Dollar General | NYSE: DG | Price: $74.95 | Date: 11/15/16 ... · Analysts: Luiz Arruda, Laura Del Castillo, Sam Rodas, Jose Ortiz 3 Dollar General has a strong history of top and

Company Overview Dollar General is the largest U.S. discount variety chain by number of stores.As with other industry players, Dollar General offers a variety of general merchandise at heavily discounted prices.

Investment Thesis Risks

Analysts: Luiz Arruda, Laura Del Castillo, Sam Rodas, Jose Ortiz

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BUY Industry: Retailing Sector: Retail Market Cap:21.19B Beta: 0.79 P/E: 17.59 P/B: 3.88 ROE: 22.70 ROA: 10.69 Yield: $1.00 Div: 1.34% LT Growth: 12.9% 52 Week Range: $59.75-$96.88

Dollar General | NYSE: DG | Price: $74.95 | Date: 11/15/16

Target Price: $110.00 | Intrinsic Value: $103.48

Due to an overreaction to lower than expected earnings and same-store sales growth from the latest quarter, Dollar General experienced a 22% price decline. We believe the consensus overemphasized the impact from decreasing government welfare spending. We are impressed by Dollars General’s ability to generate consistent high levels of cash flows and its strong historical top and bottom-line growth. We believe Dollar General’s advantageous cash position enables the firm to sustain an aggressive buyback plan, accompanied with rising dividend payments. We have an intrinsic value of $103.48 for the stock, implying an undervaluation of 39.09%.

• Declining government spending towards SNAP and tighter eligibility restrictions

• U.S. election causing uncertain future on foreign trade.

• Pricing war could continue to pressure margins growth

• Vulnerability to deflation on key products

Negative News Upon releasing 2nd quarter results, Dollar General’s stock price dropped 22% as a result EPS missing consensus’ estimates by $0.01. This drop can be credited to operational inefficiencies and unfavorable macroeconomic trends.

Same-store sales growth for the quarter came at an underwhelming rate of 0.7%. This slower-than-expected result was perceived very negatively given that it was down from a 2% increase in the first quarter and below management’s goals of 3% same-store sales growth. CEO Todd Vasos attributed the weakening same-store sales performance to a greater than anticipated headwind from price deflation across key perishable items and a reduction in the participation rate and benefit level from the Supplemental Nutrition Assistance Program.

Milk and eggs retail prices, the two largest products within perishables, were down nearly 8% and 50%, respectively. Furthermore, declining government investing towards the Supplemental Nutrition Assistance Program will have a negative impact on the company’s average ticket amount as the purchasing power of Dollar General’s core customers decline.

Following the purchase of 42 Wal-Mart express locations, the company will need to relocate 40 existing Dollar General stores. This is will create leasing conflicts that will have a negative impact of $0.02 to $0.03 towards diluted EPS.

The operations of the company are proving to be undergoing a period of inefficiency with increasing shrink and markdowns. Dollar General has reduced retail prices by 10% on nearly 450 of their best selling SKUs across 2200 stores, representing nearly 17% of its store base. We suspect this strategy reflects their reaction to a heightened competitive environment.


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DOLLAR GENERAL - NYSE: DG NOVEMBER 15, 2016

Thesis Breakdown Strong Fundamentals

Same Store Sales Performance According to the Congressional Budget Office, Office of Management, and the Bureau of Economic Analysis, it’s expected that the spending from SNAP is likely to continue declining until 2020. The consensus predicts an improving economy will diminish the need for significant SNAP investment, as well as a return to pre-recession normalized investment levels. However, we believe the slow pace of economic recovery in low-income households will prevent massive cuts in welfare spending. The consensus estimates that SNAP caseloads will decline to pre-recession levels by 2020. However, variables strongly positively correlated to SNAP funding, such as poverty rate, participation rate, food insecurity levels, remain significantly above pre-recession levels. The number of households classified as food insecure has grown by 30% since 2007.

The dollar and variety store industry has always been one with high competition. Dollar General has been able to remain a top performer despite the high level of competition and pricing wars. We see same-store sales improvement resulting from increased store traffic and the introduction of higher margin products.


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Dollar General has a strong history of top and bottom-line growth. Sales have increased at an average annual growth rate of 9.36% over the past five years, while net income has increased at an average of 13.45%. While gross margin has been declining mildly, Dollar General has been able to reduce SG&A expenses through the zero-base budgeting program, an initiative that aims at cutting any costs that don’t add value to the customer experience. We expect management’s cost cutting efforts to continue increasing the firm’s operating margins during the next 3 to 5 years.

On August 25th, due to lower than expected same-store sales growth, the company released Q2 earnings that missed EPS consensus estimates by $0.01. As a result, Dollar General lost 22% of its value despite its fundamentals remaining intact.

Top and Bottom-Line Performance Cash Strong Cash Position Dollar General’s business model allows the firm to generate substantial cash flows. The company has been able to maintain an average cash balance of $178 million during the past five quarters. We believe the firm’s ability to consistently generate substantial cash flows is an important aspect of its undervaluation. Most notably, the company has generated operating cash flows of over $1 billion since 2012, always higher than the previous period.

Buybacks and Dividends The cash position allows the firm to execute its expansion initiatives without becoming highly leveraged. Management has announced an expansion plan for 2017 that targets the opening of 1000 new Dollar General’s stores throughout the U.S., with 800 of them already on the pipeline. The discrepancy between operating cash flows and the amount of cash added each quarter is a result of higher PP&E expenses caused by expansion initiatives, and by an aggressive share repurchase and dividend policy. On August 14th, the company’s Board of Directors authorized the repurchase of $1 billion of common shares in addition to the $400 million that was previously available. Dollar General has consistently repurchased over $200 million in common shares during the past five quarters, and the newly announced buyback plan of $1 billion leads us to believe this positive trend will continue during the next five years. We expect dividends to increase at a lower rate of 8% to 10% during 2017 due to difficulties originating from pricing pressure and lower SNAP participation rates. From 2018 to 2022, we believe the firm will be able to sustain dividend growth between 15% to 20% as economic conditions improve.

Economic Outlook

Millennials are quickly becoming the largest population segment in the U.S., and we believe Dollar General will be able to capitalize on key characteristics of this age group. For instance, considering Dollar General offers low-priced routine items, the company’s business model appeals to Millennials’ mindset of spending less on necessities and more on luxurious goods and services. In addition, the company is actively seeking for methods to attract this group. For instance, the company is investing in key growth initiatives such as offering web and mobile services, as well as reaching out to the younger crowd through social media.


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Economic Drivers

Per Capita Disposable Income We expect higher disposable income per capita to be a major driver of same-store sales during the next five years. Among Dollar General’s core clients (>$40,000), higher levels of disposable income will result in larger store traffic and sales transactions. We also believe the company will be able to retain its wealthier customers as income rises due to the inclusion of higher-priced national brand products among the firm’s merchandise.

Valuation

FCFE The FCFE model resulted in an intrinsic value of $103.48, implying an undervaluation of 39.09%. Our EPS expectations are slightly higher than the consensus’, reflecting our positive outlook for the company. We predict rising depreciation and CapEx expenses as a result of Dollar General’s aggressive expansion initiatives. We utilized a discount rate of 8.42% based on an adjusted CAPM.


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2015 2016 2017 2018 2019EPS 3.96 4.51 4.92 5.56 6.23Depreciation/share 1.2 1.235 1.271 1.307 1.345CapEx/share -1.71 -1.81 -1.92 -2.04 -2.16NWC/share -0.98 -1.27 -1.66 -2.15 -2.80FCFE 2.47 2.66 2.61 2.68 2.62PVofFCFE $2.46 $2.22 $2.10 $96.70IntrinsicValue $103.48StockPrice 74.4%tofairvalue 39.09%DiscountRate 8.42%

FreeCashFlowtoEquityModelTerminalValue

131.01

Multiple

We conducted a P/E expansion model to estimate a reasonable 3-year price target. We expect Dollar General’s P/E to expand to a multiple of 17.66 by 2019. The model resulted in a 3-year target price of $110.


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6.87% 7.47% 8.07% 8.67% 8.73% 8.79% 8.85%3.05% $137.77 $117.70 $102.46 $90.51 $89.45 $88.42 $87.413.30% $147.12 $124.51 $107.62 $94.53 $93.38 $92.26 $91.163.55% $157.88 $132.18 $113.34 $98.94 $97.69 $96.46 $95.263.80% $170.40 $140.90 $119.73 $103.81 $102.43 $101.09 $99.774.05% $185.13 $150.89 $126.91 $109.02 $107.68 $106.20 $104.764.30% $202.73 $162.46 $135.05 $115.21 $113.52 $111.88 $110.264.55% $224.13 $176.01 $144.35 $121.95 $120.06 $118.23 $116.45

DollarGeneral'sFCFESensitivity

PerpetuityGrowthRate

DiscountRate

2016 2017 2018 2019 2020EPS $4.51 $4.92 $5.56 $6.23 $6.85P/E $15.80 $17.25 $18.17 $17.66 $16.98Price $71.32 $84.87 $101.01 $110.00 $116.34

PricetoEarningsExpansionModel

Business Overview Business Model

“Save Money. Save Time. Everyday!

Dollar General distinguishes itself by delivering competitive low prices in both small and large markets. Its stores are strategically designed to get clients in and out quickly during convenient hours and locations.


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Convenient Locations ‣ The company establishes its stores

in close proximity to its core customers, which drives customer loyalty, trip frequency, and creates an attractive alternative to larger discount retailers.

Everyday Low Prices on Quality Merchandise ‣ Dollar General’s ability to offer everyday low prices on quality merchandise is

supported by its low-cost operating structure and its strategy to maintain a limited number of items per merchandise category. It offers quality nationally brands at everyday low prices in addition to similar-quality private brands at value prices.

Time-Saving Shopping ‣ ExperienceThe firm’s small box stores are

easy to get in and out of quickly. The convenient hours and broad merchandise offering allows customers to obtain their basic necessities while minimize their need to shop elsewhere.

Growth Opportunities The company has opportunities to expand, relocate and remodel the existing store base to better serve its customers. Characteristics of the business model that have allowed the company to continue implementing the successful expansion strategies include low initial capital requirements and low store operating costs.

Operations The typical Dollar General store is operated by a store manager, one or more assistant store managers, and three or more sales associates. The stores feature a focused merchandise offering within a broad range of categories. They are 7,400 square feet and nearly 70% of them are located in towns of 20,000 or fewer inhabitants. Many of its stores are subject to build-to-suit arrangements with landlords, which typically carry a primary lease term of up to 15 years with multiple renewal options. They also have stores subject to shorter-term leases, many of which have leases renewal options.

Distribution Its stores are currently supported by thirteen distribution centers. Most of its merchandise flows through its distribution centers and is delivered to stores by third-party trucking firms, utilizing Dollar General`s trailers. Sporadically, vendors and third-party distributors ship certain food items and other merchandise directly to stores.

Consumers Dollar General’s customers are attracted to the firm’s low prices and convenient shopping experience. The company’s core customers are low and fixed income households who are often underserved by other retailers. During the last fiscal year, 66% of sales derived from shoppers which average annual income is less than $40,000. The remaining 44% derived from shoppers that earn between $40,000 and $57,000 per year.

Suppliers Dollar General purchases its merchandise from a wide number of suppliers. During the most recent fiscal year, the two largest accounted for a total of 14% of total inventory purchased. The company secures its flow of inventory by establishing long-term relationships with them. While the loss of certain suppliers could impact the firm’s performance, we believe Dollar General is well prepared to obtain alternative sources or merchandise without seeing any substantial disruptions to the business.


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Products Dollar General offers high-quality national brand products along with similar-quality private brand products that are sold at discounted prices. The company’s product assortment is partially responsible for the firm’s ability to offer products at competitive prices. Limiting each product category to only a certain number of items allows Dollar General to have a pricing advantage in dealing with suppliers. The products are separated into four categories: consumables, seasonal, home products, and apparel.

Competitive Landscape Competitors

Dollar General has 6 major competitors across the U.S. and holds 30.90% of the market share.


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Competitive Moat Dollar General doesn’t have a wide competitive moat, however, the company has certain operational advantages over its competitors. First, the company’s ability to generate cash flows is relatively higher than those of competitors, which allows the company to capitalize on expansion opportunities more efficiently. Second, the company has been able to establish itself as the industry leader among dollar stores, which facilitates maintaining relationships with suppliers, as well as acquiring inventory at lower costs than its competitors.

Risks Breakdown Government Policies and Regulations Demand for Dollar General’s products is dependent on consumer’s discretionary income. The company exercises no control over the future of governmental programs, many of which have a direct impact on the firm’s core clientele. Therefore, terminations and modifications of welfare programs, such as the return of the three-month-limit rule to the Supplemental Nutrition Assistance Program (SNAP), could have a material impact on the firm’s same-store sales performance. Other governmental actions that could adversely impact Dollar General’s ability to grow sales and sustain margins include: changes to the minimum wage, higher taxes, higher-than-expected interest rate hikes, credit availability, and labor regulations.

Political Uncertainty The unexpected result of the presidential election creates market uncertainty and augments the government regulation risks stated above. In particular, changes in trade policy with China could adversely impact the firm’s ability to offer its products at competitive prices and to sustain healthy margins. Despite certain states recently approving an increase in minimum wages, the inception of the new government increases the likelihood of a prolonged period of low minimum wages nationwide.

Price Deflation Price deflation has weighed on Dollar General’s margins since the start of 2016 and could continue to present difficulties for the firm. Price deflation is most notable in the consumables market, where the price of milk and eggs dropped by 8% and 10% during the second quarter, respectively.


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Intense Competition Dollar General faces fierce competition from other discount stores and a variety of retailers. Pricing pressure from competitors could result in loss of profitability and customer base. In particular, major retailers are implementing aggressive price cuts in an attempt to increase store volumes. There is evidence of a price war occurring in the consumables market. However, the company has been historically successful overcoming competition and maintaining its position as an industry leader.

Company Management Todd Vasos - CEO

Mr. Vasos has served as Chief Executive Officer and a member of Dollar General`s board since June 3, 2015. He joined Dollar General in December 2008 as Executive Vice President, Division President and Chief Merchandising Officer and he was promoted to Chief Operating Officer in November 2013. Prior to joining Dollar General, Mr. Vasos served in executive positions with Longs Drug Stores Corporation for 7 years, including Executive Vice President and Chief Operating Officer (Feb. 2008 through Nov. 2008) and Senior Vice President and Chief Merchandising Officer (2001 – 2008). He also previously served in leadership positions at Phar-Mor Food and Drug Inc. and Eckerd Corporation.

John W. Garratt - Executive VP and CFO

Mr. Garratt has served as Executive Vice President and Chief Financial Officer since December 2, 2015.Prior to joining Dollar General, Mr. Garratt held leadership positions in corporate strategy and financial planning at Yum! Brands, Inc. between May 2004 and Oct 2014.He began his career in May 1990 at Alcoa, where he served for approximately 9 years.

Jim Thorpe - Executive VP and CMO

Mr. Thorpe returned to Dollar General in August 2015 as Executive Vice President and Chief Merchandising Officer, with over six years of previous employment experience with the Company. Following his retirement from Dollar General, Mr. Thorpe provided on a limited ad-hoc basis certain retail industry consulting services as President of JW Thorpe & Associates, Inc. Prior to Dollar General, he served in various positions of increasing importance and responsibility with Sears Holdings Corporation from March 1991 to May 2006.


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Analysts Luiz Arruda has a 4.0 GPA and served as an undergraduate research assistant at USF for nearly two years. He also received the Excellence in Undergraduate Research award. Arruda interned with AXA Advisors, where he analyzed clients' portfolios and researched mutual funds. He is highly involved at USF, serving in a leadership role for Global Business Brigades and participating in the Corporate Mentor Program, where he is paired with a mentor from the business community. The Brazilian native speaks three languages – Portuguese, English, and Italian.

Jose Ortiz spent two high school years in his homeland of Mexico, saying the experience helped him better understand Latin American culture and how business operates there. He joined USF as a member of the invitation-only Bulls Business Community which serves high-achieving students. Ortiz enjoyed the program so much that he volunteered to mentor three incoming business students the following year. His finance acumen, bi-lingual skills, and understanding of Latin American business led to an internship in Miami for Beta Capital Management. There he handled equity

research and conducted anti-money laundering investigations.

Samuel Rodas is a Peruvian native whose family moved to the United States when he was 8 years old. Rodas is the first in his family to attend college. He has held an internship at Wells Fargo Advisors, where he assisted two financial advisors. Rodas is a member of two honor societies: Phi Theta Kappa and the National Society of Collegiate Scholars. He is also a member of the Student Finance Association. Rodas aspires to work in corporate finance and to earn a master's degree in finance.

A finance and MIS double major, Laura Del Castillo aspires to work in equity research. She is well on her way as she has held three internships in the finance industry. She worked as a financial operations consultant at JPMorgan, served as a credit risk management intern at Raymond James, and interned as a controller at Goldman Sachs. Del Castillo is an active leader and has held numerous positions such as president of Toastmasters, co-leader for a career workshop, and coordinator for a missionary trip. She speaks three languages and is an artist and pianist.


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Documents

Dollar General | NYSE: DG | Price: $74.95 | Date: 11/15/16 ... · Analysts: Luiz Arruda, Laura Del Castillo, Sam Rodas, Jose Ortiz 3 Dollar General has a strong history of top and