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Why Dollar General Is a Buy

- By Robert Stephens, CFA

Its increasing investment in digital growth opportunities could boost the stock price of discount retailer Dollar General (DG).

The company's mobile app is set to be expanded after boosting sales frequency and basket size among users. The company also plans to improve the customer experience through self-checkouts and increasingly flexible delivery options.


While it faces margin pressure, investment in its transportation needs and in diversifying its product sourcing could enhance its operational flexibility.

Even though the stock has risen 23% versus a 6% gain for the S&P 500 in the last year, it continues to offer investment appeal.

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Digital growth

The company's focus on digital opportunities is expected to increase its differentiation versus sector peers. Its DG GO! app allows customers to use their phones to scan items as they shop, view a running total of items and benefit from a faster checkout. It has resonated with customers, with more than 140,000 downloads and 25,000 monthly active users. The company plans to increase the number of stores in which it is offered from the 250 it has connected so far.

Customers who use the DG GO! app make more frequent visits to stores and have baskets that are on average twice the size of those of non-digitally engaged shoppers. Dollar General intends to increase use of its app through promotional activities to its 15 million digital coupon subscribers, with an increasing use of personalization expected to be a central part of this.

Customer experience

As part of its efforts to improve the customer experience, the company is introducing a "Buy Online, Pick Up in Store" offering later in the year. This forms part of a wider Fast-Track strategy to increase labor productivity in its stores, as well as improve on-shelf availability. As part of this, it will streamline the stocking process in its stores, intended to reduce the amount of labor required to complete the task. This is expected to have a positive effect on margins.

Self-checkouts also form a key part of Dollar General's Fast-Track initiative. Thesey will reduce labor requirements, while also meeting customer demand for a faster in-store experience.

Alongside this, the company intends to open 10 DGX stores. These are approximately half the size of traditional Dollar General stores and have a product selection that is targeted at vertical-living customers, as well as millennials. Following a pilot of DGX stores, the company believes that it is able to offer a compelling customer experience that could bring incremental profit growth and a broader range of customers.

Risks

Dollar General's near-term outlook is uncertain, with its transportation costs expected to increase in the remainder of the year. This could reduce margins further after a fall in gross margin of 91 basis points to 31.2% in the most recent quarter. This was partly due to continued weakness in the wider retail industry, which meant that the company's markdowns were higher than anticipated. With the prospect of higher tariffs in future months, the company's margins could come under further pressure in the current fiscal year.

In response, the company is seeking to exert greater control on its expenses through efforts such as optimizing product assortment, reducing operating complexity and cutting down on product movement within its stores. It is also expected to roll out Electronic Article Surveillance units to around 3,000 stores in order to reduce shrinkage.

Alongside this, it will seek to broaden its foreign sourcing in order to diversify its supplier base. This could help to mitigate the impact of additional tariffs. Dollar General will also seek to expand its private fleet, with the aim of reducing transportation costs and providing strategic flexibility.

Outlook

In the current year, Dollar General is forecast to post a rise in earnings per share of 8%. This is due to be followed by growth of 11% next year. This helps to justify its price-earnings ratio of 20, while the changes it is making to its strategy could improve its rate of profit growth in the long run.

Investment in its digital opportunities could enhance the customer experience, while also differentiating it from sector peers. Likewise, the company's Fast-Track strategy may boost customer loyalty, while improving efficiency.

Although Dollar General's margins could come under further pressure, plans to reduce transportation costs and diversify its supplier base may offset higher costs.

Having delivered a higher return than the S&P 500 in the last year, further outperformance of the index could still be ahead.

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This article first appeared on GuruFocus.