Dollar General’s Resilient Business Model Hard Not To Like (NYSE:DG)
By The Valuentum Team
On May 26, Dollar General Corporation (NYSE:DG) reported first quarter earnings for fiscal 2022 (period ended April 29, 2022) that beat both consensus top- and bottom-line estimates. Even in the face of major supply chain issues and inflationary headwinds, Dollar General modestly increased its net sales and same-store sales growth guidance for fiscal 2022 and maintained its other forecasts.
We are big fans of Dollar General’s resilient business model, strong cash flow profile, and its various strategic initiatives, including rolling out new store concepts, expanding into Mexico, improving its distribution operations, upgrading its digital operations, adding checkout kiosks and additional cooler/freezer capacity to its stores, and adding new offerings to its stores (including produce, frozen foods, and non-consumable items).
Our fair value estimate sits at $234 per share of DG with room for upside potential to ~$292 based on the high-end of our fair value estimate range. Shares closed Friday, June 24, 2022, at ~$248 per share. Shares yield ~0.9% at the time of this writing.
Dollar General’s Investment Considerations
Dollar General is the largest discount retailer in the U.S. by number of stores with over 17,900 neighborhood stores in 46 states. It provides products that are frequently used and replenished such as food, snacks, and health and beauty aids. The company helps shoppers: ‘Save time, Save money, Every day.’ It was founded in 1939 and is headquartered in Tennessee.
Dollar General’s strategy is built on catering to regions that e-commerce operations are less viable in, particularly towns with populations of 20,000 or less. The company intends to open its first ten stores in Mexico by the end of fiscal 2022.
Dollar General’s strategy involves steadily growing its unit store count, rolling out new store concepts in select U.S. markets (such as pOpshelf and larger Dollar General store formats), and more recently, expanding into Mexico. The firm is also growing its cooler and freezer capabilities, and aims to increase its higher-margin non-consumable product sales as well.
In October 2020, Dollar General announced a new store concept, pOpshelf. These stores sell a variety of products ranging from the realm of home décor to health and beauty, among other things. If successful, this new store concept could significantly extend Dollar General’s growth runway.
Through its DG Fresh initiative, Dollar General shifted towards the self-distribution of perishable products, namely fresh and frozen food. In fiscal 2021, Dollar General completed the initial DG Fresh rollout across its entire store base and supply chain.
Assessment of Dollar General’s Latest Quarterly Report
In the fiscal first quarter, results released May 26, Dollar General’s GAAP net sales grew 4% year-over-year as growth in its net store count offset a marginal decline in its same-store sales. Dollar General’s same-store sales were negatively impacted by a decline in customer traffic, which was largely offset by growth in its average transaction amount. An increase in same-store consumable sales offset declines in its other categories (seasonal, apparel, and home products), though this dynamic weighed negatively on its margins as sales of non-consumable products generally carry stronger gross margins than sales of consumable products.
Dollar General’s GAAP gross margin shifted lower by ~150 basis points year-over-year in the fiscal first quarter due to unfavorable product mix shifts, inflationary pressures from higher product costs and distribution expenses, and increased inventory damages. These factors were only partially offset by higher inventory markups. Rising SG&A expenses as a percentage of net sales along with declines in its gross margin saw Dollar General’s GAAP operating margin shift lower by ~230 basis points year-over-year in the fiscal first quarter. Its GAAP diluted EPS came in at $2.41 in the fiscal first quarter, down from $2.82 in the same period the prior fiscal year as a decline in its GAAP net income was only partially offset by a 4% reduction in its outstanding diluted share count.
The discount retailer is contending with multiple headwinds, along with difficult year-over-year comparisons due to the banner performance Dollar General put up in fiscal 2020 and fiscal 2021, though its guidance for fiscal 2022 remains strong. Dollar General now expects to generate 10.0%-10.5% annual net sales growth (up from 10.0% previously) in fiscal 2022 due primarily to a combination of forecasted same-store sales growth, ongoing growth in its net store count, and the favorable uplift from an extra reporting week. Please note that fiscal 2022 includes a 53rd week, with the extra week expected to add ~200 basis points to its annual net sales growth figure.
Management reiterated Dollar General’s plans to spend $1.4-$1.5 billion on capital expenditures this fiscal year to complete 2,980 real estate projects, including opening 1,110 new stores, 1,750 store remodels, and relocating 120 stores, among other initiatives. Additionally, Dollar General now expects to generate 3.0%-3.5%
annual same-store sales growth in fiscal 2022 (up from 2.5% previously).
Furthermore, Dollar General maintained its diluted EPS growth guidance of approximately 12%-14% on an annual basis in fiscal 2022, with the 53rd week adding ~400 basis points to that growth forecast. Dollar General reiterated plans to repurchase $2.75 billion of its stock this fiscal year. We appreciate the company’s confidence in its near-term performance and its resilient operations through thick and thin.
Dollar General’s Economic Profit Analysis
The best measure of a company’s ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm’s economic profit spread. Dollar General’s 3-year historical return on invested capital (without goodwill) is 46.5%, which is above the estimate of its cost of capital of 9.5%.
As such, we assign Dollar General a ValueCreation rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate. We like Dollar General’s ability to generate value for shareholders.
Dollar General’s Cash Flow Valuation Analysis
During its fiscal first quarter 2022, Dollar General generated $168 million in free cash flow and spent $125 million covering its dividend obligations, along with spending $747 million buying back its stock. The company experienced an enormous build in its working capital last fiscal quarter (due primarily to Dollar General bulking up its merchandise inventories), though the firm was still able to generate substantial positive free cash flows.
One of Dollar General’s biggest downsides is its net debt load, which stood at $4.5 billion (inclusive of short-term debt) at the end of its fiscal first quarter along with other non-cancellable financial liabilities. We view that burden as manageable given its ability to generate substantial normalized cash flows. Dollar General generated ~$2.0 billion in annual free cash flow on average from fiscal 2019-2021 and its run-rate dividend obligations stood at ~$0.4 billion in fiscal 2021.
However, in our view, we think it would be prudent for management to remove their foot from the gas pedal as it concerns the firm’s share repurchase program. Dollar General is contending with various exogenous shocks while pursuing multiple strategic initiatives and the firm has a net debt load to consider. Improving its financial strength would be a better use of its capital in the current environment.
During Dollar General’s latest earnings call, management had positive qualitative comments on the discount retailer’s push into Mexico, its first store international expansion. The firm aims to open up to ten stores in Mexico by the end of fiscal 2022 and maintained that goal during its latest earnings update. We are keeping a close eye on its international expansion efforts given how, if successful, these efforts could significantly extend Dollar General’s growth runway though these are still early days.
When it comes to our discounted cash flow valuation, we think Dollar General is worth $243 per share with a fair value range of $194-$292 per share. The margin of safety around our fair value estimate is driven by the firm’s LOW ValueRisk rating, which is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them.
Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 6.6% during the next five years, a pace that is lower than the firm’s 3-year historical compound annual growth rate of 12.9%.
Our valuation model reflects a 5-year projected average operating margin of 10.6%, which is above Dollar General’s trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 4.7% for the next 15 years and 3% in perpetuity. For Dollar General, we use a 9.5% weighted average cost of capital to discount future free cash flows.
Dollar General’s Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate Dollar General’s fair value at about $243 per share, every company has a range of probable fair values that’s c
reated by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn’t see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Dollar General. We think the firm is attractive below $194 per share (the green line), but quite expensive above $292 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion. Dollar General’s shares have upside potential to the high end of the fair value estimate range, to $292 per share, in our view.
Dollar stores sell a variety of inexpensive bargain goods, items that generally will not make sense economically to be distributed via e-commerce given the shipping costs. The ease at which consumers can visit their local dollar store (and the collection of low-priced goods in one place) is also a big advantage. Dollar General’s business model has proven to be incredibly resilient in the face of numerous exogenous shocks including the Great Recession and the COVID-19 pandemic (seen through its strong same-store sales performance during these crises). The company’s impressive free cash flow generating abilities support its robust Dividend Cushion ratio.
Dollar General is steadily growing its unit store count, rolling out new store concepts in select U.S. markets, and more recently, announced plans to expand into Mexico. The firm’s balance sheet health is not what we would like it to be for a retailer in the midst of such growth plans (we always prefer a net cash position), but free cash flow generation should be sufficient in handling its net debt load and expansion plans, in our view. Free cash flow covers the dividend nicely. We would only expect management to keep raising the payout and buying back shares, though we would like to see some deleveraging a bit. The dividend is solid, nonetheless, and it’s hard not to like the resilience of Dollar General’s business model. Shares have upside potential.