Valuentum Exclusive Analysis for the Discerning Investor

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Image Shown: Shares of Dollar General Corporation, a holding in our Best Ideas Newsletter portfolio, have aggressively outperformed the S&P 500 Index over the past year as of the end of the normal trading session on March 12.

By Callum Turcan

Retail firms, particularly companies that sell consumer staples products, have held up relatively well during the ongoing rout in global equities (including in the US). The novel coronavirus (‘COVID-19’) pandemic is the "black swan" event that could potentially tip the global economy towards recession, in our view, but please note this pandemic was the straw that broke the camel’s back, not the single source of this potential downside (rising non-financial corporate debt levels, slowing industrial activity, large national budget deficits and enormous public debt loads worldwide, rising geopolitical tensions and the impact trade wars have on global supply chains, and the lack of “dry powder” at major central banks are several reasons why the global economy has asymmetrical downside risk when it comes to growth).

Best Ideas Newsletter portfolio holding Dollar General Corporation (DG) is a prime example of a retail firm holding its own against major exogenous headwinds. As of the end of the normal trading session on March 12, shares of DG are up 18.7% while the S&P 500 index (SPY) is down 11.1%. Dollar General reported earnings for the fourth quarter and full-year fiscal 2019 (period ended January 31, 2020) that beat on both the top- and bottom-line, and its same-store sales performance also beat expectations. Let's dig into the specifics in this note.

Earnings and Outlook Overview

In fiscal 2019, Dollar General reported 3.9% same-store sales growth versus fiscal 2018 levels, assisted by higher customer foot traffic and larger ticket sizes. We appreciate strength on both fronts when viewing same-store sales performance. To augment its growth runway, Dollar General is aggressively expanding its store footprint in regions that cater to smaller population sizes (20,000 people or less) in a bid to outmaneuver the likes of Amazon Inc (AMZN) by meeting demand in regions where e-commerce logistics gets trickier. On March 7, Dollar General announced it had expanded into its 45th US state, Wyoming.

The company’s GAAP net revenues grew by ~8% in fiscal 2019 on a year-over-year basis (a product of a rising store count and nice same-store sales growth) and its GAAP gross margin expanded by almost 15 basis points during this period (due to higher initial product markups offsetting weaknesses elsewhere). Dollar General opened 908 net new stores in fiscal 2019, and the company continues to see room for growth. Modest gross margin expansion offset modest increases in operating expenses as a percent of net revenues, allowing for marginal GAAP operating margin expansion in fiscal 2019 on a year-over-year basis as Dollar General’s GAAP operating income climbed higher by ~9% in fiscal 2019.

Management is guiding for 7.5%-8.0% net revenue growth in fiscal 2020 along with 2.5%-3.0% same-store sales growth. Dollar General’s top-line growth trajectory is supported in part by 1,000 planned new store openings in fiscal 2020 (which will be modestly offset by 80 planned store relocations and other factors).

Dollar General’s cash flow profile is quite strong and underpins its growth ambitions. In fiscal 2019 (according to its 8-K SEC filing), the firm generated over $2.2 billion in net operating cash flow (up 4% year-over-year) while spending a little under $0.8 billion on capital expenditures (up 7% year-over-year due to its growth strategy), allowing for ~$1.45 billion in free cash flows. That easily covered $0.3 billion in dividend payments made during this period, however, a small portion of its $1.2 billion in share buybacks conducted in fiscal 2019 were funded by the balance sheet. From fiscal 2018 to fiscal 2019, Dollar General’s outstanding diluted weighted-average share count dropped by 3%.

In fiscal 2020, Dollar General plans to spend $1.15 billion on share repurchases and $0.925-$0.975 billion on capital expenditures. On an adjusted non-GAAP basis, management is targeting for Dollar General to generate 10% diluted EPS growth in fiscal 2020 on a year-over-year basis, after realizing adjusted non-GAAP diluted EPS growth of almost 13% in fiscal 2019 over fiscal 2018 levels.

At the end of January 2020, Dollar General had over $0.2 billion in cash on hand versus a negligible amount of short-term debt and $2.9 billion in ‘long-term obligations’, a net debt burden that we view as manageable given its strong free cash flow profile. Going forward, it would be prudent for Dollar General to bulk up its cash position given rising exogenous headwinds, in our view. However, it appears that isn’t going to be the case for now given management’s share buyback strategy. The firm exited fiscal 2019 with a current ratio north of 1.1x, which we appreciate, but more should be done given how consumer spending would take a major hit should US economic activity contract.

Management Commentary

As it relates to the aforementioned guidance for fiscal 2020, management had this to say within Dollar General’s earnings press release:

“The diluted EPS growth guidance… includes the anticipated impact of previously implemented tariff rates on certain products imported from China. The guidance does not contemplate any additional increases in tariff rates, any expansion of additional products subject to tariffs, or any tariff-related impacts to broader consumer spending.

Based on information currently known by management, the Company does not anticipate that supply chain disruptions experienced to date as a result of the coronavirus outbreak are likely to have a material impact on its fiscal 2020 financial results.However, the Company continues to monitor this evolving situation, and there is no guarantee that this outbreak will not have a more significant impact on its business.

The Company is also reiterating its plans to execute approximately 2,600 real estate projects in fiscal year 2020, including 1,000 new store openings, 1,500 mature store remodels, and 80 store relocations.”

Management is communicating to investors that while there are potential downside risks from the ongoing COVID-19 pandemic and the potential for a return of a more active US-China trade war dynamic (which has since been put on ice, keeping in mind meaningful tariffs remain in-place), as things stand today, Dollar General’s growth trajectory remains intact.

To enhance this growth trajectory further, Dollar General launched its DG Fresh initiative to sell more perishable foods (prepared foods, dairy products, meats, and other products) that come with higher gross margins and can act as a draw for demand. Additionally, the company is also adding produce offerings to its stores. Dollar General plans to add produce to ~400 of its stores this fiscal year, bringing the total number of its store that sell produce to over 1,000 by the end of fiscal 2020. Please note management previously targeted rolling out produce offerings to just ~250 of Dollar General’s stores this fiscal year.

Pivoting back to Dollar General’s DG Fresh strategic initiative, the company has since rolled out this program out to ~6,000 of its stores (keeping in mind Dollar General had ~16,300 stores at the end of January 31, 2020) supported by five DG Fresh facilities. Going forward, Dollar General plans to keep aggressively expanding this offering and management had this to say during the firm’s latest quarterly conference call:

“…we expect DG Fresh will be accretive to operating margin in 2020 as the benefits begin to exceed associated expenses and grow in the years ahead, as we continue to scale this transformational initiative. Another important goal of DG Fresh is to increase sales in these categories by enabling the accelerated rollout of our higher capacity coolers increasingly and eventually expanding our overall assortment offering.

This could include a wider selection of both national and private brands as well enhance our offering of Better-For-You items. And while produce is not included in our initial rollout plans we believe DG Fresh could eventually provide a potential path forward to expanding our produce offering to more stores in the future.

In total, we are currently self-distributing products to more than 6,000 stores from five DG Fresh facilities. Our goal for 2020 is to capture benefits from DG Fresh in approximately 12,000 stores or about double the current store count, from up to 10 facilities by year's end. In short, we are very pleased with the results we are seeing from this initiative and excited about the potential long-term benefits, it can deliver for our customers and our business.”

These programs are intertwined and can readily build off each other, in our view, and in the view of management (plenty of synergies to be had as it relates to logistics, cold storage, and more). Furthermore, Dollar General is also making material investments in its digital capabilities and its mobile app. For instance, mobile checkout is now available in ~750 of its stores. These programs are putting pressure on its operating expenses, to a modest degree, but that has been offset by its expanding gross margin as mentioned previously. We appreciate Dollar General making major investments in its core business and its results of late indicate these programs are having a powerful impact on its growth trajectory.

Concluding Thoughts

Dollar General faces material exogenous headwinds and so far has been able to effectively mitigate those hurdles through investments in the right categories (fresh food, digital capabilities, stores in regions that are more resilient to the threats posed by e-commerce). We continue to like shares of DG in our Best Ideas Newsletter portfolio, and appreciate its operational, financial, and technical performance of late.

Dollar Store and Department Store Industries – KSS M JWN BIG DG DLTR PSMT

Specialty Retailers Industry – AAN BBBY BBY GME HD LOW LL ODP SHW TSCO WSM

Food Retailing Industry – CASY COST CVS KR SYY TGT WBA WMT

Related: AMZN, SPY

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Callum Turcan does not own shares in any of the securities mentioned above. Cracker Barrel Old Country Store Inc (CBRL) is included in Valuentum’s simulated Dividend Growth Newsletter portfolio. Dollar General Corporation (DG) is included in Valuentum’s simulated Best Ideas Newsletter portfolio. Some of the other companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.