Dollar General: Is Not So General

June 10, 2004 - TheStreet.com: Street Insight

• DG should be accumulated on any consumer weakness numbers.
• There is still growth ahead for this retailer.
• Operational performance is improving, margins will likely expand.

The near future will likely to present multiple buying opportunities in Dollar General that are to be taken advantage of. DG will likely to trade down in sympathy with other retailers on any indication of consumer weakness. We think that's a buying opportunity because DG business will not be impacted by a consumer weakness in fact it will likely benefit as more affluent consumers will look for bargains in DG's stores.

Dollar General reported good numbers a couple of weeks ago. The key operating indicators showed positive operating momentum. Operations have definitely turned the corner.

Dollar General operates general merchandise stores where it offers consumable basics at very low prices. DG targets low income consumers, typically in very small towns. DG's strategy is to concentrate stores (average size 6,800 square feet) in a 200-250 mile radius from its distribution centers. This allows the company to leverage its distribution centers, achieve low transportation costs (increasingly important with high oil prices), and dominate its markets. We have owned Dollar General for a long time, and it is one of the few companies that we have given multiple second chances. The reason that we have been willing to give the company the chance to work things out is that the problems that company has run into in the past were a result of its robust growth.

Over the years, DG had a very disciplined growth strategy, growing square footage about 15% a year. That growth rate has been trimmed down recently to 10% year, which is still staggering: the company plans to open 695 stores in 2004. That's nearly two stores a day. New stores are financed from internal cash flow. The company uses very little debt and has a very strong balance sheet.

Being skeptical optimists, we look at problems as opportunities. DG's major problem had to do with managing inventory, which is a must for a slim-margin retailer. The inventory problem was three-fold: ordering the right amount of inventory, having the right merchandise on hand, and shrink. The cause of the problem was that the systems the company had in place gave local store managers control over inventory management.

Dollar General's management has made all the right moves to solve the inventory problems. It has installed POS systems in every store and linked them to headquarters. Now management knows the composition of inventory at every store by SKU every day. With new inventory management systems in place, inventory management and merchandising decisions are made by seasoned professionals at company headquarters rather than by relatively unskilled store managers.

Now Dollar General can analyze sales trends at every store and deal with problems before they escalate -- a proactive approach. It utilizes a perpetual inventory management system. Merchandise for each store is loaded on an individual pallet at a distribution center and delivered to each store weekly. One truck is able to carry inventory for multiple stores at once and unload it in a very efficient way. Perpetual (continuous) inventory management also allows DG to respond quickly to changes in demand.

These investments in the inventory management systems have paid off. Inventory turnover has improved substantially. Inventory went from 119 days in 1999 to 87 days last year, and that number has improved every single quarter over past three years. Managing inventory levels becomes even more important when a company is growing rapidly since inventory consumes a lot of cash flow.

Technology will not solve all the problems. Another problem that company still faces is shrink. The company has made good improvements in this area, but still a lot of work has to be done. Latest quarter numbers were up to 3.13% vs. 3.10% last quarter. Management said shrink has decreased on an item basis, but I will need to do more research to understand their way of calculating it. Management also indicated that reduced turnover in store managers and proactively dealing with problem stores should solve the shrink problem. We do believe that the shrink problem will be resolved but it may take a while longer. Reduction in shrink will go directly to net profits.

There are several initiatives that should help to accelerate earnings growth in the long run:

• Buying more goods from Asia. DG has established a subsidiary in Singapore that will purchase directly in Asia. This initiative should drive margin expansion for years to come.
• Installing coolers. Coolers drive higher levels of repeat customers. The company has indicated that stores with coolers experienced higher sales growth.

The presence of coolers will allow DG to accept food stamps, thus accessing a higher share of customer wallets.

There is still strong growth ahead of this company. A large portion of DG's stores are still fairly young, so same-stores sales should be fairly robust for years to come. Growth in new stores growth should remain around 10% a year (and possibly accelerate in the coming year once shrink issues are completely resolved). Margins are likely to expand, thus driving earnings growth at mid- to high-double digits. A strong balance sheet, improving operating performance, ample future earnings growth, and attractive valuation are the reasons why DG is part of our portfolio.

Vitaliy N. Katsenelson, CFA Copyright TheStreet.com