Dollar General's Expansion Plans

Dollar General is worth considering for investment due to its niche moat, sound balance sheet, strong management and solid growth outlook. While management's growth outlook may be a bit bullish, the current price still offers solid return prospects, making it a BUY at present prices.

DG's efficient store operations and business model enable it to offer a unique blend of value and convenience, giving it a niche moat within a competitive retail sector. Its efficient store operations come from its streamlined mix of products. Given its annual revenues of nearly $23 billion, this small product line enables it to purchase items in large quantities, thereby leveraging considerable pricing power compared to DLTR. furthermore, it makes stores extremely easy to keep organized and stocked (saving considerable sums of employee and supply chain costs). The company also enjoys an advantage in real estate costs due to its simple, cheap and minimal maintenance, rural-based small-box layout.

Business strategy: The small, simple and rural stores result in discounted rents that cost only 82% per foot of what its rival DLTR pays and roughly half of what larger retailer Walmart and Target pay. DG effectively combines this efficient operating model with its smaller -sized and low-price business model to target a niche customer base in blue-collar lower-income rural areas where the blend of value and convenience is at a premium, thereby achieving consistently high margins (9% Operating Margin) and ROICs (14%).

The company highlighted its conservative financial strategy in the recent conference call, stating: "Underlying our capital allocation strategy is our goal to maintain our investment grade rating by managing to a leverage ratio of approximately three times adjusted debt-to-EBITDA. "

The only significant negative point on the balance sheet is that the company has nearly twice as many total liabilities as current assets and a strikingly low cash-to-debt ratio (0.07), implying limited capability to make large acquisitions or shareholder capital return hikes without growing debt significantly.

Future Prospects:

Dollar General's aggressive expansion plans are credible as dollar store market is still far from saturated.

At the same time, DG's strong cash generative ability means that more cash can be returned to shareholders.

DG is currently fairly valued compared to its peers based on TTM and Forward P/E.

I find Dollar General to be a unique stock that investors should consider having in their portfolios, as it has a surprisingly strong growth runway for a mature company with solid cash generation ability. My belief is driven by two main observations. Firstly, Dollar General's aggressive future growth will be driven increasingly by sales from new stores as compared to same-store sales growth. Fortunately, my saturation analysis finds that the dollar store market is still far from saturated. Secondly, Dollar General generates a ton of cash for its shareholders and has more than enough to increase its return of cash to shareholders even after capital expenditures.

Dollar General's 2016 top-line growth of 7.9% was achieved in spite of a paltry 0.9% same-store sales growth, implying that sales from the 900 new stores opened in the same year drove the top line. Going forward, I expect this trend of sales driven by new store openings to be the new normal for Dollar General. In fact, it is currently in the process of converting 322 stores it acquired from a small -box, multi-price point retailer in April and has plans to open another 1,290 new stores for 2017. But how credible are these ambitious store expansion plans? We see other retailer, especially departmental stores, consolidating and shutting down stores. Moreover, Dollar General's competitors such as German discounters Aldi and Lidl have also announced aggressive expansion plans. Aldi, which has about 1600 stores in the US currently, wants to increase the number of its US stores to 2,500 in the next five years while Lidl, a new entrant to the US grocery market, plans to open 100 stores along the east coast by mid-2018.

With still that much room for growth in the dollar store market, it appears that Dollar General's ambitious store expansion plans are pretty credible after all.

Dollar General is also a large, stable and defensive company that generates a lot of cash. According to its 10-K, the company produced $1.054 billion in free cash flow in fiscal 2016, representing a 10.4% increase since 2015. In the chart below, we see the seasonal trend in free cash flow by quarter. For Q1 2017, Dollar General had about $367 million of free cash flow compared to $304.98 million a year before.

Clearly, Dollar General has strong cash generation ability. It is thus able to grow the business through store expansions while rewarding shareholders at the same time. Management has chosen to achieve this through a combination of share repurchases and dividend payouts. In the first quarter of 2017, Dollar General repurchased $89 million or 1.3 million shares at an average price of $70.86 per share. As management has forecasted total share repurchase for fiscal 2017 to be approximately $450 million, this implies that about $360 million worth of shares will be repurchased for the remainder of 2017. On top of that, Dollar General paid a dividend for the first time in 2015, and since then, its dividend per quarter has been inching up.