Description

Like my PZZA and CTR ideas last year, DG might be another dull boring stock that essentially goes nowhere in a rotten market. I will admit to wanting to post something more exciting but DG represents, like LTD or HD or TOO, a busted story trading at an intriguing valuation, albeit without a readily identifiable catalyst beyond the lure of valuation in a low-interest rate environment. Still, I have 4% of my AUM in DG and believe the best way to approach these sorts of issues is with a diversified basket and a scaling approach which increases the position as the valuation descends. And while it might not excite anyone to say that Dollar General is currently trading at a 52 week low and close to the high price from 1996, it excites me because I’ve followed this company for years and would welcome even lower pricing.

Description:
Dollar General (DG) operates more than 6,000 discount stores averaging 6,700 sqft which sell consumables along with a modest selection of toys, office products, cards, and apparel. About 33% of the items retail for $1.00 or less, with most priced below $10.00.

The Ugly
For years the Dollar General story was dull and predictable - open new stores, make more money, see the stock price march ever higher. Management had a fixation for the 5/4 stock split, doing it 12 different times, and the general perception in the discount store industry was that Dollar General was the leader and Family Dollar the follower. Much of this had to do with DG's early recognition that hardlines could drive sales growth and a transition to an everyday low pricing strategy in a business that traditionally generated sales from advertising circulars. Value Line's array shows the results (pgs 1676, 1678). DG achieved a net margin of over 5% from 1994 to 1999 while FDO could only achieve this on consecutive years beginning in 1999.

All this changed in April 2001. The company became aware of 'accounting irregularities' and proceeded to descend into a black hole, no longer generating earnings statements while the entire business underwent a comprehensive financial and operational review. The full details can be muddled through in the restated 2001 10K on file. The bottom line is that the company's issues resulted in "an aggregate effect on diluted earnings per share, excluding the litigation settlement expense, of $0.30 over the three-year period of 2000, 1999 and 1998." And the litigation settlement with many well-meaning lawyers also cost the company a substantial sum of money this year, though the company had already accrued for it. The SEC is also still conducting an investigation with results underterminable. Finally, some of this has led to a deterioration of the company's capital position, leading to some aggressive (my words) attention from the various rating agencies.

As you might expect, there were changes to the management team with this company along with the recent appointment of a new acting CEO Donald S. Shaffer who came aboard as a result of the accounting problems. A search for a long-term CEO continues.

The Bad
The stock price has fallen to a 52 week low for several reasons:

• In the Dec press release DG reported, like most other folks, below-plan comps, which combined with higher shrink and labor costs led the company to reduced bottom line eps expectations. The previous quarter was also a disappointment for similar reasons. This is despite a same store sales increase which normally would result in static margins at worst.

• The company remains in the penalty box from the various events of the past and the ongoing SEC investigation.

• Rating agencies had downgraded the company’s debt for reasons unknown (in my opinion, the cash flow this company produces should not reflect in a ratings downgrade, though conservatism is of course expected in today’s fearful climate).

• The company reduced store growth rates to 10-11% next year. This is a far cry from the 20% CAGR of the past 10 years, though with modest comp growth the company could achieve a 12 to 14% top line growth rate in 2003.

The Good
So why in the world would I be interested in this company? Quite candidly, I cannot reassure you that the accounting issues are completely and totally resolved. One would hope so, but frankly Dollar General from pre-2001 would have been the last company I would have suspected as being mentioned in the same sentence as Worldcom, Adelphia or Enron. But unlike those folks, DG has a good balance sheet, generates massive amounts of cash flow, and has shoppers who neither know about nor care about the company's problems. I think DG is interesting because it has:

• An attractive valuation. At 11.56, the market cap is 3.872b. Trailing earnings equal 254 million with cash flow of 387 million. There should be about 150m in capital expenditures this year. The trailing pe is about 15, pcf ratio at about 10, and pb at 3.6. The company pays a modest 13c yearly dividend.

• A solid Balance Sheet. DG has 1.190b in shareholders equity. Of this, 37m is cash, 1.25b inventory, and 673m in current liabilities with another 548m in longer term liabilities. In the past 12 months excess cash flow has been used mainly to pay down debt. The inventory is obvious key, and with accounting issues there along with the recent higher shrink rates some doubt does remain, but this is not generally ‘worthless’ inventory ala a fashion oriented retailer.

• A competitor with a valuation that reflects what happens when things aren’t crummy. Family Dollar, a direct competitor with an identical store model, currently trades for 23x earnings and 17x cash flow. That's a cap of 5.3b and trailing cash flow of 300m.

• A business that isn’t just about to fall apart. DG has no lack of competitors (I won’t bore you with them here), but this is a business which never has lacked for competitors. Despite this, the business just churns along (naively ignoring accounting problems here for a minute) with higher same store sales as the company experiments with layout changes, new departments like frozen items, and new technology. WMT hasn’t crushed these stores because some people enjoy parking close to the storefront and not dealing with rapid shopping carts and long lines.

• Plenty of Room for Growth. Last year they only reached 27 states, and there is plenty of growth left at the company’s option.

• Cash flow, cash flow, cash flow. In three years DG should generate over 1b in cash flow, in 5 years more than 2 billion. Management previously used cash flow to buy shares (along with a very modest dividend). While the current CFO intends to pay down debt for the time being, a reduced store growth rate should lead to substantial free cash flow which could essentially eliminate the company’s long-term obligations in short order. An increased dividend or buyback plan could also be a consideration.

Misc:

For the past 5 years DG has, on average, issued 1.9% of its ending diluted count in options each year with a 31% cancellation rate. Management felt unusually generous with its grant last year, perhaps in recognition of the problems they had to clean up, and this is something to closely watch in 2002, though the Q's do contain B/S option data for those who are interested.

Value Line's estimate for 2003 is 90c. The 05-07 estimate is 1.50. The median pe was 23, though that is a thing of the past for now.

I'm expert on the accounting issues and couldn't answer detailed questions about them. IN essence, my thesis with these folks is that problems are as fixed as they will ever be.

Catalyst

the passage of time