Dollar General Stock Analysis
Analyzing Dollar General, a mid-cap retailer selling below 2/3 its fair value
Normally I do not pay too much attention to retailers, but a few have looked cheap. I have written about Big5 Sporting Goods, Walgreen’s, and a couple of weeks ago I profiled Dollar General. DG looked like a better business than the other two retailers I’ve looked at, and the valuation appeared attractive so I spent the last week digging deeper. The company is definitely out of favor right now, but I think shares a trading more than 2/3 below their fair value.
Business Description
Dollar General is the largest retailer by store count. At the end of 2013 DG had 11,132 stores, now they have 20,345. The company operates stores that are much smaller than a supermarket or Wal-Mart, so it is cheap to open a new store and DG can open stores in less densely populated areas. About 80% of Dollar General stores are in towns with less than 20k population. DG has a focus on rural areas, and slightly more geographical emphasis on the South. However DG has a wide footprint and does penetrate suburban and urban markets.
Dollar General breaks out their sales into four categories: consumables, seasonal products, home products, and apparel. Last year consumables were 81% of sales, seasonal 10.6%, home products 5.6%, and apparel 2.8%. The ratio of consumables sales has slightly risen over the last year or so, suggesting low income shoppers are pulling back from the other items. Seasonal and home products have higher gross margins than consumables.
A large portion of DG shoppers are low income or fixed income. The average customer income is less than $35k, and typically customers spend $15 when they visit Dollar General. The shopping patterns of the customers vary. Some buy a couple of items like a convenience store, or maybe they ran out of laundry detergent and don’t feel like driving all the way to Wal-Mart. Others shop at DG more akin to a grocery store.
Looking at the stock price, it peaked at $257 in November 2022, fell down to $105 in September 2023, recovered a bit, then fell further down to its current price of $78. The recent turbulence has distracted the fact that DG has been quite the growth stock. I already mentioned that stores have nearly doubled in the past 10 years. Revenue was $18.9B in 2013, now $38.7B, which is a CAGR of 7.4%. Same store sales has grown every year since 1990, except for 2021 where sales normalized after a big bump during COVID. However same store sales have slowed recently, which is part of the negativity around DG.
Todd Vasos was CEO for 7 years during DG’s boom times. He retired in 2022 at a pretty young age as far as CEOs go. The term of replacement CEO Jeff Owen coincided with DG’s stock cratering, so he did not last long. Todd was brought back on as CEO in October 2023. Hopefully Todd’s experience can right the ship.
Moving to shareholder returns, last years dividend amounted to $518M. Dollar General usually pays out 15-20% of cash from operations as dividends. Currently the stocks dividend yield is 3%. Before 2021 DG was spending around $1B a year in buybacks, then 2021-23 they were spending over $2.5B. Last fiscal year they spent zero on buybacks. I do find it annoying that the company was buying back lots of stock when it was at a much higher valuation. If the company has the resources, I hope they can start doing buybacks soon with the stock trading at a much lower valuation.
Why its Cheap
There seems to be several reasons why Dollar General has sold off over the past year. First, DG traded at premium multiples because it was a fast growing company. Now there is a belief that the company is reaching a saturation point where opening new stores won’t be as profitable. Increasing store counts is one way to grow sales, but increasing sales in the existing stores is the other half of the equation. Last quarter, same store sales was only 0.5%, which is pretty bad compared to historical results. When a stock is deemed a “growth stock” and trades at high multiples due to the growth, things can get ugly if the growth disappoints expectations. As I will get to later, I think Dollar General’s current valuation makes sense even if you don’t assume much growth.
The other headwind DG is facing is a slight deterioration in their financial performance. Lately there has been small declines in gross margin. Part of that is due to inventory shrink, and increased distribution costs. The management has mentioned an effort to increase efficiencies in their distribution network. As for inventory shrink, DG is rolling back its use of self-checkout and increasing employee count in the store.
Operating margin has seen pressure, declining to 5.3% last quarter compared to the historical range of 8-10%. The reasons for this decline include labor costs, increased construction costs, and increased use of discounting to maintain sales.
Another aspect is that low income consumers are adjusting their spending decisions due to economic conditions. Thinking back to Capital One’s latest earnings call, the consumer as a whole is in pretty good shape, but low income consumers are feeling the impact of inflation and reduced savings built up from stimulus money. So Dollar General’s core demographic is pulling back on spending for higher margin home goods items and conservatively buying the lower margin consumables products. In the past, when the economy is weak, middle class consumers trade down from shopping at more expensive stores to shopping at DG. This has not happened yet since the job market is decent and middle class is handling inflation better than the lower class.
As inflation settles down and consumer confidence increases, I think Dollar General’s margins will improve. I don’t think they will necessarily revert back to the top end of historical levels, but 7% operating margins seems doable.
Valuation
When valuing a company, I look at its return assets and profitability to decide the best valuation method to use. Historically Dollar General has had return on assets around 10%, which is higher than their cost of capital. As I mentioned before, they have been growing faster than the general economy. This suggests DG has a competitive advantage and could be valued using the growth return method. I think DG is/was a good business, but I’m not sure that they have any sustained competitive advantage. For the sake of being conservative, I will value Dollar General without factoring in growth.
After doing more research on Dollar General, I don’t see any reason to change the much of the assumptions I made in my original writeup of the company. DG’s management guidance is 5% sales growth from last year, which gets us $40.6B in sales this year. Morningstar’s analysis on DG suggested a 7% operating in the medium term, so I’ll use that figure. That gets $2.84B in operating income. Next, DG usually pays a 22% tax rate so that gets an after tax income of $2.22B.
Dollar General has a BBB credit rating, which means their cost of debt is about 5.3% right now. Historically DG has traded around a price to earnings ratio of 20, implying a 5% cost of equity. A few years ago, the market would be baking in continued growth and the low interest rates at the time to get this low cost of equity. With higher rates, conservatism on future growth, I think a 7% cost of equity is reasonable for Dollar General. DG’s long term debt is about 20% of its assets, so factoring in this ratio of debt and equity, I think Dollar Generals cost of equity is 6.7%.
Dividing the after tax income by 6.7% gets an enterprise value of $33.1B. Adding DG’s $1.2B in cash and subtracting $7B in long term debts gets an equity value of $27.3B. With 220M shares outstanding, my estimated equity value comes out to be $124 a share. Dollar General’s stock is currently trading around $77.50, which is more than 2/3 below its fair value.
Looking through all the negative noise around Dollar General, I think the main risks are that their financials worsen or take a while to improve. Same store sales growth has been weak, but if it turns negative then there should be a very compelling reason or else its a red flag. While I think margins will eventually improve once inflation settles down, who knows how long that will take. An investor would need to be patient instead of thinking the situation will improve next quarter. The key things to keep tabs on is inflation and the health of low income consumers.
Conclusion
Lately I have looked at a couple of other cheap retailers such as Big5 Sporting Goods and Walgreens. Big5 had a large ramp up in sales during COVID and now sales are falling below 2019 levels, while its larger rival Dick’s Sporting Goods continues to increase sales. So there is a lot of uncertainty whether Big5 is seeing a temprorary correction or a secular decline. Walgreen’s also look cheap, but most of its sales comes from the pharmacy, not the retail store. The pharmacy business does not look good so I am not interested in the stock. Dollar General is still growing and still profitable, just a little less than it was. Unless things deteriorate further, Dollar General looks like a solid business facing temporary headwinds causing it to be very out of favor with the market. Based on my assumptions, Dollar General seems to be trading at a large discount to its fair value. A few days ago started buying shares and will continue to build a position.
Stocks Mentioned: DG 0.00%↑ BGFV 0.00%↑ WBA 0.00%↑
Agree with your thoughts. DG and FIVE stocks are undervalued, in my opinion, and I'm watching carefully for any developments.