitdar).  DG recently refinanced a large portion of its debt, with over 60% of total outstanding debt now fixed-rate (weighted cost of total debt currently approximately 3%).  The company will throw off almost $700 million in free cash flow in 2013; this figure should grow to $1 billion in 2015 under conservative assumptions.  While DG management is foremost committed to re-investing in new store growth given the exceptional ROIC profile, the company recently started buying back stock, spending an aggregate of $1.1 billion over the past seven quarters to reduce the share count by a cumulative 13.5%.  Management has indicated share buybacks will remain its number-two capital allocation priority behind opening new stores; DG may be able to accelerate buybacks by taking on additional debt to maintain target rent-adjusted leverage of 3.00x as the company grows its operating earnings (similar to AZO and SBH).

5)      Highly sustainable and visible earnings growth.  DG has delivered positive same-store comp growth for 23 consecutive years and grown its square footage/store count by a compound rate in excess of 7% since 2000.  It does not require heroic assumptions for DG to deliver earnings growth in the mid-teens for the foreseeable future through a combination of growing square footage (management targets continued 6% to 7% per year), comp increases (target mid-single digits) and stock repurchases (reduce share count by 3% to 4% per year, perhaps more).

6)      Rational valuation relative to business quality and growth prospects.  While DG currently trades near its all-time high, the stock is valued at only 15.0x 2014E earnings and 12.6x 2015E earnings, which is attractive given (i) DG should continue to compound EPS in the mid- to high teens over the next several years under reasonably conservative assumptions, and (ii) the company and stock price are likely to hold up better than most businesses in the event of macro deterioration.  Overall, DG at current levels provides an excellent risk-adjusted opportunity to invest in a high-quality, defensible business with above-average growth prospects.

Other Topics:

• California as example of opportunity to grow stores in new markets.  DG ended 2012 with only 51 stores in CA; management believes CA could some day be as large asTexas(1,155 TX stores end of 2012).
• Tobacco.  DG rolled out tobacco products across all 10,900 doors early in Q1 2013.  While tobacco is a lower gross-margin product, management has cited tobacco as a key driver of increased traffic.  Moreover, tobacco sales are expected to be largely incremental to DG and will not cannibalize / represent a shift of consumer dollars away from existing sales; tobacco another example of initiative to drive positive same-store comps.
• Regulatory threats almost non-existent.  Unlike businesses in a number of other key industries—healthcare, media/communications, financials—DG’s business model of retailing essential items at EDLP to people of modest means is unlikely to face any meaningful regulatory changes, adding to the overall attractiveness of the risk-reward profile. 

Target Price / Financial Summary (Figures in millions, except per foot and per share data):

2015 year-end target per share price range of $82.00 to $85.00 predicated on 15.0x 2016E EPS and 10.0x 2015E Ebitda (Implies upside of 40% to 50% over approximately 2.25 years).  Longer term, DG stock could approach $100.00 per share over next four to five years (2017E EPS of $6.42). 

 Risks:

• Price wars / irrational pricing in industry (DG/dollar stores have withstood recent WMT return to EDLP over past two years; WMT would likely lose more than it would gain from severe price war; conventional grocers may become desperate if they continue to lose share, although they have less margin to work with(KR and SWY have Ebit/operating margins of only 2.9% and 2.5%, respectively)
• WMT aggressively rolls out smaller-format Express stores (unlikely this is imminent given (i) WMT management is clear that supercenters remain number-one priority, (ii) distribution model significantly different than fulfilling big-box supercenters and (iii) 15,000 square foot stores will not move needle for WMT (Morgan Stanley estimates WMT would require 100 Express stores at full productivity to $0.01 to EPS); additionally, industry expert during conversation expressed skepticism that WMT would roll out Express despite WMT management at times displaying enthusiasm for concept).  Worth monitoring Neighborhood Market roll-out (here again industry expert was skeptical that returns for Neighborhood Market were in line with management commentary and noted this format was more directly competitive with conventional grocers (KR and SWY, etc.)).  WMT Express roll-out could be threat that will emerge over medium- to long term, however, once WMT exhausts other growth avenues
• Macro deterioration (although DG well positioned to capture “trade-down” consumers)
• Same-store sales comp miss (partially mitigated by estimated 150 to 200 basis points of comp growth from new and remodeled/relocated stores embedded in comp each year; also worth reiterating company track record of 23 consecutive years of positive same-store comps)

Catalyst