Recession Proof Stock With Solid Upside Potential
Gaurav is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Dollar General’s (NYSE: DG) stock has been under pressure lately and have corrected more than 16% over the last six months. The company recently reported strong Q3 results with year over year earnings growth of 21%. However, this strong showing has not moved its price and the company is still trading more or less in-line with its peers. Does that mean that the market is under appreciating the growth prospects and investment strategy of the company? Well, I certainly believe so. In my opinion, Dollar General is a safest bet among the Dollar Channel stores and offers a great investment opportunity at the current levels.
Dollar General has the highest consumable mix as compared to other dollar stores including Family General (NYSE: FDO) and Dollar Tree (NASDAQ: DLTR). Let’s compare the consumables mix of Dollar General with Family Dollar, Dollar Tree and Big Lots (NYSE: BIG).
A high consumable mix remains a tailwind to margins, but it certainly brings more stability to the stock. During these times of elevated unemployment and reduced levels of discretionary income, I believe Dollar General offers good stability and thus, exhibits recession proof characteristics. A quick look at these companies' PEG ratio reveals quite a lot. Dollar General is trading at a PEG ratio of 0.88 and looks cheap with respect to its peers including Big Lots, Dollar Tree and Family Dollar. Going forward, I believe investors will view third quarter results favorably, especially given the weak performance and outlook of others in the industry, especially Big Lots and Dollar Tree, and the shares will rebound overtime.
The outlook for Dollar General looks positive and I believe that the company is only in the early innings of its operating margin enhancing initiatives. I also see potential for industry leading high-teens long-term earnings CAGR for the company. The company has opportunities to improve operating profit rates through improved category management, increased direct sourcing, expanded private labels, shrink reduction, and price optimization. Moreover, I see attractive long term growth opportunities in California and the company’s nascent new store concepts, DG Market and DG Plus.
Significant Growth Potential in California
Dollar General has a limited presence in California with a total store base of just ~50 stores as compared to Big Lots’ store base of around 180 and Dollar Tree’s store base of around 400. However, the company believes the longer-term store opportunity in California is comparable to its current store base in Texas (where it has over 1,000 stores). While management believes the ideal store size for the California market will be larger than its typical store (which averages ~7,200 square feet), it has been pleasantly surprised by the availability of desirable real estate locations. Encouragingly, Dollar General stores in California are doing well, with store volumes higher than the average store volume and I see a significant growth potential in the region.
Gross Margin Expected to Increase; SG&A Will De-Leverage in 4Q
Due to smaller YOY LIFO charges and some improvements in distribution costs, I expect gross margins to rise in the tail end of the year. The inflation environment seems relatively benign at the moment, which reduces the likelihood of having to take margin hits on vendor price increases (although that could change next year depending on the fall out of this year’s droughts). Moreover, I expect the company to post SG&A de-leverage in 4Q due to the 13 vs. 14 week comparison.
Encouraging Results at Dollar General Market
The company has opened 34 new Dollar General Market stores (a store concept which is essentially a larger version of its standard Dollar General store with additional space dedicated to fresh food and produce) so far this year. Given the encouraging returns at the current Dollar General Market locations (including the locations that were opened as part of the company’s entrance into the western U.S. market), the company has plans to open an additional 20 stores in fiscal 2013. While the gross margin rate at Dollar General Market is lower relative to a standard Dollar General location (given the skew in product mix toward consumables, which are lower margin), overall margin dollars should be higher given the additional sales volume. Additionally the company has also been working on a newer concept called Dollar General Plus, which is essentially a larger core DG store – built with extra square footage and wider aisles to accommodate the heavier customer traffic and additional inventory demands that simply can’t fit in a traditional ~7,200 square foot Dollar General.
Looking ahead, I believe that Dollar General can capture a larger share of its existing customers’ wallets, as well as attract and retain higher income customers based on improved merchandising and in-store initiatives. Huge white space opportunities in California and promising new concepts like DG Market and DG Plus further make me optimistic about the stock. In addition, the company’s recession proof characteristics limit downside risk even in case of an economic slowdown. Hence, I rate it as a buy.
gauravguru has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!