Dollar General DG
January 26, 2017 - 6:00pm EST by
rhubarb
2017 2018
Price: 71.69 EPS 4.39 4.69
Shares Out. (in M): 281 P/E 16.3 15.3
Market Cap (in $M): 20,159 P/FCF 0 0
Net Debt (in $M): 2,974 EBIT 0 0
TEV ($): 23,133 TEV/EBIT 11.1 10.7

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  • Retail

Description

The setup:

DG has sold off as weak Q2 (0.7%) and Q3 (-0.1%) same store sales growth came in well below both sell side consensus and DG’s own historical performance.  This occurred within the backdrop of persistent commentary in the grocery channel highlighting increased competitive pressures, primarily caused by food price deflation and SNAP (food stamp) cuts.  As a result, DG has become an out-of-favor stock (only 13/30 analysts now list DG as a buy) in an out-of-favor sector (retail). 

Thesis:

The recent share price decline is an opportunity to build a position in a competitively advantaged, defensive compounder.  I believe recent weakness in SSS has been primarily driven by cyclical and temporary factors.  However, even if the tepid comp environment persists, I think DG can drive mid-to-high single-digit organic EBIT growth (and low-to-mid teens EPS CAGR) through continued store expansion at high incremental returns.  Given that point of view, 15.5x NTM consensus earnings is too cheap. 

Company description:

DG is an operator of neighborhood discount stores with ~13,000 locations in 43 states.  The typical box is 7,400 sf and carries ~10,000 SKUs.  76% of sales are from consumables.  Private label penetration is 25%.  Their pricing strategy is to be near parity with mass merchandisers (i.e. WMT, TGT), 15-20% cheaper than grocery, and 40% cheaper than drug. 

DG’s value proposition is to provide both low prices on everyday items and a convenient shopping experience.  In a country where recent surveys have indicated that nearly 7/10 Americans have <$1,000 in their savings account, this value proposition continues to resonate.  To get a sense of their core customer, credit cards make up only ~5% of sales. 

How can DG offer such low prices?

As the largest operator of neighborhood discount markets, with $21b of revenue spread over 1.9b transactions, DG benefits from a number of scale efficiencies.  DG utilizes centralized procurement to ensure best-in-class pricing and is a top 5 customer of most CPG vendors.  On the supply chain side, DG’s scale and footprint density allow for a COGS advantage over the vast majority of their competition.  In addition, DG recently upgraded its supply chain and logistics ERP software to further optimize routes for millions of cases each week.  To get a sense of the scope of DG’s operation, their distribution centers occupy 13mm sq ft and contain 120 miles of conveyors. 

These scale advantages are complemented by a strong operating culture in which data and testing are central to pricing and merchandizing decisions.  Management is also highly disciplined on the cost side and employs a zero-based budgeting framework. 

If Walmart can’t do it…

A clear indication of DG’s moat is the case study of Walmart Express, a 12,000 sf concept introduced in 2011.  Over the next several years, WMT concentrated its Express store openings in the rural south (attacking DG head on), however, the concept was a disappointment.  While WMT was not disadvantaged on the procurement side, the stores were operationally inefficient and did not conform to WMT’s traditional supply chain model.  In January 2016, WMT finally gave up and closed all 102 Express stores.  DG purchased the 41 best locations.

Growth opportunity:

Very few retailers have unit economics that rival DG (store-level cash-on-cash returns are running at 35%+) and the ability to reinvest organically at such a high return is powerful.  DG management gets that and is growing its footprint at 6-7% per year.  DG estimates that there are an additional 13,000 locations that could support a DG (or a Family Dollar) and is accelerating its land grab.  While it is impossible to pin down the exact point of saturation, I am comfortable that there is enough white space to support at least 5-7 more years of aggressive unit growth for DG.  It helps that DG’s primary competitor for new locations is distracted with a merger integration (DLTR purchased FDO in mid ’15). While productivity of recent DG store openings remains consistent with past years, even if one assumes diminishing incremental returns over time, this growth will still generate substantial economic profits. 

So why are comps so weak?:

The U.S. is in the midst of the longest period (a little over a year) of food deflation since 1960.  Food-at-home prices declined 2% in 2016.  Generally speaking, food deflation results in increase competitive intensity among grocers.  This has come at the same time that the government is cutting back on SNAP benefits (5% of DG sales) exacerbating the issue. 

More specifically, WMT has gotten a lot of headlines with its public statements about “investing in price” which has caused some of its competitors, including DG in 2Q, to follow suit in certain markets  (DG is taking ~10% retail price reductions on 450 SKUs across 2,200 stores, ~17% of the store base).  This has sparked fears of a vicious price war, however, I think concerns are overstated for a few reasons.  1) WMT has always invested in price (and DG has compounded sales at 13% the past 20 years).  2) WMT does not benefit from a race to the bottom and needs the retail cash flow to fund its e-commerce ambitions.  3) WMT and DG satisfy different needs (stock-up trip vs. fill-in trip) 4) it is not a zero-sum game between WMT and DG.  There is still plenty of share to take from grocery, drug and other channels.  5) I expect food deflation to eventually subside (it always does) which will moderate the associated promotional activity. 

Another contributor to weakening SSS is the countercyclical nature of DG’s business (I would argue we are late-cycle).  Some portion of DG’s customers trade up (and away from DG) in good times and down (back to DG) in tough economic times.  Historically, DG has posted its weakest comps (still positive) in 1990, 2000, 2007, and 2016. The first three examples preceded the prior three recessions (which is also when DG puts up its best comps). 

Risks:

Threat from Amazon/e-commerce:  I do not expect Amazon to have a major impact on DG.  As previously mentioned, DG is catering to the fill-in trip of low-income, rural, and often cash-paying customers.  DG’s average ticket is ~$11.  This shopping trip is not vulnerable to e-commerce disintermediation because 1) it takes time to ship – so you lose immediacy and 2) shipping small quantities of low value items to rural locations is cost prohibitive.  For example, this WSJ article indicates that shipping a 42-count container of Tide Pods to rural Oklahoma would result in a loss of -$12.25 to the retailer. 

http://www.wsj.com/articles/e-commerce-a-boon-for-rural-america-but-it-comes-with-a-price-1473615741

Border-tax adjustment:  My personal view is that border-tax adjustment is unlikely to be implemented.  However, if it is implemented the impact is uncertain.  I’ve read reports indicating it would be a net positive for DG and other reports with the opposite view.  Key variables include how much the dollar strengthens, what the new corporate tax rate is (DG is a full tax payer), how DG’s buying patterns shift, how DG’s suppliers respond, and how much DG can pass price increases on to the customer.  I take comfort that DG’s relative competitive advantage will remain intact. 

Dollar store saturation:  I will be monitoring for signs of deteriorating store economics as value-creating growth is important to the long thesis. 

Accelerating economic growth:  In a super-charged economy DG will lag on comps as customers trade up.   

Valuation/Conclusion:

I utilize a DCF to come up with a FMV of $90/share.  Key assumptions include declining gross margins in the near term, LSD SSS growth, minimal operating leverage, a 35% income tax rate, and 130bps of P/E multiple contraction on the exit.  Looking at this another way, DG’s relative (to SPX) and absolute P/E (of 15.5x NTM) are at/near trough levels and the balance sheet is in good shape.  When you plot EV/EBITDAR vs. lease-adjusted ROIC, DG also stands out as undervalued.

DG is just too cheap given the quality and defensibility of the business.  Despite healthy reinvestment opportunities, DG still generates more capital than it can put to work.  As a result, the company is a consistent purchaser of its own shares, which have declined by a 4.2% CAGR since 2011.  Moreover, you have recent insider buying (~5.5% higher) by two strong capital allocators:  1) Michael Calbert, Chairman of DG board and retired KKR partner who led 2007 DG buyout, and 2) William Rhodes III, who in addition to being a DG board member is Chairman and CEO of Autozone, a fantastic retail success story.  

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Compounding earnings

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