Thursday, June 13, 2013

Dollar General Still isn't Good Value

The latest results from Dollar General (NYSE: DG) were met with a sharp mark-down as they disappointed in terms of both the sales and margin outlook.

In general the dollar stores are attractive for their defensive properties, but many of the headwinds that began in mid 2012 are still around and they are finding growth a lot harder to come by. In summary Dollar General’s results raised more questions than answers and the current valuation still makes it a difficult stock to get too excited about.

Dollar General disappoints

After a disappointing quarter Dollar General declared that its expected sales growth rate and gross margin performance for the full year would be less than it had -only recently- predicted.

There were a few reasons cited and I have pulled out the salient points below

  • Payroll taxes, tough weather comps and sales headwinds from tax refund delays hurt the current quarter’s results

  • The sales mix contained a larger amount of consumables which tend to be lower margin. Furthermore even within consumables there is a shift to lower margin consumables

  • Inventory shrink was larger than expected

  • Increasing tobacco sales are naturally reducing margins

The issues hurting consumer’s income were somewhat expected (and Dollar General had previously argued that this would be a weak quarter anyway) but the sales mix concerns were somewhat more surprising. For example, Dollar Tree (NASDAQ: DLTR) had recently given results and notably pointed out that its discretionary sales were growing faster than consumables. This suggests that Dollar General’s issues might not be solely down to tighter customer wallets in the quarter.

Moreover if we look at how Family Dollar (NYSE: FDO) has performed in recent times, we can see that comparable sales growth has been achieved in a climate of falling gross margins. In short, Family Dollar tried to expand its non-consumables sales (mainly home based and apparel) and ran into difficulties as it found it hard to sell higher margin products to its customers.

In summary, Dollar Tree did fine with expanding discretionary sales and therefore gross margins, but Family Dollar has had problems doing this (particularly last year) and now Dollar General is lowering estimates thanks to lower-than-expected discretionary sales.

My feeling is that Dollar General’s difficulties are more a consequence of the difficulty in increasing higher margin sales. It seems that hard pressed consumers feel more inclined to shop for consumables in its stores. As to the weather effects, if they had significant effect on discretionary sales then why wouldn’t the management raise guidance now that spring weather has arrived?

Comparable same stores down across the industry

As ever it is useful to compare how same store sales are faring across the industry. Please note that these numbers are adjusted to the calendar year as these companies have different reporting periods.

It’s clear that same store sales growth started slowing in mid 2012. Family Dollar did achieve some growth but, as discussed above, that was largely a consequence of an expansion in lower margin product sales. The dollar stores are seeing slowing comparable same store sales growth and traditional grocers (Safeway, Kroger etc) are starting to fight back through engaging customers with pricing and promotional activity.

While these issues are affecting the industry there has been no let up in their store expansion strategies. Indeed Dollar General affirmed that its number one investment priority was to open new stores. Indeed it is planning $575 million to $625 million in capital expenditures and hoping to open 635 new stores while relocating/remodeling around 550 stores.  Is this push for growth, by the whole industry, a wise strategy given that same store sales growth is slowing?

Are the dollar stores good value now?

As ever we need to put the growth prospects in the context of valuation. Dollar General’s forecast for comparable same store sales growth of 4-5% isn’t bad in a slow economy and its earnings are forecast to grow double digits over the next few years. On the other hand none of the dollar stores look particularly cheap right now and the expansion plans are impacting the generation of free cash flow.

For companies in a growth phase I like to equate their capital expenditures with depreciation in order to create an adjusted free cash flow number.

In conclusion I think it’s still time to hold fire on the sector right now. It's probably better to follow its customers and hold out for a discount.

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