2024-01-02 07:30:00 ET
Summary
- Dollar General’s financial results have materially declined during the last 3 quarters, owing to cracks in its business model and a continued weakening of macroeconomic conditions.
- We are expecting headwinds such as shrink and markdowns to subside in the coming 12 months, although this will not be sufficient to revert to its historical levels.
- Management must invest in its customer experience and growth strategy, which will involve a strategic overhaul of its store expansion approach and store experience.
- Despite the weaker financial performance, DG continues to outperform its peers, which is important context for the long-term quality of DG. We do expect Dollar General to continue to outperform, although not to the degree historically.
- DG stock is trading broadly in line with its fair value in our view, suggesting execution risk is not rewarded.
Investment thesis
Our current investment thesis is that we are not yet questioning the fundamental quality of Dollar General Corporation ( DG ), although do believe a decade of chasing growth and superior margins has left the business in a position of weakness.
We expect the coming 5 years to involve slower growth and lower margins/FCF, although will still be competitive compared to peers. Once over this hurdle, the room for growth should improve, but is highly dependent on how Management overcomes its store growth issues.
We do not see upside at its current valuation. Given the execution risk and recent share price expansion, we suggest patience.
Dollar General overview
Dollar General 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.
Recent developments
DG has experienced an incredibly tough 2023. The company’s share price is down ~45% relative to this time last year, at a time when much of the market has struggled with economic conditions. This said, as the below graph illustrates, the pain has been disproportionately felt relative to both its peers and the S&P 500.
In response to this, DG has rehired its longstanding CEO Todd Vasos, with a restructuring process underway to revitalize the business. This is a strong response given the rapid decline in fortunes.
Within this paper, we will discuss the primary reasons for this and whether this represents an opportunity to acquire DG at an attractive valuation.
Financial analysis - Quarterly
Presented above are DG's financial results for the last 8 quarters.
Revenue & Commercial Factors
Dollar General’s revenue growth has ground to a halt in recent quarters on a same-store basis (”SSS”), with growth of +1.6%, (0.1)%, and (1.3)% in its last four quarters. This is incredibly disappointing given the positive impact of inflation thus far, driving the price component of sales.
Top-line growth remains positive, primarily due to new store expansion. During the last decade, DG has grown revenue at a CAGR of +9%, which is still above the LTM rate (+3%).
We consider these results highly disappointing. We have analyzed a number of discount retailers across many industries and generally believe the current economic conditions to be beneficial for the discount segment. Consumers are seeing a squeeze on finances, encouraging them to trade down and seek deals.
Management attributes this slowdown in growth to the following factors (We have split these between near-term headwinds and fundamental concerns).
Headwinds:
- Inventory shrink - DG has been negatively impacted by inventory shrink, which is an issue that has significantly increased in the last 12-24 months across many industries, as consumers grapple with a cost-of-living crisis. As disinflation continues and the US moves closer to a decline in interest rates (signaled for 2024), there is hope this should subside in the coming quarters.
- SSS decline across segments such as home - A key driver of the decline in SSS is softening home spending. We again attribute this to the current macro environment, which is heavily dissuading home purchases. In the US, home prices have remained robust despite a significant decline in activity, suggesting consumers are able to avoid selling (thus maintaining their wealth rather than crystalizing the decline in value). This positions DG well for an improvement in sales once rates begin to decline.
- Lower inventory markups and increased markdowns - This is partially a reflection of the concerns discussed below, as we as the compounding effects of an extended period of high inflation/interest rates. Consumers are unable to bear the consistent price inflation across their outgoing expenses, leading to an inevitable “breaking point”.
Broadly, we believe these factors will begin subsiding in the coming year, with the majority ceasing to be a material issue come the end of 2024. This should allow DG to return to SSS positivity in mid-to-late 2024.
Fundamental concerns:
- Softening customer traffic and transaction value - DG has struggled to maintain transaction value and customer traffic, which is particularly concerning because US retail sales remain positive. When considered in conjunction with our expectation for discount retailers to remain robust, this is highly disappointing and a reflection of a fundamental weakness in the company. We have seen numerous critiques of its stores’ experience, with limited staff availability (likely impacting shrink), unattractive store visuals, and uncompetitive product types.
- Store closures - Management has also closed a number of stores and is forecasting a meaningful reduction in new store growth. This is part of a broader issue around its store strategy. Many have suggested DG is suffering from cannibalization, with the proximity of its stores contributing to a downward pressure on average sales. The company has aggressively grown during the last decade and has potentially neglected strategic positioning in favor of gross sales generation.
Management has been tight-lipped on its turnaround strategy, although will involve:
- Increased recruitment and training - In response to increased shrink and poor customer feedback, DG is investing in the customer experience. Given wage inflation, this will likely have a negative impact on margins.
- Reduction in SKUs - Offsetting its investment in quality, Management is seeking to reduce SKUs as a means of protecting margins, particularly in consumables, where it is less competitive. Inventory turnover remains below its historical average of ~4.6x but should begin to improve.
- Reduced store openings - Management is switching focus from quantity to quality, a correct move in our view, although will lead to a softening of its long-term growth trajectory.
- Revitalization of existing stores - In conjunction with an investment in staff, Management is investing in its store experience, as evidenced by an uptick in capex spending as a % of revenue. This will likely act as a short-term drag on cash.
Overall, we are positive about the actions taken by Management, although note almost every identified action will contribute to a near-term weakness in financial results to deliver the improvement.
Margins
The factors discussed above, namely shrink and markdowns, have contributed to a decline in margins. Historically, DG has boasted impressive consistency, although we believe it will struggle to revert to these levels in the next 5 years.
The industry is highly competitive and DG has neglected investment in its services, which will now contribute to a higher cost base. We suspect the company will normalize at a lower level, although economies of scale and efficiencies will sequentially drive improvement.
Fundamentals
We believe DG, and the discount segment, remain fundamentally attractive. Consumers have been consistently turning to discount retailers, particularly post-GFC, with the current climate post-pandemic likely to accelerate this in the decade to come. Although its store locations are not optimal, it has unrivaled reach in the US, positioning it well to capture this growth.
Further, DG services geographies that are underserved by the leading retailers, allowing it a strong competitive position from a pricing and demand perspective. This does not guarantee growth but does allow for resilience and incremental improvements.
Finally, Management has done well to respond to industry trends. The company has aggressively expanded its online presence and product offering, ensuring it remains the go-to retailer for consumers in the face of changing trends and competitive dynamics.
Dollar General balance sheet & cash flows
Dollar General has historically utilized its cash by repurchasing shares and paying a small dividend, with expansion funded through capex commitments of ~3% of revenue. In order to maintain growth, DG has persistently issued debt, increasing its ND/EBITDA ratio from 1.1x in FY14 to 3.1x in LTM Oct23.
The issue for DG is that now it has faced a slowdown, it cannot maintain this strategy (repurchases have been paused for 3 quarters thus far), particularly due to the cost of debt rising. We previously covered this stock in Mar23, stating that distributions would have to slow. Following recent developments, this may be more pronounced.
Many businesses have followed this strategy of laddering debt with low interest rate notes. This is not the last business to find itself in an uncomfortable position. With a ND/EBITDA ratio of 3.1x, DG does not have room for substantially more debt.
Outlook
Presented above is Wall Street's consensus view on the coming years.
Analysts are forecasting a decline in growth relative to its historical average, in conjunction with its margins normalizing at a lower level. We concur with these forecasts following DG’s change in fortunes, with reduced store growth required and investment in staff.
It is worth noting that EPS has been revised down 29 times, with only 5 upward revisions. It is clear DG is in a negative spiral that has not necessarily ceased yet.
Industry analysis
Presented above is a comparison of Dollar General's growth and profitability to the average of its industry, as defined by Seeking Alpha (10 companies).
We highlight this comparison to contextualize DG’s struggles. Despite a noticeable decline in financial performance, it remains more profitable than its peers and its growth rate is comparable.
This exemplifies that DG is still a fantastic business but future expectations must be adjusted for what will likely be a degree of reversion toward the mean. This is inherently unsurprising given the gulf of outperformance.
DG stock valuation
Dollar General is currently trading at 13x LTM EBITDA and 15x NTM EBITDA. This is a premium to its historical average.
A premium to its historical average is undeniably unwarranted. We believe this is a reflection of investor expectations for an imminent improvement in performance alongside subsiding headwinds in the coming 12 months.
Further, DG is trading at a small discount to its peers on an LTM EBITDA basis, a significant reversal from the premium during the post-pandemic period.
DG’s valuation is at an inflection point that is shrouded in uncertainty. Management’s ability to execute a rapid improvement alongside the subsiding of headwinds will have a material impact on where its valuation normalizes.
Currently, we suggest pricing the business based on its NTM indicators. FCF yield is 1.4ppts below its average while the NTM EBITDA premium is ~16%.
Our base case is that Management execution will be slower than expected but coincide with declining headwinds. This will allow for growth to return, although margins will normalize at a lower level. Based on this, we see a trading EBITDA multiple of ~14x (Ceteris paribus).
In our prior analysis, we assessed fair value as 17x EBITDA (based on a DCF analysis). Assuming a 15% discount for the decline in financial performance (~14x), the company is likely broadly in line with its fair value when pricing in risk.
Key risks with our thesis
The key risk to the business is a combination of execution risk, although slightly lowered due to the return of its proven CEO, alongside how economic conditions develop in 2024.
Final thoughts
Dollar General’s impressive trajectory has been completely derailed in the last year. Much of this is likely attributable to the direct and indirect impact of the wider macroeconomic environment, as the “good times” likely masked the weaknesses in DG’s business model.
Whilst this paper has been broadly negative on the issues experienced by DG, we do believe this is fundamentally a strong business that will continue to outperform its peers due to its inherent strengths and market position.
This said, the coming 12-24 months will be difficult, and its 5 year period will likely be worse than its prior decade.
Given the limited upside at its current valuation, we suggest investors await progress.
For further details see:
Dollar General: Why Things Have Gone Wrong And If A Revitalization Is Possible