Is This Retail Stock a Great Opportunity?

Victor is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

What would you say if I told you that you could get your groceries and other shopping items at a prices 20% below the supermarket average, in a conveniently located store, where you won’t get lost in the aisles? Pretty good deal, right?

When analyzed that way, understanding the success of the Dollar Store sector is not a difficult thing to do. In this article we will look into the main Strengths, Weaknesses, Opportunities, and Threats to consider before investing in Dollar General (NYSE: DG).

Strengths

  • In the highly contested retail arena, many players compete for the lead. One would think that retail giants like Wal-Mart or Costco would dominate the market. However, in the past few years, Dollar Stores like Family Dollar (NYSE: FDO), Dollar General, and Dollar Tree (NASDAQ: DLTR) have taken the advantage, with share gains significantly higher than the ones provided by other retailers (Supermarkets, Drugstores, Discounters, etc.). The concept is one of the most differentiated within retail today, in my view. Dollar stores price their products 20% below supermarkets and drugstores, yet offer equal or better convenience. According to Credit Suisse, the industry is more convenient than big box discounters, yet pricing is close .
  • Amongst Dollar Stores, Dollar General is the big sibling. With over 10,000 stores in the U.S., this leading company owes an important piece of its success to efficient management. Defined as best-in-class execution, good administration has been crucial for Dollar General´s constantly increasing sales productivity and EBIT Margins over the past few years.
  • The above mentioned strengths stem from the sector’s solid business model: low operation costs and prices for public, convenient locations, small-box format stores for a more comfortable shopping experience, and a targeted customer base. All these elements compose an appealing scenario for investors, as growth opportunities continue to exist and arise.

Weaknesses

  • Dollar Stores´ sales appear to be correlated to fuel prices. Increasing fuel prices imply not only greater operational costs, but also reduced personal disposable incomes among customers. The inability of Dollar Stores to transfer growing costs to prices (in order to remain competitive) implies that these oil price increases would certainly diminish the profit margins.
  • Dollar General´s substantial debt (over U$S 2.7 billion by February 2013) adds a liability when considering to invest. The company´s net debt (if contrasted to it´s total capital) is the highest in the sector, reaching 35% (compared to Family Dollar´s 22% and Dollar Tree´s (2)%). Apart from the obvious limits that financial obligations impose to free cash flow within the firm, additional restrictions derive from their loan agreements (i.e. proscription to sell assets, issue disqualified stock, acquire new debt, between many others), thus reducing even further the enterprise’s action margin.
  • Limited expansion compared to Dollar Tree and Family Dollar. Dollar General operates 10,052 stores compared to Family Dollar's 7,442 stores, and Dollar Tree's 4,344 shops. Dollar General has a long term goal of increasing its store base by 100%, taking the number to 20,100 stores, but Family Dollar and Dollar Tree plan to increase the current store base by 160% in average.

Opportunities

  • Growth potential in this industry is far from reaching its limit (currently, Dollar Stores only control about a 4% of total market share for groceries and other domestic supplies). Expert calculations reveal that over 15,000 Dollar Stores can still be introduced successfully in the U.S. market. The growth of disposable personal income over the past few years has provided, and is expected to continue to offer, another source of progress for the sector.
  • The introduction of Tobacco sales at Dollar General will most likely boost their profit. Competing companies like Family Dollar have already implemented this policy, showing considerable signs of success. As stated by Howard Levine, CEO of Family Dollar, tobacco buyers spend 8% more in each shopping basket (not counting the Tobacco in the basket) and they tend to take 60% more trips to the shop than beer and wine consumers. Dollar General will make an incursion in the tobacco retailing, thus providing an opportunity for investors that could see the company´s profit grow considerably.

Threats

  • The incursion of Wal-Mart and other retail giants into the small-box format retailing, along with aggressive expansion strategies implemented by other Dollar Store chains (principally, Family Dollar and Dollar Tree), generate fierce competition in the market. Store overlapping, although not substantial, is not negligible: overlapping (within a 3-mile radius) with other Dollar Stores reaches figures as high as 55%. The numbers, when compared to supermarkets, are somewhat lower, but still over 40%.
  • Dollar General´s competitiveness largely relies on the payroll tax cut and the distribution of food stamps (which represent around 5% of the stores’ sales). Cuts and set-backs in these policies would considerably impact the company’s profit margin.
  • Private Equity investors still own 19% of Dollar General's shares outstanding. This group has been selling stock consistently and will continue to do so, creating an overhang on the shares.
  • Family Dollar appears to have entered a period of outperformance relative to its peers. While Family Dollar has typically lagged Dollar General, it has started a number of strong initiatives, such as an aggressive remodeling campaign, the roll-out of tobacco, a new distribution agreement with McLane and the eventual roll-out of beer and wine. Bolstered by new management with critical small box experience, Family Dollar recently accelerated multiple initiatives that should yield industry leading comparable sales growth, strong earnings growth, and increased competitive pressures to Dollar General.

Foolish bottom line

Although the Dollar Store segment is fast-paced, many believe that its momentum is not over, and growth opportunities are still plenty. Dollar General might not be the right call at the moment, since the stock provides limited upside. 


Victor Selva has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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!

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