Dollar General: Local Monopoly Generates Big Returns (NYSE:DG)

Investment Thesis

A wise old investor once said, “boring is beautiful.” Dollar General (DG) is anything but glamorous – selling basic houseware items and consumables. They generate large profits from dominating local markets where there are no formidable competitors. We believe the company will continue to grow and generate excess earnings regardless of the economic environment. Our analysis suggests investors should earn annualized returns of 10% to 12% with less risk than the overall stock market.

aboutus.Dollargeneral.com

General background

With over 16,500 stores located across 46 states, Dollar General’s goal is to be America’s hometown general store. Founded in 1939 as J.L. Turner and sons, the company changed its name to Dollar General in 1955 and became public in 1968. In 2007, the company was taken private. Over 400 stores were closed due to their failure to meet specific requirements such as having a loading dock, adequate parking, profitability, etc. The company once again became public in 2009, listed on the New York Stock Exchange. They are also a part of the Fortune 500.

What they sell

Dollar General sells packaged food, snacks, health and beauty aids, cleaning supplies, family apparel, housewares, seasonal items, paper products and more. Brands sold include Clorox (CL), Energizer, (ENR) Procter & Gamble (PG), Hanes (HBI), Coca-Cola (NYSE:KO), Mars, Unilever (UL), Nestlé (OTCPK:NSRGY), Kimberly-Clark (KMB), Kellogg (K), General Mills (GIS), and PepsiCo (PEP). Private labels are also offered under the “DG” brand. In 2010, they also became the exclusive retailers for the Rexall brand of vitamins and supplements.

The total addressable market for grocery in the U.S. is estimated at $800 billion yet dollar stores make up only 4.4%, with grocery stores bringing in 35%, mass retailers 24%, and convenience stores 11%. CNN reports only 3% of Dollar General stores offered fresh produce. There are roughly 650 stores which now offer fresh produce and the number is growing. After the results of a 2018 survey, they also developed a house-brand of healthier food options called “better for you.” We believe there are significant opportunities for growth.

New Store Formats

Dollar General is not only building new stores but remodeling existing stores as well.

Dollar General Video presentation, YouTube

Additionally, they have been experimenting with new formats, both small and larger than their traditional 7,400 square foot stores. New formats include a compact 6,000 square foot store for urban areas, a larger 8,500 square foot store known as DG Plus, and a 12,400 square foot store known as DG Fresh. The number of coolers is expanded from 22 to 34 and 50, respectively. DG Fresh includes fresh fruits and vegetables. It looks, in many ways, like a newer Aldi grocery store. By the end of fiscal year 2020, they plan to have 10 distribution facilities serving 12,000 stores.

Where they sell

Dollar General’s 16,500 stores and 17 distribution centers are located throughout 46 States. Since 2011, the store base is increasing by an average of 6% per year.

How they sell

Sales are primarily focused on physical locations. Dollar General has online shipping available as well as “Auto Delivery,” a recent addition giving customers the ability to have products shipped directly to their door on a recurring basis. According to the company’s website, with each recurring order, you save 5% off their retail price and receive free shipping on recurring orders over $25. A mobile app is available for customers as well as digital coupons. Their customers engaging digitally spend significantly more.

Strategic Analysis

Revenue is reported in four segments: Consumables, Seasonal, Home, and Apparel.

Company annual report, author created graph

Consumables continue to experience the highest year-over-year growth rate of just under 9% and a compounded annual growth rate of 10.8% over a 10-year period. Apparel is experiencing the lowest growth rate yet is still about 4%. For comparison, Walmart (WMT) has an overall growth rate of about 1%. We believe Dollar General has a lot of growth opportunity before maxing out its store base.

FactSet data, author created graph

Local Monopoly

Many stores are in small towns where the population is only several thousand. This is a huge competitive advantage as it is not likely Walmart will ever build one of their supercenters in towns with a population of 5,000 and under. While a customer will drive 30 or 45 minutes for their weekly shopping, it is much more convenient to drive 10 minutes to Dollar General for something like a 2-liter bottle of Coke.

The map below features Washington, Missouri, the hometown of the author. Located about 45 minutes west of St. Louis, Missouri, it has a population of 14,000. The next largest town is Union, Missouri, with a population just under 12,000. Both towns have a Walmart supercenter. With a higher per capita income, Washington also has Target (TGT), Kohl’s (KSS), and other retailers. The map below demonstrates how Dollar General dominates the local markets in the areas outside of the largest towns.

Google maps, Author created graphic

Barriers to Entry:

Dollar General’s barriers to entry are based on their local monopolies. While every store is not in a small town, most are outside the “city” limits. Their willingness to serve these markets where others do not care to participate is their advantage. As they continue to grow, economies of scale increase, giving them greater buying power and distribution efficiencies. They have a long runway to allow them to continue dominating small markets.

Annual store growth for Dollar General is consistently 6% while their peer group average is “0%.” Walmart’s closure of international stores resulted in a reduction of locations. Dollar Tree (DLTR) bought Family Dollar in 2016 and has since rebranded some Family Dollar stores while closing others. During the acquisition, 330 Family Dollar stores were told to Sycamore Partners, which in turn, sold 323 of the stores to Dollar General in 2017.

From a competitive nature, Dollar General shines in virtually every category vs. its peer group. Only in return on invested capital (ROIC) does the company lag competitors but only by a small margin. Perhaps most impressive is their ability to achieve high-teen levels of ROIC while maintaining strong growth in sales.

FactSet data, author’s table

Sales growth (3 years) Operating Profit growth (3 years) Same store sales Operating margins ROIC

Market share

Dollar General has about half of the “dollar store” market share. The merger of Dollar Tree and Family Dollar in 2017 created a competitor with an almost equal number of stores. Today, Dollar General has 16,500 stores vs. Dollar Tree’s 15,300 and Big Lots’ (BIG) 1,404 stores.

FactSet data, author created graph

Macro-Economic Factors

Dollar General lists unemployment, wage growth, U.S. trade policy, and Government programs to be the primary macro-economic factors affecting the company in their annual report. In addition, general expenses such as rent, healthcare, and fuel also contribute to their customers’ disposable income.

The unemployment rate achieved record low levels in 2019. We believe the recent spike due to the pandemic will be short-lived. St. Louis Federal Reserve President Jim Bullard recently told the media he expects the rate to decline to about 7% this year.

Household income grew less than 1% over the past 34 years with the median inflation adjusted household income being just over $63,000 per year. The majority of Dollar General’s customers have an income of less than $49,900 and one-third earn less than $25,000 (Washington Post).

Dollar Tree imports 40% of their merchandise from China and we assume the same would be true for Dollar General. A trade war between the United States and China is now over a year old and is almost non-existent in the news, given the current pandemic. It is worth re-visiting a potential tariff impact on both stores’ margins in the future, yet it does not seem to be a big factor now.

The Supplemental Nutrition Assistance Program (SNAP) clearly peaked in 2013 and has declined 23% since. According to the Center on Budget and Policy Priorities, the number of people participating in the SNAP program declined by more than 7 million people from 2013 to 2018.

Center on Budget and Policy Priorities

SNAP participation as a percentage of the population peaked in 2013 at roughly 15% and is projected to decline back to 10% in 2021, which is the same participation rate seen in 1995.

Competitors

Dollar General’s gross margins are not the highest among the dollar stores, yet they are similar to those of Dollar Tree. Big Lots’ higher gross margins are a result of a different product mix which includes furniture, a higher margin business than grocery or consumables.

Dollar General and Dollar Tree have operating margins near 8%. Big Lots has operating margins much lower, near 3%, because of higher spending on sales, general, and administrative (SG&A) expenses. Target has an operating margin of 6% while Walmart’s is 4.5%.

Fundamental economics and accounting demonstrate the importance of low fixed costs and high variable costs. Low fixed costs allow businesses to have greater financial flexibility. Rental expense can be devastating for retail stores. Big Lots has the highest rental expense of the peer group with Dollar General having the lowest.

Growth Drivers

There are several growth drivers which should allow the company to continue its strong same store sales growth. Launched in 2018, the company’s own “Better for you” branded food options provide healthier alternatives for customers. We expect this segment to continue to grow as many customers have few alternatives available in their respective markets while some desired healthier options, not available prior to 2018.

According to IBISWorld, the total addressable market for grocery is $682 billion. Dollar stores have roughly a 4% market share in the space. We believe there is a lot of opportunity for all of the dollar stores to grow by increasing their offerings and changing the product mix offered.

Dollar General offers fresh produce in about 3% of stores, yet this segment is expanding and should be a catalyst for growth. We believe the company can easily take market share from Walmart and grocery stores.

What about Amazon?

There is no doubt, Amazon (AMZN) is the most feared company, especially if you are a retailer. Yet in the case of Dollar General, we see little to no threat from Amazon. In June 2017, Amazon agreed to offer “Prime” membership for $5.99 per month vs. the normal $10.99 cost to low-income households. We learned through a survey from Chain Store Age that 26% of low-income households already had a Prime membership and of those who did not, 80% of those were not interested.

Establishing a monopoly in small markets is a key to Dollar General’s barriers to entry, one which is not likely to be impeded by Amazon anytime soon.

Management

While investors may assume management has their best interests in mind, history proves it is not always the case. The “Agency problem” is a topic commonly covered in MBA programs and refers to conflicts between management and shareholders – it seems to us to be much less of a problem at Dollar General than other companies we have become familiar with over the years.

While management’s objective is to increase shareholder wealth, executives often fund their favorite projects even though they may not generate greater wealth for those who own the company. GameStop (NYSE:GME), a company who has been suffering from declining sales for several years, recently sold a corporate jet they owned. Tailored Brands (OTCPK:TLRDQ) paid corporate executives just before filing for bankruptcy. There is no lack of examples, unfortunately.

With respect to Dollar General, 88% of the CEO’s pay is based on performance with just 12% coming as a salary. By comparison, the average comparable CEO’s compensation is 25% salary, 21% short-term incentives, and 54% from long-term incentives.

Valuation

We begin by determining the asset value of the equity for Dollar General. It may be thought of as the cost of reproducing the assets. Next, we will determine the value based on earnings. Next, we will estimate the return an investor should earn from investing in Dollar General and lastly, examine the market multiple the company is trading at in the stock market relative to its historical market multiple.

Asset Value

The balance sheet contains the most reliable information yet is largely ignored by analysts performing valuation. The method, made famous by Benjamin Graham, is where valuation will begin. For intangible assets and certain property, plant, and equipment measures, reasonable values are used. Given Dollar General’s high barriers to entry, more attention is focused on its earnings power value and returns.

Real Estate

The company owns 214 million square feet of retail store space, 2 million square feet of warehouse and distribution center space, and 1 million square feet of office space in Atlanta, Georgia. Our estimates of each segment coincide with marking up the PP&E by 20%.

Valuing the Brand

We valued the brand using last year’s advertising expenses of $82.7 million capitalized at the weighted average cost of capital (WACC) of 5.4% to arrive at a brand value of $1.53 billion.

Workforce

There are 143,000 associates which come to work at Dollar General. Salaries range from $16,000 a year for sales associates to $80,000 for district managers (Glassdoor). We use a reasonable average of $25,000. Using a recruiting fee of 10%, the value of the workforce is about $338 million.

The asset value of Dollar General is in the table below.

Earnings Power Value

The earnings power value (EPV) method is essentially a discounted cash flow without growth. A value investor seeks to buy a franchise business close to its earnings power value enabling them to get the growth for free.

While Dollar General is a growth company, to be conservative, we used the revenue from the last fiscal year. Margins generally fluctuate more than revenues; here we used the 10-year average.

As the EPV is a no-growth valuation, we added back the sales, general, and administrative (SG&A) expenses related to growth, estimated at 10%.

We arrived at our discount rate beginning with a 6% cost of equity and the company’s 3% cost of debt. We calculate a 5.4% weighted average cost of capital (WACC) for Dollar General. This is lower than the discount rate we use for most businesses yet this is also a business, which does well in all economic environments.

The earnings power value (EPV) far exceeds the asset value. Dollar General is undoubtedly a franchise (meaning dominant and high-quality) business. The current market price is 19% higher than the earnings power value, suggesting investors are paying 19% for the franchise.

Distribution Yield

The distribution yield is equivalent to all distributions including dividends, share repurchases, debt reduction, and interest paid divided by Enterprise Value (market value of stock + net debt). The current distribution yield is 3.2%. Given Dollar General’s history, we believe this is conservative.

Earnings Growth

We use two methods to assess the organic growth. The first is calculated using a 10-year compounded annual growth rate (CAGR) for revenue, operating earnings (EBIT), and property, plant, and equipment and using the average. We calculate this to be 9.2%.

The second method is to determine the return the company could earn on incremental invested capital. We calculate this to be 4.0%.

Organic Growth

This is growth which can be achieved for free, either by raising prices, increasing quantity, or a combination thereof. Same store sales are used as a measure of organic growth. Dollar General achieves higher-rates of same store sales than virtually all other retailers. We expect this to continue as they take a larger share of perishables and other categories from companies such as Walmart, convenience, and grocery stores. We use 4% for the organic growth which is both the same store sales growth for the last fiscal year as well as the average for the last 10 years.

Expected return from Investing in Dollar General

What kind of return should an investor expect to earn by investing in Dollar General? Using our estimates, 3.2% for distribution yield, 4% for incremental invested capital, and 4% for organic growth – the total return is estimated to be 11%.

Consider the Market Multiple

The final piece an investor should keep in mind is the market multiple shown in the table below. Dollar General’s EV to EBIT multiple averaged 22 over the time period shown. It is currently trading at a multiple slightly higher than the average. As the company is resilient to most economic shocks, the stock performance is indicative of that. One should be somewhat cautious here as the higher multiple could impact investors’ long-term returns. However, if an investor lost 4% of their long-term return due to multiple contraction, they would still enjoy a return of 7% to 8% – which is in line with long-term historical stock market returns over the past 100 or so years.

The other aspects to consider with Dollar General is the fact it is a counter-cyclical company, meaning a recession doesn’t have the same detrimental impact on their business as it does on others. From a portfolio perspective, it may make sense to add a stock like Dollar General as a means of risk management.

Final Thoughts

Dollar General is a very unglamorous company, the best kind for value-oriented investors. This is a very well-run company in a higher growth mode than one might think. Dollar stores are generally resistant to economic downturns and recessions. An expected yield in the low teens is attractive. Our only concern is multiple contraction, yet it will likely stay elevated until investors are comfortable buying riskier assets. This company has a lot going for it and we plan to stay along for the ride.

Disclosure: I am/we are long TGT, DG,AMZN,NSRGY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclosure: This article is not intended to be investment advice. Risks to investing may include a permanent loss of capital (money). Roth Investment Management owns Dollar General stock in some of the accounts it manages. Roth Investment Management LLC, is a Missouri state registered investment advisor.