Description

Today DG discounts several near-term concerns depressing FCF. Due to inflation and economic uncertainty (plus a reset from stimulus), the consumer has shifted towards lower-margin consumable products as DG is facing increased capex, working capital, and SG&A investments. Things don’t look good for dollar stores in 2023. This provides an opportunity to buy a strengthening business below a market multiple that has a path of reasonable certainty to consistent double-digit EPS compounding and much higher FCF conversion in 3-5 years:

• Inflation is straining DG’s low income consumer and challenging gross margins. This is impacting DG’s high margin discretionary sales from the stimulus enhanced levels of 2021. Traffic has been soft.

• The dollar store business is trending more competitive, with both DLTR and DG increasing investments in SG&A and wages. This will likely be a headwind to 2023 margins with incremental investments possible.

• Construction costs for new store and distribution projects have risen materially. This has led to a significant step-up in 2023 capex along with incremental owned-fleet investments, and a subsequent reduction in FCF for buybacks.

• Working capital in inventory has ballooned as a % of sales due to product-cost inflation, greater mix of higher-value items due to discretionary initiative rollouts, and early receipt of goods. This has also reduced FCF.

• A poorly managed buyback program is disappointing for ongoing shareholders and a red flag for prospective shareholders.

On the other hand, there are positives happening for DG with the low/middle income consumer, competitive positioning, and opportunities to deploy capital at attractive returns.

• DG’s core customer is feeling the strain of rising costs of essentials, but they’re making more money.

  • Weekly earnings growth is highest at lower income brackets, with strong employment, and the majority of layoffs are occurring at tech companies and white collar jobs, with ongoing hiring challenges at lower paying service jobs shows there’s still meaningful employment available for DG’s customer profile. https://www.wsj.com/articles/its-a-richcession-not-a-recession-heres-your-investing-playbook-ddffb60?mod=hp_lead_pos10

• DG is seeing higher income demographic profiles shopping at an increasing rate as consumers are showing trade-down in grocery (Wal-Mart has also called out)

  • DG has reported continued share gains in both consumable and nonconsumable categories

  • $100k+ income customers are shopping DG more frequently. This is a testament to DG’s expanded assortment of fresh and discretionary goods at sharp price points from initiatives rolled out in recent years

    •  A similar trend occurred in the 2007-2010 time period, where DG was challenged initially as its core customers were strained by rising costs but then saw new customers from higher incomes hoping to stretch their wallet. Above average comp sales followed

    • DG’s assortment has never been more relevant to higher earning demographic customers than it is today, with additional assortments in Fresh, frozen, health, and non-consumable categories. DG has an opportunity to gain $100k+ income shoppers that have been set-back by inflation and that will drive discretionary sales in the future

  • Discretionary sales and gross margin are likely nearing a trough as inflationary pressures push customers toward consumable while also impacting product costs

    • Today, DG’s sales mix is near 80% consumable vs 77% pre-covid five year avg despite numerous non-consumable product rollout initiatives (NCI) and assortment upgrades over the last few years. These initiatives are young, subscale, and underearning their potential benefit to gross profit

• DG has consistently out-executed DLTR to this point, maintaining a focus on scale and serving customer communities over near-term margins and capital returns

  • DG saw 30% comps in the $1.00 price point in Q4 after leaning into the category

    • DLTR raised price 25% in 2021 which resulted in LDD unit volume declines, with much of the initial margin benefit now eroding

  • DG has nearly double the sales per distribution sqft as DLTR, which demonstrates DG’s greater ability to leverage costs and maintain sharp prices for customers (Save to Serve ethos) while defending margin

  • Recent and ongoing capital expenditure programs at DG dwarf what DLTR has been able to take on while attempting to optimize their store network and distribution with volatile margins

    • DG has demonstrated innovative initiative with strategic investments in DG Fresh distribution projects and its owned fleet to control distribution and lower costs

      • DG treats their store model like an R&D lab, consistently testing new initiatives and box models to increase profits (characteristic of a Phil Fisher growth company)

    • DG appears less concerned in pleasing the street (details below) but rather manages the business for long term competitive standing and reinvests at attractive returns (new store model below)

  • DG’s wage investments are focused on more hours rather than higher wages, which should have a productivity benefit at the store level and not be a complete margin headwind as the headline may imply

• Margin opportunity

  • The majority of new stores being opened are performing at higher sales per square foot productivity than historical openings due to an expanded NCI and Fresh assortment, plus at a greater scale of 15% more square feet – 8,500 sqft vs 7,400 historically

  • A store profile with 15% greater sqft and higher sales per sqft has materially higher sales, combined with a higher discretionary/quality mix, should result in a step-up in store gross profit that leverages fixed costs at the store level. 

  • This would result in higher store operating margins at maturity, above the 8-9% (excl covid) margin DG has historically achieved while also being diluted by aggressive new openings

    • 20% of current store base was opened in the last four years

  • The larger and higher productivity new store model should provide a tailwind to chainwide sales/sqft, gross and operating margins going forward

    • 80% of new openings are this model

• DG still sees an opportunity for 16,000 new dollar store opportunities in the US

  • DG has historically captured two-thirds of with a strong record of real estate execution

  • Mgmt notes above target pro-forma returns on new stores, plus new store model successes (larger box, popShelf), aren’t showing signs of store saturation for DG, although one would logically expect future store level returns to be lower than past openings

  • DG has entered Mexico with positive results on its first store

  • Mexico can provide additional growth on top of the US opportunity to expand DG’s TAM 

• Net capex as a % of sales should peak in 2023 or 2024

  • DG is currently at full throttle on store builds, remodels, and distribution projects at the same time construction costs have ballooned and discretionary sales are weak

  • FCF conversion will improve as new store sales mature, remodel activity is maintained or comes down, and distribution capacity is filled

    • New store and distribution capex will make up a declining % of sales going forward as DG is likely near max expansion capacity with 1k new stores annually

• Cost advantage defends margin due to growing purchasing power and category management of limited SKUs

  • Costco is well known as the leader in SKU concentration with sales per SKU of $49 million (excl gas). While it’s not close, what’s not discussed is that DG comes in second at $3.6 million per SKU (Walmart $3 million, Target $1.4 million) with the opposite retail model – densely clustered network, small box size, small package size

  • DG effectively “category manages” to lower costs and benefit margins in the process of distributing staggering amounts of sharply priced, small package goods to low to middle income consumers across what will soon approach a 25,000 store network in five years

    • This scale of volumes in a unique supply chain of concentrated SKUs should defend margins at historical levels or higher when new stores and initiatives mature. Steadily scaling purchasing power will grow in importance as sales near $50 billion in 2025/2026 

    • There is high predictability to sales growth

      • DG has recorded a positive annual comp essentially every year for over three decades

      • Selling sq ft will increase ~15% the next three years and new store pro formas are above target

    • Small package size goods are higher margin than bulk sizes for suppliers, giving the emerging “big dog” buyer opportunities to capture more margin

      • In five years DG’s total sales are likely to be nearly double 2019 sales

    • With an average basket of $16 and five items implies $3.20 average unit price

      • On $50 billion of sales, DG will be annually distributing ~15 billion units of low-cost consumer essentials in a few years which is an incredible scale and cost advantage

• Buyback implementation has been disappointing, but the overall capital allocation framework is solid

  • Management’s first focus is to invest in the business - either high return on capital investments or investments to strengthen long-term competitive position (distribution projects, store model testing, initiative rollouts)

  • Next DG prioritizes a small & growing dividend followed by buybacks for any excess FCF 

    • Shares outstanding are down 13%, or 4.5% annually since 2019

  • The new CEO, former COO, Jeff Owen, has a tenure of 29 years and owns $55 million of stock (10x COO salary and 4x current CEO pay), a stake which is uniquely large for a new CEO and should continue to grow. 

    • The large stake properly incentivizes long term decision making and rational capital allocation from the top.

For an outsider looking in, Dollar General seems to be well managed judging by their clear disregard for near-term numbers. In Q2 2022 mgmt invested extra SG&A dollars to capture sales and customer loyalty despite creating operating deleverage on a strong comp.

I have a hard time seeing their closest competitor acting in similar fashion, who at the same time had raised prices 25% while losing double digit volumes (but referred to the high end of an aggressive EPS guide at “38% growth” a full seven times counted on the Q4 2021 earnings call). New management is in at DLTR, but those differentiating details lend me to think DG is quite a ways ahead of the competition at this point and not showing signs of giving much ground. Despite this, DLTR’s ugly 1Q2023 report has further pressured DG stock.

In 2023, DG will execute more real estate projects than any year in its history, roll out initiatives that add SG&A, and significantly expand capex for its owned supply chain fleet. All in the midst of market concerns around margins and capital returns. These actions demonstrate management’s willingness to look beyond the next quarter in order to build a stronger business.

Valuation

DG has demonstrated long-term focus to stay price competitive and prioritize scaling volumes in a price competitive industry to capture the opportunity for $60 billion in annual sales by 2030. By securing a lead in the dollar store industry and garnering significant purchasing power of small package consumable essentials, DG should maintain and/or gain pricing power using their ability to category manage. 

Despite being a business with a high degree of certainty, predictable sales growth runway, and characteristics lending to strengthening competitive position, DG trades less than a market multiple:

• Consistent demonstrated store sqft growth:

  • Can support 4-5% growth annually

    • 27,500 US stores at maturity implies avg opening of 850/yr for the next decade. DG has been opening ~975/yr net for several years. Implies lower than DG’s historic capture of the stated new dollar store growth opportunity

    • Mexico opportunity is an upside tail to the total selling sqft opportunity

• Positive comp sales in 32 of the last 33 years (with the only mark being the 2021 covid reset):

  • Expect annual comps of 2-4%

    • Variance coming from market share execution, new store model results, and inflation

    • Host of nonconsumable initiatives, DG Fresh and Health expansion, higher  performing new store models should provide tailwind to sales/sqft as stores mature 

•  Operating margin maintained with opportunity to increase up to 150 bps over time

  • Expanding cost advantages should support margins vs competitors pricing actions

  • Discretionary sales are cyclically low, especially given recent initiatives, which is holding down gross margin

  • Management believes that peak margins have not yet been maintained, given immature initiatives and a ramping store base

  • Sales and purchasing power doubling from 2020 to 2030 will result in stronger power with vendors and more control over gross margin

• Shareholder friendly capital allocation

  • Capital return of 3-5% of market cap

    • Variance on P/FCF valuation and FCF conversion given current situation with capex and inventory

All considered DG has a high probability path to compound earnings power at LDD even with more conservative assumptions on certain drivers of the algorithm. 

With DG you have:

1) Sales of recurring nature being a weekly staple with limited alternatives (rural markets) for a growing customer base 

2) Growing importance to suppliers

3) Predictable sales growth

4) Strong operational execution and aligned capital allocators 

I believe DG has essentially established a strong franchise in distribution of cheap consumer staples that deserves a moderate premium to the market of 21x to 23x EPS as FCF conversion improves, given the above market growth prospects for EPS and FCFPS and terminal value + durability. DG has been around for over 80 years. Given its cost advantage and importance to customers in existing markets there is a reasonable possibility DG will be around another 80 years from now. 

After the quarterly headlines are cleared of low income consumer pressure, weak discretionary sales and margins, bloated capex and inventories, then DG will be a much cleaner story with a consistent DD annual growth algorithm for the first time since 2019. On 2025 EPS of $14 that is a price target of $294 to $322 in two years, or 50% upside at the midpoint.

Risks

• Store base saturation or cannibalization. New stores are performing as expected but may underperform the existing chain going forward.

• Further step-ups in capex due to the size and condition of the store network. I would be surprised if management severely underinvested in the existing store given other actions that support a long-term orientation, but the prevailing narrative of the dollar store industry is one of poor store and labor conditions.

• Rise in unemployment at lower income levels would impact sales and potentially deleverage margins. DG could be benefiting from the abnormally low unemployment rate which will eventually normalize and reset sales/earnings lower.

Catalyst

• Trade down customer and/or rebound of discretionary sales

• Decline in capex as % of sales, increased buybacks

• Fwd view to steady double digit EPS growth after 2023