Back To Basics Strategy Boosts Revenue While Challenges Loom On Profit Margins

Key Takeaways

• Dollar General's Back to Basics strategy and inventory management aim to boost customer traffic, sales growth, and improve net margins by focusing on essential items and efficiency.
  
• Enhancements in supply chain, in-store experience, and strategic inventory reduction are designed to lower operating costs, increase sales volume, and improve customer satisfaction.
  
• Reliance on struggling core demographic and operational challenges may erode margins, affecting profitability amid increased competition and supply chain issues.

Catalysts

A discount retailer, provides various merchandise products in the southern, southwestern, midwestern, and eastern United States.

• Dollar General's Back to Basics plan aims to increase customer traffic and drive sales growth by emphasizing everyday low prices, reducing inventory complexity, and focusing on essential and consumable items, which should directly support revenue growth and improve net margins through better inventory management.
  
• Improved supply chain efficiency through optimizing distribution centers and enhancing on-time and in-full delivery rates is expected to reduce operating costs and improve gross margins by lowering stem miles and transportation costs.
  
• Investments in markdown activities and increased promotional activities are designed to support and increase customer traffic. This strategy aims to drive higher sales volume, which could lead to improved revenue and potentially better leverage of fixed costs in the long term.
  
• Enhancement of the in-store shopping experience through increased employee presence at the front end and focused labor hours on inventory management will likely lead to improved customer satisfaction. This could translate into higher store traffic and sales, positively impacting revenue growth.
  
• Strategic inventory reduction, particularly in non-consumables, aimed at a net reduction of approximately 1,000 SKUs by the end of the year, should improve the quality of inventory and in-stock levels. This approach is designed to simplify operations, potentially increasing sales through better product availability and reducing costs associated with inventory management, which could improve net margins.

Assumptions

• Analysts are assuming Dollar General's revenue will grow by 5.3% annually over the next 3 years.
• Analysts assume that profit margins will increase from 3.6% today to 3.7% in 3 years time.
• Analysts expect earnings to reach $1.7 billion (and earnings per share of $8.0) by about September 2027, up from $1.4 billion today. However, there is a considerable amount of disagreement amongst the analysts with the most bullish expecting $2.0 billion in earnings, and the most bearish expecting $1.4 billion.
• In order for the above numbers to justify the analysts price target, the company would need to trade at a PE ratio of 16.7x on those 2027 earnings, up from 12.8x today. This future PE is lower than the current PE for the US Consumer Retailing industry at 20.4x.
• Analysts expect the number of shares outstanding to grow by 0.2% per year for the next 3 years.
• To value all of this in today's dollars, we will use a discount rate of 6.95%, as per the Simply Wall St company report.

Risks

• The reliance on a core customer demographic that is experiencing financial hardship and a decrease in confidence due to higher prices and softer employment levels could lead to reduced consumer spending, impacting revenue and net margins.
  
• Increased use of credit cards among customers for basic needs, with a portion reaching credit limits, could signal financial distress among the customer base, potentially affecting the company's sales volume and earnings.
  
• Heightened promotional activity in response to competitive pressures and customer demand for value may erode gross margins and negatively impact net earnings.
  
• A shift in sales mix towards consumables, driven by customer necessity, combined with increased markdowns and inventory damages, could further pressure gross margins and overall profitability.
  
• Operational challenges such as managing increased shrink (loss of inventory due to theft or damage) and maintaining effective supply chain operations amidst an initiative to close temporary facilities may increase operational costs, thereby affecting operating profit margins.

Valuation

• The analysts have a consensus price target of $106.08 for Dollar General based on their expectations of its future earnings growth, profit margins and other risk factors. However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $157.0, and the most bearish reporting a price target of just $87.0.
• In order for you to agree with the analyst's consensus, you'd need to believe that by 2027, revenues will be $46.3 billion, earnings will come to $1.7 billion, and it would be trading on a PE ratio of 16.7x, assuming you use a discount rate of 6.9%.
• Given the current share price of $82.58, the analyst's price target of $106.08 is 22.2% higher.
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.