Dollar General Corp. (NYSE: DG). DG is a rare company that is growing square footage and delivering positive comparable sales. It also appears to be well positioned to weather the COVID-19 crisis. We believe those expectations are adequately reflected in the share price. The company has delivered 30 consecutive years of growth in same-store sales.
We also believe that management has an opportunity to grow expenses more slowly than sales, and to improve the efficiency of store operations and the supply chain. We see an additional opportunity for DG to enhance EPS by repurchasing shares.
In September 2018, the company’s CEO saw an opportunity to open an additional 13,000 stores in the continental U.S., with a significant number in more urban areas.
On December 3, Dollar General reported fiscal 3Q21 net sales of $8.2 billion.
Third-quarter comp sales increased 12.2%, for the quarter ended October 30, driven by an increase in average transaction size, partly offset by a decline in customer traffic as shoppers are still trying to minimize social contact. Our estimate was 9.1%. The company saw sales growth in consumables (+15.6%), seasonal merchandise (+20.7%), products for the home (+29%), and apparel (23.4%). Comp sales growth was in the mid-teens in August and declined to the low double-digits later in the quarter.
The company gained market share in ‘highly consumable’ product categories. Company data suggests that they are winning new customers who are younger, have higher incomes and are more ethnically diverse than the chain’s core.
The 3Q operating margin rose by 240 basis points, to 9.4% of sales. Our estimate was 7.3%. In dollars, operating profit of $773 million rose 57% and exceeded our estimate of $582 million. The gross margin was better than we expected, up about 180 basis points, as strong demand reduced the need for markdowns. The company also raised some prices and had higher sales of non-consumable items, which are more profitable. Higher COVID costs and bonuses weighed on operating profit.
While some high-demand products remained out of stock, the company made progress in getting merchandise back on shelves and preparing for what it expects to be a good holiday season.
EARNINGS & GROWTH ANALYSIS
The company withdrew its earnings guidance in 1Q and did not provide specific guidance on the 3Q call or in its earnings release. We are raising our FY22 EPS estimate to $9.60 from $9.25.
We look for a 6%-7% increase in square footage. We still expect comparable-sales to increase approximately 3% over the period. On the negative side, the retail environment remains fiercely competitive, with dollar stores, convenience stores, drug stores, grocery stores, big-box stores and warehouse clubs all competing for the same scarce dollars. Aldi, in particular, is a strong and growing competitor and Amazon seems intent on lowering shipping fees and minimum order sizes to win business from rural customers who are buying consumer staples rather than tech products and discretionary items.
However, DG maybe able to use promotions more effectively, reduce theft, improve logistics, add private-label merchandise, and improve merchandising with the right mix of discretionary items and clothing. We also see an opportunity for the company to offer selected private-label merchandise with higher margins. An offset is that beer, tobacco and milk could be instrumental in driving store traffic, and those products tend to have very low margins.
We see SG&A leverage as an imperative in all of retail. DG has reduced its cost structure.
FY21 is poised to be an extraordinary year. After the 4Q earnings report, we will take a look at our expected five-year growth rate. We don’t expect changes to any of the drivers but we are starting from an elevated level. While FY22 should be a good year by normal standards, we expect lower earnings than FY21.
FINANCIAL STRENGTH & DIVIDEND
Retailers generally do not earn our highest rating because competition is intense, dozens of retailers sell similar products, the businesses are economically sensitive, and margins tend to be low. That said, DG has delivered positive comps for 30 consecutive years and our bias is for raising our assessment by one notch.
Dollar General’s FY20 operating margin of 8.4% is very healthy for a company that sells low-priced items to value-conscious customers. Wal-Mart, by comparison, had an operating margin of 4.1% last year. DG offers convenience, and we believe that DG’s logistics are very efficient, with procedures for loading trucks and delivering merchandise that allow stores to quickly restock their shelves. DG’s earnings may also be less cyclical than many other retailers.
Dollar General’s debt is rated in the mid-BBBs by the credit rating agencies, putting it at the lower end of the investment-grade range. Outlooks are stable. Dollar General has targeted a leverage ratio of 3-times lease-adjusted debt to EBIT plus depreciation, amortization and rent, which it has consistently maintained. DG ended FY16 and FY17 with a ratio of 3.2, FY18 with a ratio of 3.3, and FY19 with a ratio of 3.25.
The company issued $1.5 billion of debt on April 1, 2020. DG initially held the bond proceeds as cash. DG ended 3Q21 with a debt/capital ratio of 66%. The cash position remained elevated.
For FY20, the company moved its operating leases to the balance sheet, in compliance with new accounting guidelines, rather than having them appear as off-balance-sheet items in the annual report. Dollar General leases all of its distribution centers and most of its stores. We have always treated the leases as financial obligations and included them in an adjusted debt calculation. There was very little difference between our estimates and the new values on the balance sheet and there was no need to change our financial strength assessment as a result of the new guidelines.
DG ended 3Q21 with no outstanding borrowings under its $1.25 billion revolving credit facility.
The company is committed to investing excess cash into the business and returning cash to shareholders through buybacks. Since 2012, DG has returned over $6 billion to shareholders through buybacks. In FY16, it repurchased $1.3 billion of its stock. The company had repurchased $1.6 billion of shares through 3Q.
The company paid FY19 dividends of $1.16 per share. In March 2019, DG raised the quarterly payout to $0.32, or $1.28 annually. FY20 dividends totaled $1.28 per share. In March 2020, DG raised the quarterly payout to $0.36 per share.
MANAGEMENT & RISKS
Dollar General shares are up about 30% this year. As a retailer that sells mostly food, cleaning supplies and over-the-counter medicines, DG is well positioned. In the annual report the company acknowledged limited insight into the impact of COVID-19. The company initially mentioned that the receipt of some goods could be delayed but it did not expect a material impact on the business. DG did note that further disruptions to the supply chain or to customers could become a more significant drag on business. The virus could also delay the company’s plans to open new stores and distribution centers and could continue to raise expenses. While still high unemployment may hurt the company’s customers, sales of food and other essentials have been strong. The company said in the 10-Q for 1Q21 that it expects adverse economic conditions caused by COVID-19 to continue at least through 2020 and possibly longer.
We believe that DG is less affected by competition from Amazon than most of our retail universe, for several reasons. First, it does a good job of serving cash-strapped consumers who live farfrom a Wal-Mart or a value-priced grocery store. In addition, about 75% of the products DG sells are under $5, which makes them far less economical for an online retailer to ship than a $250 X-Box gaming system, a pair of $189 Air Jordans, or an iWatch. The economics of providing food delivery are probably also less attractive to Amazon because many of DG’s customers live in rural areas, with a lower population density and lower average income than the affluent urban and suburban areas served by Amazon’s Whole Foods stores.
We appreciate the company’s effort to ensure an orderly transition: replacing a CEO does introduce an element of risk – especially in a competitive industry that has gained the attention of activist investors. We believe that Mr. Dreiling and the board put shareholders first in their succession planning.
Gross margin pressure is an additional risk factor. Competitive pressures coupled with an increase in sales of consumables, the product category with the lowest gross profit rate, could put pressure on overall gross margin. DG’s gross margin improved in FY16, helped by lower transportation costs, but it ended the year about 100 basis points lower than in FY11. Gross margin declined by 11 basis points in FY17, 8 basis points in FY18, and 30 basis points in FY19, as a result of a higher mix of consumable products, which is a lower margin category, and increased promotional activity. Gross margin improved by 14 basis points in FY20 helped by higher initial markup.
Dollar General must balance the need to expand its store count with the risk of growing too fast – which has been a problem in the past. The company currently has more than 16,000 stores, representing slightly more than half of the comparable U.S. dollar-store market. Management opened approximately 900 stores in FY17 and a net 1,200 new stores in FY18. DG opened about 900 stores in FY19 and 917 stores in FY20. The company plans to open approximately 1,000 new stores in FY21.
The economy is a risk for all retailers because of their sensitivity to changes in consumer discretionary spending. Low gas prices will put more discretionary money into consumer’s pockets, but one risk perceived by some investors is that lower gas prices could make shoppers more willing to drive longer distances to grocery stores or superstores. Deflation can also be a challenge as it can reduce unit revenue on selected products such as groceries.
The company’s two biggest suppliers each accounted for about 8% of purchases in FY20. The company directly imported approximately 6% of its purchases in FY20.
The company is subject to litigation, as detailed in the annual report.
About 75% of DG stores are in communities with populations of less than 20,000. Total selling space is approximately 108 million square feet, and individual stores have approximately 7,400 square feet. The current year, which we call FY21, is a 52-week year ending on January 29, 2021.
DG shares are up 36% this year. We would consider raising our rating if the shares dipped below $190.
What are some issues with this analysis? We’re using 10 years of combined growth and transition. Maybe DG can grow for longer than this. That would raise the value. On the negative side, the current FY21 is a big year for earnings growth, and it is fair to wonder if the company can grow at 11% from our FY22 estimate, which is 42% above what the company earned in FY20.
DG is a rare company that is growing square footage and delivering positive comparable sales. It also appears to be well positioned to weather the COVID-19 crisis. We believe those expectations are adequately reflected in the scenario above. The shares appear to be fairly valued.
On December 8 at midday, HOLD-rated DG traded at $212.25, down $1.11.