2023-03-07 09:29:23 ET
Summary
- Dollar General Corporation is a discount retailer that operates in the United States.
- DG has navigated the current economic conditions well, experiencing growth while retail stagnates.
- Management expansion has yielded impressive growth in the last decade, with our view that outperformance can continue.
- Profitability is attractive relative to other retailers, with investors likely to see gains through distributions.
- The company is slightly too expensive currently given the backdrop and the need to reign back distributions. We thus rate DG stock a hold.
Company overview
Dollar General Corporation ( DG ) is a discount retailer that operates in the United States. The company offers a variety of merchandise products, including consumable products, as well as snacks, health and beauty products, pet supplies, and seasonal products such as holiday items and toys. Additionally, DG offers home products such as kitchen supplies and apparel.
Share price
DG's share price performance has been fantastic in the last decade, gaining over 300%. This has been driven by greater demand for discounted products and DG's ability to service this demand. The company has grown impressively during a time when brick-and-mortar retailers have struggled.
With markets weakening and the stock price ticking down from its ATH, now is a great time to consider if DG remains an attractive investment proposition. Our analysis will focus on considering the company's financial performance, alongside key trends impacting the retail space. This will help us take a view of how well the company will perform in the coming years. Finally, we will conclude with a comparison to other retailers in the US, to assess the relative attractiveness of the business.
Economic conditions
Current economic conditions are marred by heightened inflation levels, which is a result of supply-chain issues and robust demand post-lockdowns. This has contributed to a decline in consumer discretionary income as living costs rise. As expected, consumers have cut back spending for many goods in response to this as they position their finances more defensive in anticipation of things worsening. Elevated interest rates have only compounded this issue as the cost of borrowing rises substantially. Due to this, many of DG's competitors have seen softening demand and are guiding weaker sales. This is not the case for DG, who has seen quarterly sales continue to remain resilient, gaining marginally Q/Q. In the most recent quarter, sales were up 11.1%. This is due to DG's pricing superiority relative to its competitors. As a discount producer, the company is seeing growth as consumers look for cheaper alternatives to the products they are currently consuming. This may not necessarily continue but our view is that demand show remains strong regardless. This positions DG as a strong defensive choice during market downturns.
Looking ahead, our view is that conditions will likely weaken further as inflation is remaining stubborn. It is inconclusive as to whether rates will have to increase further but regardless, softening demand is expected. This should allow DG to gain further market share from its competitors and continue to grow, although not necessarily at the levels in prior years.
Another economic factor impacting DG is inflationary cost increases. As we have mentioned, the supply side has contributed to inflationary pressures due to issues expanding production following the end of lockdowns. For DG, this has contributed to rising transportation and other supply-side costs, leading to a decline in margins. Although these pressures are beginning to ease, we could see margins tick down further in FY23.
E-commerce
While DG has historically been focused on physical stores, the rise of e-commerce has presented a challenge to the business, requiring an adjustment to its strategy. The problem for the likes of DG is that these online businesses lack store overheads, allowing them to price more competitively and gain market share quickly. DG has done well to expand its online presence but still earns the vast majority of its revenue through stores. Interestingly, DG's in-store demand has remained strong despite the soft online offering which goes against the trend seen by many other retailers. Most retailers have seen softening in-store sales while e-commerce has grown quickly. The reason is that their target audience is not those who care about the benefits of e-commerce, with consumers seemingly happy to forego the convenience in exchange for DG's attractive pricing. This bodes well long-term as it shows the company's resilience against arguably the biggest threat to its wider industry.
Convenience and accessibility
Touching on DG's strategy further, the company has focused on continually improving its core target's accessibility to its stores. DG looks to service low-earning households who care about value for money. DG has been opening stores in rural and suburban areas where there are few other retail options, allowing the business to be the first choice for many consumers. This allows the company to easily gain growth in areas in which it faces less competition. Many of the company's competitors do not care about servicing these areas due to the low growth and margins that will come with it. This has shown itself to be a successful strategy so far as DG is focusing on a segment of the population that is seemingly underserved, reducing competition. This comes with relatively low risk, with the cost of a new store far below that of other retailers .
Expansion of product offerings
Dollar General has been expanding its product offerings beyond traditional discount products, into such items as foods. This perfectly complements its store expansion as many consumers find convenience and thus value in being able to shop for a host of products in one place. From DG's perspective, they can upsell products that consumers would otherwise buy from elsewhere, purely by having the products in view of consumers. Further, in those locations where they are one of a few retailers, DG can easily sell more as consumers find themselves with little choice. DG can compete on price with almost any big-box retailer, let alone a local business.
Overall, DG's strategy is fantastic in our view. It is focused on the long-term development of the business while being defensive in nature. The company does not face a material risk from e-commerce or the economy while exploiting industry weakness in its core segment.
Financials
Presented above is a breakdown of DG's financial performance in the last decade. The overall assessment is very positive, with growth on the top and bottom lines.
Revenue has grown at an impressive rate of 9%, driven by both aggressive expansions of their geographical footprint in the US and same-store sales. In the most recent quarter, DG achieved 6-7% same store-sales, which is an incredible performance during such times. Our view is that consumers are flocking to the business more and more as their financial position deteriorates. Looking ahead, our view is that strong growth should continue, as Management continues this strategy of expansion.
With a business that targets the discount segment, margins are not going to be groundbreaking but the company has done well to keep these under control. GPM has remained flat at c.31%, with a decline in the most recent periods as a result of rising costs. Taking a conservative view, it is likely margins may slightly tick down further in the coming year but stabilize and increase from then on.
S&A has grown in line with revenue, driven by labor and compensation costs, as well as occupancy costs. We would like to have seen some scale economies here, which the company has seemingly been unable to achieve. For this reason, DG's EBITDA margin has remained flat across the historical period.
Capex has contributed to the lower FCF in the current period, with the company remodeling 485 stores and opening 268.
Overall, the company produces a pretty attractive income. The company can achieve a resilient EBITDA margin, alongside FCF conversion in the region of 4-7%, when factoring a normal level of capex. When marrying these moderate margins with the current growth, DG looks fantastic.
Moving onto the balance sheet, the company has aggressively increased its debt, as a means of growing the business and funding distribution to shareholders. This might look concerning but our view is that a 3x ND/EBITDA ratio is as far as a company should go, leaving some margin remaining. Alongside an 18x coverage of interest payments, we see no liquidity issues.
This does mean distributions will need to decline, with the company now unable to fund the current year's expenditure again. Assuming a similar FCF to FY22 in FY23, DG would have a total war chest of $2BN. When compared to a total distribution of c.$2.6BN in the LTM period, we could see a decline in the region of 35-55%. This is not ideal for investors clearly but we are seeing a similar pullback from a host of mature businesses.
Outlook
Based on our qualitative analysis, our view is that the company can continue anywhere between 5-10%, purely through store expansion supported by soft same-store growth. With economic conditions unable to materially break margins, it is reasonable to assume these will continue at their current level with potentially some improvement through efficiency. Finally, FCF should begin to aggressively improve as capex spending should soften compared to the current levels.
To summarize, our view on the next 5 years are:
- Revenue growth of 5-7.5%.
- GPM and EBITDA margins at current levels, increasing by 100bps over several years.
- FCF margin improving to 6-7% by FY27.
Peer comparison
Presented above is a cohort of brick-and-mortar retailers with their key financial metrics.
DG performs fairly well against these businesses. The company is equally as profitable on an EBITDA level while producing far superior growth. Only Target ( TGT ) performs at a similar level but is not forecast to grow as quickly, owing to DG's aggressive store expansion.
Valuation
DG's fantastic financial performance and strategic success are reflected in the company's current valuation, with the business trading at a noticeable premium to the cohort chosen.
Our view is that an EBITDA trading premium beyond 10% looks to be a stretch and so on a relative multiple basis, the company looks overvalued by 6%.
The company's cash flows look far more attractive, however, with our DCF suggesting a 3% upside. Our key assumptions are:
- An average revenue growth rate of 6%, followed by perpetual growth of 2.5%.
- A FCF conversion initially of 4%, trending up to 6%.
- An exit multiple of 14x, which is in line with the company's historic average, as well as a discount rate of 6%.
We are least confident about our final 2 assumptions and so present the following sensitivity analysis.
Final thoughts
DG's Management is laser-focused on executing a great growth strategy, achieving impressive financial results. Importantly, the company has shown itself to be robust. Growth continues during weakening demand and e-commerce has not hurt the business. These are the hallmarks of a long-term compounder. The company is not perfect, however. Excessive distributions in past years mean the company will likely need to slow down and the company commands a rich valuation. Finally, the valuation leaves investors no headroom if the company does see growth slow to a halt, which is not out of the question. Our view would be that the stock price may trend down as investors reprice the asset to reflect a lower level of dividends/BBs. We thus rate the stock a hold.
For further details see:
Dollar General: Long-Term Win But Expensive