Thursday looks set to be a good day for Dollar General Corp. (NYSE:DG). Dollar General stock is up 3% as of this writing, after a strong DG earnings report for fiscal Q3. And depending on how regular trading plays out, DG stock has a chance to break its all-time high of $96.75, reached last July.
To be sure, DG earnings were strong, beating consensus on both the top and bottom lines. But with DG stock now up ~29% so far this year, and that all-time high in sight, I’m not sure they were quite strong enough to jump in.
There are some key concerns in this report looking forward.
DG Earnings for Q3
From a headline perspective, Dollar General’s Q3 looks strong, and the premarket gains in Dollar General stock make some sense. Revenue rose nearly 11% year-over-year, an even $100 million better than consensus, with growth nearly two points stronger than expected. Same-store sales rose a sizzling 4.3%, with a 30-35 bps benefit from hurricane-related activity.
That’s a big number — and might on its own be enough to keep the rally in DG stock going a little longer. Comps weakened noticeably last year, falling to just 0.9%, and were just 0.7% in Q1. The same deflation cited by supermarkets such as Kroger Co (NYSE:KR) was a factor — but traffic also was relatively weak, with the 10-K citing a flat figure last year and the Q1 FY17 10-Q mentioning a decrease in customer count.
But both traffic and basket have risen in Q2 and Q3, which raises hopes that traffic increases should continue. And the Q3 comp print of ~4%, even excluding the help from storms, represents a nice acceleration from the Q2 figure of 2.6%.
EPS of 93 cents, meanwhile, missed Street estimates by a penny. But that figure includes a 5 cent net impact from the storms. Backing that out, DG earnings beat the consensus by 4 cents. Considering the lack of movement in Street estimates heading into the report, it seems likely analysts didn’t incorporate that impact, or at least all of it, into their models.
All told, it’s a strong quarter across the board. But that doesn’t mean it was a perfect quarter.
Near-Term Concerns for Dollar General
The most obvious concern in the DG earnings report – which admittedly isn’t new – is on the margin front. Gross margin compressed 8 bps year-over-year – a smaller compression than seen in the first half, but still a decline, if a modest one. Increased transportation costs (with gasoline prices playing a part) and mix changes toward consumables, where deflation remains an issue, were cited as the factors, offset in large part by higher pricing.
SG&A deleveraged ~40 bps as a percentage of sales, continuing a long-term trend in that metric. One-time effects, including charges related to last year’s purchase of 41 Express stores from Wal-Mart Stores Inc (NYSE:WMT), had a modestly negative effect. But increased compensation was the main driver, as wage inflation continues to pressure margins.
It’s also worth noting that implied Q4 guidance appears to have disappointed relative to expectations. Full-year same-store sales guidance was raised to 2.5% against a previous commentary around 2%, implying a ~2.2-2.4% increase in Q4. The EPS range narrowed to $4.37-$4.47, including the $0.05 storm impact, against $4.35-$4.50 heading into the quarter. That implies Q4 EPS of $1.35-$1.45, below consensus estimates of $1.46.
All told, while sales trends are improving, there’s still some concern on the margin front. And looking forward, there’s one key question facing Dollar General stock, particularly at the current valuation.
The Key Question For Dollar General Stock
Just ahead of earnings, the Wall Street Journal detailed Dollar General’s increasing importance to rural customers being skipped over by larger chains. Many of those customers are struggling economically – and live in areas too small to be served by larger rivals like Walmart or Target Corporation (NYSE:TGT).
DG management told the Journal it sees an opportunity in those markets. As such, Dollar General plans to build a whopping 900 stores next year, adding nearly 7% to its current store count of over 14,000.
Even though Dollar General stores cost much less to open than big-box locations, those efforts still require a major investment. Beyond capital expenditures, they will potentially add to SG&A inflation, at least in the near term. And so the key question for Dollar General is whether that model necessarily is a good thing. Is being the “only game in town”, or close, for economically struggling customers a good thing – or a path to further pricing and/or margin pressure?
That question takes on added importance in the context of the current valuation of DG stock.
DG Stock Valuation
After this year’s gains, and including the premarket move, Dollar General stock now trades at over 21x the midpoint of FY17 (ending January 2018) guidance, adding back the ~$0.05 in hurricane impact.
That is a reasonably attractive multiple. Rival Dollar Tree, Inc. (NASDAQ:DLTR) trades at almost 23x its guidance for the same period (backing out one-time impacts). But it’s also a multiple that requires growth to perhaps accelerate from the ~7% net income growth guided this year.
It’s a multiple that requires the current strategy to work, particularly for the big run to continue and for DG stock to break $100. And it’s a multiple I’m not quite willing to pay. Q3 was a good quarter – but it wasn’t a great quarter. Margin concerns persist. And the small-town focus seems potentially dangerous, given that those populations are getting older and getting smaller.
There are worse stocks than Dollar General stock, to be sure. I’m not recommending a short … but neither do I necessarily see room for much upside beyond a new all-time high.
The last time DG stock was at these levels, it fell sharply after FY16 Q2 earnings disappointed. I’m not sure that will happen again, but it’s not a risk I’m willing to take.
As of this writing, Vince Martin has no positions in any securities mentioned.
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