Dollar General: Has The Stock Become A Buffett-Style Fat Pitch? (NYSE:DG)

Investment Thesis

Dollar General Corporation (NYSE:DG) is one America’s largest variety retail stores. They target lower-income households across rural and underserved regions in America.

Recent struggles due to falling consumer spending and increasing COGS has placed downward pressure on shares resulting in a massive 53% YTD selloff.

However, the firm’s fundamental profitability remains uncompromised, and I believe the excessive selloff and negative market sentiment has created a real buying opportunity for the value-oriented investor.

When combined with a potentially 43% undervaluation in shares, it is clear to me that DG is a real Buffett-style “fat pitch” value opportunity.

Company Background

Dollar General is an American chain of low-end variety stores who operate more than 19,100 stores across the U.S. Since the firm’s creation in 1939, the chain has grown into one of the largest and most profitable store brands in the U.S.

DG has achieved this massive growth and profitability through targeting consumers in rural America often placing stores in towns with less than 1000 people. This allows DG to operate monopolistically within these localized markets due to the complete lack of competitors within these tiny towns.

The chain also targets lower-income regions of larger cities where “food deserts” have been created due to the reluctance of larger retailers or grocers such as Target (TGT), Walmart (WMT) or Kroger (KR) to place outlets within these areas.

A recent change in CEO due to the retirement of Todd Vasos has seen Jeff Owen take over the helm at DG. Vasos was an established and successful figure at DG overseeing the company’s more than doubling in market capitalization through the opening of over 7000 new stores and creation of over 60,000 new jobs.

This leaves Owen some pretty big shoes to fill. Nonetheless, Owen started with DG all the way back in 1992 as a trainee store manager and has worked his way up through multiple management positions, including Vice President and most recently COO, since August 2019.

I believe Owen is perhaps the most suitable candidate to takeover the reigns from Vasos and illustrates a DG’s careful and systematic approach to transition planning. I also think this attitude reflects well on the rest of their business operations and suggests the firm – despite their massive growth and current size – has not become complacent in an increasingly difficult market environment.

Economic Moat In-Depth Analysis

Dollar General has what I consider to be a medium-width economic moat. This moat is built primarily upon their unique sales model, competitive pricing and extensive geographic reach.

DG’s variety store model helps offer customers in rural and often underserved areas with a huge variety of product categories which otherwise would be unavailable or difficult to obtain.

Emphasis here must be made on a wide variety of product categories rather than a wide range of products within each category. Unlike Walmart or Target where consumers can get a huge variety of different products within each segment, Dollar General may only stock one or two items per category in the name of keeping down stock-keeping units.

DG tends to offer around 11,000 different items per store whereas larger rivals offer anywhere between 45,000-100,000 different items. This helps DG to maintain an incredibly streamlined supply-chain network as the total number of different items is minimized. This also allows DG to simplify their in-stores stocking processes and item categorization requirements.

The simplification of their in-store processes also allows Dollar General to hire between 2-5 employees per store which is substantially lower than larger retail competitors. This allows individual DG stores to operate daily with wage expenses of less than $1000 (calculated assuming federal minimum wage of $7.25/hour).

Once again, DG has created a massively streamlined and operationally efficient structure than helps the firm maximize profits from a traditionally tricky market segment.

Thanks to DG’s huge scale and strategy of offering just one or two types of products per category, the firm has huge negotiating power with manufacturers when it comes to supply deals and agreements. By working closely with Coca Cola, PepsiCo, General Mills, Kraft Heinz and Nestlé to name a few suppliers, DG is able to negotiate on exclusive partnership deals regarding the supply of products.

These partner brands often offer DG with significant unit discounts as the massive size of DG orders still provide these companies with the opportunity to increase their own sales volumes. Furthermore, many of these brands create value-sized offerings for DG to sell exclusively at their stores in order to keep unit costs down for customers.

While this does mean that many customers end up paying more per usage, gram or ounce of product, the overall purchase cost of the item will be lower thus enabling income stressed households to buy in the first place.

The competitive pricing of goods to be around $1-3$ per item enables DG to sell to households who have a median gross annual income of around $40,000. This traditionally underserved demographic of customers is unable to benefit from the likes of offers Costco (COST) or Walmart (WMT) provide due to the lack of excess disposable income to spend on bulk-purchase items.

DG’s offering of often smaller dosage or sized products compared to those found at larger retailers helps enable these markets to purchase the goods required for daily life.

While the overall value proposition for consumers may be worse than that offered by larger competitors, DG’s differentiated strategy and consumer base helps the firm to sell huge volumes of these products.

These huge volumes and simple inventories allow DG to target small-town America and place stores in towns even with less than 1000 total residents. By placing stores in towns where larger retailers are unable to go, DG eliminates large amounts of competition and essentially becomes a monopolistic retailer in these underserved regions.

This allows DG to harness sufficient sales even in these tiny-towns which, combined with their lean operations model and highly competitive sales agreements, still allows DG to earn outsized returns on their operations.

Overall, I believe DG’s innovative and lean operational structure allows the firm to extract outsized returns from what is a traditionally unprofitable market segment. Their strategy to target underserved geographic regions and income demographics allows DG to eliminate competition from larger retailers and act monopolistically within these markets.

From a business perspective, this is highly lucrative for DG, which explains the firm’s ability to rapidly expand their operations while maintaining huge profitability and efficiency within their business.

I believe these factors earn DG a moderate economic moat which should help the firm earn outsized returns for at least the next 10 years. I believe for DG to develop a wide-economic moat the firm must manage to increase the uniqueness of their business proposition in comparison to other variety stores such as Dollar Tree (DLTR).

These competitive risks will be discussed in more detail within the risks segment of this analysis.

Financial Situation

Dollar General has earned massive returns over the last five years compared to the relative performance of other retailers. The firm’s 5Y average ROA, ROE and ROIC are 9.68%, 33.82% and 13.14% respectively.

A 13.14% ROIC in particular is great to see especially when considering that Walmart has only managed a ROIC of 9.73% over the same period.

I believe these outsized return metrics act to illustrate DG’s moderately sized economic moat at work helping the firm to earn great returns from their business.

For the same previous 5Y period DG has managed to operate on gross, operating and net margins of 31.18%, 7.99% and 6.77% respectively. While not quite as impressive as their returns, I believe their robust gross and operating margins reflect the efficiency DG aims for in their operations structure.

While the net margin is not huge and has decreased from highs of around 7.87% in 2021, I believe the difficult macroeconomic conditions contribute to this contraction. Fundamentally, the robust and unchanged gross and operating margins disrepute any suggestion that an underlying fault exists in their business structure.

When analyzing their FY23 so far, the picture initially looks a little mixed for the variety retailer. Q1 saw net sales increase 6.8% while same-store sales increased 1.6%. The firm also saw an increase in average transaction amounts along with strong growth in the consumables categories.

This resulted in gross profits as a percentage of net sales increase to 31.6% from just 31.1% in Q1 FY22.

Nonetheless, the firm saw their operating profit decrease 0.7% to 740.9M due to increasing COGS associated with the highly inflationary environment increasing the cost of transportation and supply-chain related processes. Net income fell 6.9% YoY to $552.7M in Q1 FY23.

The firm also noted falling customer traffic along with declines in the seasonal, home and apparel categories as being some of the causal factors that led to overall profitability declining for the firm. These item categories are more lucrative for the firm as they allow for a greater markup than the highly competitive consumables category.

Seasonal, home and apparel items are not traditionally classified as necessities unlike food stuffs and other consumables which explains why falling consumer incomes and real pricing power has resulted in these segments witnessing the most marked fall.

Interestingly total merchandise inventories also increased by 14.7% on a per-store basis from $6.1B in Q1 2022 to $7.3B in Q1 2023. This increase reflects the impacts cost inflation has had on consumer appetite for products and is supported by the falling overall customer traffic figures supplied by DG.

A roughly similar situation can be seen in their most recent Q2 results which are once again characterized by falling operating profit and weaker than expected customer traffic.

Net sales for Q2 increased 3.8% YoY while same-store sales decreased 0.1%. This decrease in organic sales illustrates just how affected lower income households are in the increasingly inflationary and high-interest rate environment in which the U.S now finds itself.

Many of these lower income households have begun cutting back even on consumables expenditure which suggests that a recessionary effect has already taken place in this financially sensitive demographic of individuals.

The weak Q2 results were attributed mainly to lower inventory markups and increased levels of shrink, markdowns and inventory damages. This clear pricing pressure DG is seeing reflects the aforementioned pressure their core customer base is facing form a day-to-day fiscal perspective.

I believe this consumer pressure also acts as a canary in the coal mine type of indicator regarding the U.S and global economies as a whole. The real effects of the increased interest rates and inflation will only be witnessed in the coming months and could see larger scale retailers such as Walmart and Target also suffer with sales and real returns.

COGS increased 136 basis points to 24% (as a percentage of net sales). This was primarily due to an increase in the cost of retail labor, utilities and rent. This combined with the weakening sales figures resulted in a huge 24.2% drop in operating profits to just $692.3M. Net incomes fell an even larger 30.9% compared to Q2 FY22 due to a higher effective income tax rate and a 95.7% increase in interest rate expenses.

From an income perspective it is undeniable that Dollar General is facing unprecedented headwinds that were last seen in 2007-2009. The effects of inflation on both their business operations and customers real incomes has resulted in stagnating sales and weakening profitability.

Nonetheless, I believe that fundamentally DG still stands to continue growing their net sales, net profits and operating margins into the future once the difficult macroeconomic headwinds subside.

I do not believe that DG’s core profitability or business model has been compromised in any shape or form.

Seeking Alpha’s Quant assigns Dollar General with a “B” profitability rating. I believe this to be a relatively realistic overview of the firm’s current profitability considering the falling sales figures and operating profits. However, if considering the firms historic form and potential, I believe the quant is being slightly pessimistic.

The firm’s balance sheets look mostly healthy in my opinion. DG currently has $8.4B in current assets with current liabilities amounting to $6.03B. This leaves the firm with a current ratio of 1.39 and a quick ratio of 0.08 which is outstanding.

Total assets for the firm amount to $30.4B with total liabilities just $24.1B. This leaves the firm with an excellent debt/equity ratio of 0.79.

DG’s long-term debt profile is well staggered and presents what I believe to be a sound capital allocation structure. The firm’s $7.01B in long-term debts has risen sharply from just $4.18B in 2022 mainly due to the aggressive expansion DG has pursued over the past year.

Most of the firm’s long-term obligations are in the form of fixed-rate senior notes along with a relatively large amount of unsecured commercial papers. In the near-term DG will have to pay off $749M in debt which the firm should be able to finance with their FCF.

I do not foresee DG facing any liquidity concerns and believe that even with their relatively poor performance as of late, they will be able to meet all their debt obligations without issue.

Dollar General has received an affirmed Baa2 credit rating from Moody’s for their senior unsecured notes and a Prime-2 commercial paper rating. The outlook remains stable. Baa2 is classified as credit obligations which are of medium grade representing a medium investment risk grade.

From a financial perspective, I believe Dollar General is a fundamentally profitable, well-run and fiscally sound firm that still has the capability to achieve outsized returns on their invested capital.

While recent headwinds have halted the firms run of increasing profits and margin expansion, I believe no material damage has been done to DG’s fundamental core operational model.

Valuation

Seeking Alpha’s Quant assigns Intel with a “D+” Valuation rating. I believe this is an excessively pessimistic representation of the intrinsic and future value present within Dollar General’s shares.

The firm currently trades at a P/E GAAP FWD ratio of 14.94x along with a P/CF FWD of just 11.25x. Their FWD EV/EBITDA of 12.87x is a little higher than I’d like to see but not too concerning. DG’s EV/Sales TTM and FWD are both just 1.11x which illustrates just how well-priced DG really is.

To put this into perspective, DG is valued at just 1x their sales. The sector median in the retail category is 1.74x.

Considering these basic valuation metrics I believe DG is trading somewhere between a relative and significant discount compared to the relative value of their shares.

From an absolute perspective, DG shares are trading at a significant discount relative to previous valuations. Over the last 5Y, the firm has produced just -5.57% returns with a 2023 YTD -53% selloff, resulting in destruction of valuations for shareholders.

This has led to a significant souring of sentiments among investors regarding the potential that lies in DG which I believe to mostly be speculation and unfounded pessimism.

While the relative valuation provided by simple metrics and ratios along with the absolute comparison help to create a baseline of understanding regarding the value present in DG shares, an intrinsic value calculation is absolutely necessary.

By utilizing The Value Corner’s Intrinsic Valuation Calculation, we can better understand what value exists in the company from a more objective perspective.

Using DG’s current share price of $114.88, an estimated 2024 EPS of $7.97, a conservative “r” value of 0.10 (10%) and the current Moody’s Seasoned AAA Corporate Bond Yield ratio of 4.95x, I derive a base-case IV of $201.90. This represents a massive 43% undervaluation in the firm.

Even when using a very pessimistic CAGR value for r of 0.07 (7%) to reflect a scenario where Dollar General aces sees increasing losses due to their core demographic struggling further to purchase even consumables items, shares are still valued at around $159.40 representing a 28% undervaluation.

Considering the valuation metrics, absolute valuation and intrinsic value calculation, I believe Dollar General is clearly trading in what can only be considered deep value territory and a real fat pitch stock idea if you ask me.

Warren Buffett has always referred to “fat pitch” stocks as companies that present no-brainer opportunities that only come around once in a blue moon. Almost always, these opportunities present themselves when everyone else is panicking and sees nothing but red.

Considering this classification, I strongly believe Dollar General ticks all of these boxes. Fundamentally their core profitability remains unharmed whilst the prevailing market sentiment is strongly bearish and pessimistic.

In the short term (3-12 months), I find it difficult to say exactly what may happen to valuations given the uncertainty of the macroeconomic environment and the degree to which DG’s lower-income customers will be able to spend on both necessity and “luxury” items such as apparel and seasonal items.

The firm’s short-term performance is ultimately tied to the general sentiment surrounding the U.S. markets as a whole. Nevertheless, DG has historically performed relatively well even during recessionary periods. I believe DG could be a compelling bet even during a potential recession given the essential reliance many customers have on their stores in order to live.

In the long-term (2-10 years), I see a bright and prosperous future for DG. I believe they will be to (under the command of Owen) continue growing even amidst increasing competition thanks to their outstanding geographic reach and integration into underserved communities and areas.

Risks Facing Dollar General

Dollar General faces a few tangible risks that could threaten their business models success. The increasing amounts of competition DG now faces both in the form of other variety store chains and online-retailers is perhaps the greatest threat to their expansionary growth plans.

Competition from the likes of Dollar Tree is fierce given that these stores operate on an almost identical business model as DG. While DG has a relatively more well-known name and established reputation, there are essentially no real switching costs for consumers stopping them from visiting either a DG or Dollar Tree or vice versa.

Walmart, Target and Amazon are also developing a growing presence even in small-town America through improved distribution networks and online sales tactics. While this may present some increased competition to DG, I believe the effects will be negligible.

The lack of readily available income for most of DG’s target customers means that purchases must be of a small monetary unit value. For online retailers it is simply not viable from a profitability perspective to sell and ship individually packed value-sized consumables items thus limiting the ability for these players to compete with DG.

Dollar General does also face a real threat as evidence by their most recent quarterly earnings from continually falling incomes in their target demographics. This will limit the ability of their customers to purchase non-necessity items which offer DG the greatest opportunity for a price markup thus decreasing the firms profit margins.

However, I believe the significant decrease in such higher-margin sales has largely already occurred meaning that future results should not get much worse QoQ. While some weakness may still be present in customer spending as a result of persisting inflation and the potential for a severe recession to stress incomes further, I do not see much more material risk arising from this factor.

From an ESG perspective, DG faces some tangible Social and Governance risks. DG is considered by many to be destructive to the economies of small rural American towns due to the profits from sales being transported away from the local economies unlike with a small-scale grocer.

Some states and municipalities have even gone so far as to ban DG from expanding into new areas due to the economic drain their stores create on the local economy. The opening of DG in a small sub-2000-person town almost inevitably causes any small-scale grocers or town-shops to go bankrupt which many argue are crucial to the social diversity required in such areas.

Furthermore, some DG’s in more socially stressed areas have also witnessed high rates of crime which has begun to stain the chains image in these locations.

Considering these factors, I would most likely not recommend DG to a more ESG conscious investor as the material Social and Environmental risks facing the brand would make the firm unsuitable. Of course, opinions may vary and I implore you to conduct your own ESG suitability research should this be of concern to you.

Summary

Dollar General is an outstanding business that has grown and expanded their presence by targeting underserved communities and demographics. This strategy has allowed DG to avoid competition from larger retailers such as Walmart or Target while still serving a huge volume of customers daily.

Their large scale allows for powerful negotiations to happen with key suppliers to ensure DG gets excellent supply deals on products. This allows DG to specifically target income stressed households by offering them name-brand items in smaller value-oriented product sizes.

I believe that while the company has faced a few difficult quarters, the fundamental profitability of the firm is unharmed. While the macroeconomic situation has hit DG quite significantly, I do not see any real degradation of their core business model.

Considering this fundamentally sound business case and the significant 28%-43% undervaluation in shares, I believe this is a classic example of a Buffett-Style fat-pitch idea.

Therefore, I rate Dollar General a Strong Buy and have begun building a position in the company myself. I fully believe that DG will yield outsized returns to investors thanks to their strong business positioning and strategic expansion objectives.