Should I Buy Dollar General? 3 Pros, 3 Cons

by Dan Burrows | June 5, 2012 1:18 pm

Should I Buy Dollar General? 3 Pros, 3 Cons

Dollar General (NYSE:DG[1]) just gave Wall Street what it loves best: a beat-and-raise quarter, and yet shares are sliding sharply. What’s up with that?

The red-hot dollar-store chain beat top-line estimates, bottom-line estimates and raised its earnings outlook for the fiscal year when it reported first-quarter results after hours on Monday. Same-store sales — a key measure of a retailer’s health — grew robustly, too.

Nevertheless, another secondary offering (there was one in March) will dump a large pile of shares into the market. That caused the stock to plunge on Tuesday despite Monday’s strong numbers.

Chief Executive Officer Richard Dreiling and other executives plan to sell a total of 25 million shares, bringing their collective ownership of Dollar General common stock down to 37% from 44%.

The latest offering represents about 7% of all shares outstanding and more than 12% of the float (or shares actually trading in the market). That creates dilution, meaning each share’s claim on earnings is reduced. And, of course, there will be a significant jump in the supply of stock, which will weigh on the price if demand remains the same.

Still, is the sell-off in Dollar General justified? Let’s look at some of the pros and cons:

Pros

Momentum: First-quarter earnings jumped 36%, beating Wall Street estimates by 3 cents a share. Revenue rose 13%, to $3.9 billion, topping analysts’ average estimate of $3.83 billion. Same-store sales rose for the fifth straight quarter, this time by a healthy 6.7%, driven by an increase in customers who spent more during their visits. Dollar General raised its full-year earnings forecast to a range of $2.68 to $2.78 a share, up from prior guidance of $2.65 to $2.75 a share.

Defense: Dollar stores have been a bright spot during the recession and its grindingly long aftermath. Stagnant wages and high unemployment have allowed Dollar General to grab cash-strapped customers away from discount retailers such as Wal-Mart (NYSE:WMT[2]) and Target (NYSE:TGT[3]).¬†Furthermore, Dollar General benefits from the market’s broader move toward defensive names as disappointing economic data and the crisis in the eurozone have hurt more cyclical, riskier sectors.

Valuation: One knock against Dollar General lately has been that its shares look too pricey[4]. Happily, the recent sell-off and higher forecasted earnings have more than taken care of that. With a forward price-earnings ratio (P-E) of 16, the stock now offers a 10% discount to its own five-year average, according to data from Thomson Reuters Stock Reports.

Cons

Dilution: Private equity backers, who still own a sizable chunk of the company, will continue to sell big stakes into the market. The latest $25 million secondary offering follows a deal of the same size in March — and there will be more. That could cause more scary sell-offs like the one Dollar General is suffering now.

Costs: Selling, general and administrative expenses rose sharply year-over-year, hurt by higher debit-card fees, increased workers’ compensation expenses, higher distribution-center depreciation and incremental advertising costs in California, notes Guggenheim analyst John Heinbockel, who still rates the shares at buy. Furthermore, gross profit is likely to moderate over the course of the year.

Competition: As InvestorPlace has noted before[5], the lower-priced end of the retail market is intensely crowded. Dollar General faces formidable rivals, including Family Dollar (NYSE:FDO[6]), Dollar Tree (NASDAQ:DLTR[7]) and 99 Cents Only. Meanwhile, retail giants Wal-Mart and Target have doubled down on their commitments to low prices, which appears to be paying off.

Verdict

We’re going to go with Guggenheim’s Heinbockel on this one. The recent sell-off on the secondary offering was predictable and overdone. Dollar General’s beat-and-raise quarter affirms its very rosy fundamental story, while weakness stemming from the secondary offering simply creates a compelling entry point.

The stock is up 14% this year, while the S&P 500 Index is barely clinging to a 2% gain. Despite its share-price appreciation, Dollar General is actually about 30% cheaper on a forward-earnings basis than it was in March. This is a chance to buy on the dip.

As of this writing, Dan Burrows did not hold a position in any securities mentioned here.

Endnotes:
  1. DG: http://studio-5.financialcontent.com/investplace/quote?Symbol=DG
  2. WMT: http://studio-5.financialcontent.com/investplace/quote?Symbol=WMT
  3. TGT: http://studio-5.financialcontent.com/investplace/quote?Symbol=TGT
  4. shares look too pricey: http://investorplace.com/2012/03/dollar-general-stock-3-pros-3-cons/
  5. InvestorPlace has noted before: http://investorplace.com/2012/03/dollar-general-stock-3-pros-3-cons/
  6. FDO: http://studio-5.financialcontent.com/investplace/quote?Symbol=FDO
  7. DLTR: http://studio-5.financialcontent.com/investplace/quote?Symbol=DLTR

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