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Morningstar | Soft Fourth-Quarter Margins, Investment Plans Do Not Change Our Long-Term View of Dollar General

With year-end results shy of our targets and management indicating it plans to make (prudent) investments in fiscal 2019 that should crimp near-term performance, we anticipate cutting our $108 per share valuation for narrow-moat Dollar General by a mid- to high-single-digit percentage. We expect its new food, self-checkout, and stocking initiatives to deliver top- and bottom-line benefits, but the measures align with our view that Dollar General will have to use its intangible asset and cost strengths to fuel low prices and investments in a convenient and efficient store experience to hold profitability steady (as exemplified by capital expenditure guidance of $775 million to $825 million including the initiatives, or around 3% of sales, in line with our target). So, we still call for mid-single-digit revenue growth and high-single-digit operating margins over the next decade. Despite the shares’ high-single-digit percentage slide after the news, we believe the shares trade fairly.

In addition to a softer economic environment for lower-income shoppers, management cited investment plans in offering modest fiscal 2019 EPS guidance ($6.30-$6.50; we called for $6.74). We believe the initiatives are prudent, accelerating the introduction of self-checkout lines, optimization of restocking practices to reduce their in-store labor demands, and in-sourcing of more perishable food distribution. Despite the near-term costs, we expect the initiatives to improve efficiency (needed to maintain margins and low prices in a highly competitive market) while boosting the convenience that is essential to Dollar General’s value proposition. While we expect the need to hold prices down will keep operating margins in the high single digits, the initiatives should bolster Dollar General’s ability to protect returns in an environment that should remain hostile to retailers without the advantages that the chain’s scale, reasonably protected locations, and differentiated concept afford.

Dollar General posted 4% same-store sales in the fourth quarter, leading to full-year diluted EPS of $5.97. While the sales metric beat our 3% target (partly due to accelerated food stamp benefits ahead of the government shutdown, which masked soft top-line performance somewhat but skewed Dollar General's sales toward less lucrative items), we had called for $6.03 in EPS, with mix and pricing creating profitability pressure. In addition to its fiscal 2019 EPS guidance, management stated it expects 7% revenue growth on 2.5% same-store sales expansion, slightly behind our 7.4% and 2.8% pre-announcement expectations (reflecting softening at the low end of the economic spectrum; some first quarter sales were also likely pulled forward into the prior period as a result of the change in the food stamp disbursement schedule).

We believe that Dollar General’s capital expenditure needs will remain elevated in the near term as it expands store count, remodels existing locations, and improves the store experience. In fiscal 2019, management plans to open 975 new locations (near our target), remodel 1,000 mature units, and relocate 100 stores. Our forecast calls for Dollar General to spend around 3% of annual sales on capital expenditures over the next five years, slightly higher than fiscal 2018’s 2.9% mark and meaningfully above the chain’s 2.5% five-year historical average, before tapering as new store growth ebbs.