Chit Chat Stocks - Dollar General (Ticker: DG) Not So Deep Dive

Episode Date: October 10, 2023

Dollar General Corporation (DG) is a leading discount retailer offering a wide range of everyday essentials at affordable prices, with a vast store network serving communities across the United States, and it has demonstrated resilience in various economic conditions while facing competition in the retail industry. Listen closely as Brett and Ryan go through the history, financials, and future prospects of DG. Enjoy the show! ****************************** Chit Chat Money is presented by Interactive Brokers. Switch the best brokerage in investing today: ibkr.com/info ***************************** Subscribe to our Substack to receive free show notes and charts that go along with every episode: https://chitchatmoney.substack.com/ Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Contact us: [e-mail] Timestamps Company Background | (2:45) Industry | (15:09) Management & Ownership | (24:02) Earnings | (31:33) Balance Sheet | (42:46) Valuation | (44:15) Our Analysis | (45:15) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, hosts Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or a recommendation. Now, please enjoy this episode. Welcome into Chit Chat Money. My name is Brett Schaefer, and I am joined by my co-host, Ryan Henderson. Today is our Tuesday, not-so-deep-dive episode where we try to go

ingest deeply into a stock where we analyze one company, its business model, ownership, financials, future growth opportunities, much more giving listeners and watchers the context of what they would maybe need to research a stock further or put it on their watch list. Hopefully, at the end of this episode, you get a better perspective on the company we cover today. We are covering Dollar General, which is a, well, it's at a bit of a crossroads. We're starting a our discount retailers month and i think the fact that dollar general is down 60 is the reason we chose this as our theme for the month of october and question for you is this the biggest drawdown dollar general has had in its recent public

history do you know i believe i can check really quick but i believe it is it didn't go public for it's been it's only been public not too long it's been they came public again in 2009 but they were public prior to that too yeah if we go percent off high yeah i mean this is by far the biggest drawdown it went down 25 looks like in the 2017 ish time period but now it's 60 yes exactly 60 off its high so yeah way way bigger of a drawdown but yeah we're doing discount retailers for this month we got dollar general we got family dollar actually excuse me dollar tree is the company but they own family dollar and dollar tree it's a bit confusing hopefully we'll clear things up throughout this episode and then also hitting dollarama which is canadian one and then the

months after we are doing some SIN stocks, which will be fun. And then we are also doing luxury, which will be fun as well. But let's get right into it. Ryan, let's give listeners context on what Dollar General's business actually is. So can you take us through what they do? Sure. Dollar General is the largest discount retailer in the US by store count with just under 20,000 locations scattered across the country. I'll talk a little bit more about where those are, but they're not the largest in terms of revenue. They're not even close. I assume, well, I'm guessing Walmart does substantially more just because of the bigger box formats. But Dollar General's mission statement or their stated business plan, I liked reading this because

it was far more straightforward than what we typically see. It says, provide a broad base of customers with their basic everyday and household needs, supplemented with a variety of general merchandise items at everyday low prices in conveniently located small box stores. Kind of a word salad there, or maybe not a word salad, but it's a lot. Basically, they're just trying to provide value for customers in small store formats. And here's how a former CEO of Dollar General described the business. He says, if Walmart and 7-Eleven had a baby, that would be Dollar General. So I think that's a really good description, actually.

And basically, Dollar General is today essentially a rural grocery store that sells primarily consumable products, things like toilet paper, cereals, milk, frozen foods, candy, plenty of others. Consumables as a category account for 80% of everything Dollar General sells. Now, during COVID, when there was more stimulus checks, a little higher savings for Dollar General's customers, there was a little more discretionary spending. So things like seasonal items, home products, so home decor, that kind of thing, and apparel, so shirts, clothing, that kind of thing. And that used to be a bigger percentage, but seasonal is the second largest today. Home products is the third.

And then apparel is a really small part of the business. But really, for the most part, this is a consumables store. And today, Dollar General carries in total about 10,000 SKUs or stock keeping units. Just think of those as different inventory items. So not specifically different inventory products. How about that? That's a better terminology. But for context, Walmart carries 142,000 SKUs.

So Dollar General actually limited stock in terms of the products they supply. Now, I think the 7-Eleven part of that reference comes from the store format. So with about 20,000 stores across the country, Dollar General's average store size is roughly 8,000 square feet. For context, that's about somewhere in between a 7-Eleven and a Trader Joe's. So Trader Joe's is more like the 15,000, 10 to 15,000, and 7-Eleven is more the 4,000 square feet. So it's a pretty small store format. And 80% of these stores operate in areas with a population of less than 20,000 people. So Dollar General really targets sparsely populated markets.

It's cheap land typically where they can get these stores up and running and it can be a convenient stop for a lot of these lower income earners, which is that is their customer. They're very open and transparent about that. They say that their customer, and it's interesting to hear the CEO talk about the customer because they continuously refer to it as her or she. She is an hourly worker. She on average makes less than $40,000 a year. That's how they refer to it in conference calls. I think a lot of that has to do with the fact that typically it's a mom or something making purchases on behalf of the household. I've got a map here that shows all the stores located throughout the US. This is a little outdated. People aren't going to be

able to see it if you're just listening, but just know it's not just scattered to the big cities. they are huge throughout the Midwest, the South, Southeast. They have more stores in Texas than any other state. So like I said, really, it's a lot of these rural, small town communities with not that many people. A couple of stats though, that I found interesting to kind of paint a picture of who the Dollar General customer is and what the typical transaction looks like. The average Dollar General basket size is roughly $20, a little over. The average Dollar General shopper visits a store 32 times a year, so once every 11 days. And the average price per unit sold at Dollar General is just over $3.

So these are really low-ticket items. They're quick stops on your way home from work. Like Dollar General really prioritizes not only the value part of the customer proposition where they're trying to save the customer money, but they're also trying to save them time. They want to get them in and out of the stores quickly because typically, I believe the CEO at a recent conference said, if they're shopping, they're not earning because they're typically hourly workers.

So it's really, they're trying to save time and money for their customers. And then the last one that I found pretty interesting here, Dollar General has the second highest sales per stock keeping unit of all US retailers behind Costco. Now Costco's miles ahead of any other retailer, but it's Costco, Dollar General, Walmart, and then I'm not sure what the last one is, but they don't carry that many units, but they sell a lot of the units that they have. So that's, I think the basics around the business. Do you think I'm missing anything there, Brett? I don't think so. But one, maybe just to key it on that last point for the listeners, the importance there isn't necessarily that they're selling a lot, right? It's not really for the customer's benefit that they're selling a lot of the same SKU, but it's for the supplier negotiations. One of the key reasons Costco is able to sell so cheaply is that they're very strict with their suppliers and getting the best deals possible. Dollar General probably has a lot of operating leverage there as well. Now, going through the history,

Dollar General's roots date back pretty much all the way to the Great Depression. So a gentleman named J.L. Turner was trying to find a way to get by during the Great Depression and a lot of people are out of work. So his solution was, I think he had some money from kind of a previous sales career. His solution was to buy bankrupt general stores and liquidate their inventory. During this process, He would take his son, Cal Turner, who ended up being Cal Turner Senior, to accompany him where he would basically, Cal Turner would get a great view and a great experience learning what's it like during closeout sales? What's that process like? What are customers looking for? And what's kind of my dad bargaining like?

What's that whole process? And so he really gained a good experience all around in sales, and it ended up paying off. So after having some decent success liquidating the general stores, JL and Cal Turner, so the father and son, decided to open their own store in 1939, each putting in $5,000 of their own money. the shop, which was initially intended to be a wholesaling operation, ended up pivoting to a discount retailer. And by 1950, it had become a moderate success. I mean, it was financing their lifestyle. They were able to work. They were able to do this full-time. And over the following years, they kind of rolled out a couple more stores, but they were under random labels. It was not under a Dollar General store yet. In 1955, however, they decided to launch the very first now people think when they hear the term dollar general i don't think general store for items less

than a dollar that's not for some reason the general part kind of pairs in but that was the concept it was the dollar general store i i don't know if i don't know if you do the same but i picture like some some general i don't know okay anyways it uh that's that's kind of how it started And it was really a novel concept at the time, but every item in the store had to sell for less than a dollar. And so as you can imagine, when that's kind of the first concept or the original concept, it ended up attracting a lot of people. It was a major success. And so they changed their old labels on their old stores to new dollar general titles. And so this was huge for them. This was kind of the launching or the jumping off point. And Cal Turner Sr., the son of JL,

was leading the company at the time. He led it for 30 years before passing it off to his son, Cal Turner Jr., who also ran the company for 30 years. This isn't really that important to the thesis today, but Cal Turner Sr. was kind of a famous local salesman. He believed he could sell anything. In fact, according to a substack that I've linked to, and I will link to in our write-up that we do to accompany these, and it's from Sayu Lee. He's on Twitter. He wrote a good substack blog on it. Cal Turner Sr. once said, if the price is right, I can sell pink pants to guys. And that was basically, he wanted to be that kind of a salesman. I've got a picture in here outside of a Dollar General store with a bunch of guys lined up in pink pants.

So it's kind of interesting that he was, I don't know, he was just this kind of charismatic, very sales-oriented person. Anyways, following the introduction of that banner, they obviously had a ton of success, both ran the company for more than 30 years, and then finally handed over the reins to the first outsider CEO named David Perdue in 2003. He was the one that originally said, if Walmart and 7-Eleven had a baby, it would be Dollar General. Well, he didn't end up doing very well as a CEO.

He was pretty unsuccessful. Margins came in a lot while he was running the company. And so in 2007, it was a public company by this time. So in 1968, Dollar General went public for the first time. But in 2007, KKR took the company private and replaced Purdue with Rick Drayling as the CEO. Drayling is really, he's considered responsible for architecting the modern Dollar General business.

I think when drilling took over, it was in the mid-thousands stores. Today, it's almost near 20,000. He famously said that he thinks there's an opportunity for 25,000 stores across the country. He really pioneered... He was the architect of the modern strategy where he basically said, we want three things. We want same-store sales growth, store count growth, and we're going to buy back our shares. And the same-store sales growth is not just from price increases. They keep their price increases consistent with inflation. They're trying to drive more volume through the stores, more foot traffic, and then more items in the basket. But he was a really important figure in this. And he ended up stepping down in 2015 for the CEO, or sorry, COO to become

the CEO. His name was, let me get it, Todd Vassos. He resigned last year. Now this part's important. And after stepping down, Rick Drilling, I'm not sure what he did for the following seven years, but he just took over as the CEO of Dollar Tree, which is Dollar General's biggest competitor. So he's been out of the game for a little while, stepped back in. I think he was a chairman or he was on the board of Dollar Tree. And now he's officially become the CEO there. So he's still kind of in the picture now, but at a competitor, it's a brand new management

team. They've really kind of cleared house here. So Brett's going to get into that in a little bit, but why don't you start with the landscape and industry overall? options, futures, commodities, and more with high interest rates paid on instantly available cash balances, plus the ability to lend your eligible stock shares to earn passive income all on one single unified platform. That is why we at Chit Chat Money use IBKR and wouldn't use anything else. Restrictions apply. For more information, visit ibkr.com slash info member SIPC. Open an account with IBKR today.

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retail market, I think is hard to quantify because on the one hand, Dollar General is targeting their niche, which is essentially geographic and is going to be in those rural areas with 80% of the stores in population centers under 20,000. They have a goal of hitting about 30,000 stores around the country, give or take. I think that size of that potential market in the country is relevant given that they're probably going to close in on 20,000 stores here shortly. But at the 2016 Investor Day, management claimed there was a $793 billion addressable market for discount retail. But that includes drugstores and urban centers, mass market retail, grocery, and convenience store chains. Now, there's probably

a big overlap with convenience store chains and some of the mass market stuff here, but they're really not competing with a lot of this stuff, which does limit the total size of this business. But on the one hand, and we'll talk about this, this is the big competitive advantage that people and investors get attracted to Dollar General for is that in a lot of these rural communities, historically, and maybe we can discuss whether I think the big one of the big questions we'll have in the closing here is whether this has changed, but there hasn't been much competition at all for the core. Not maybe, you know, they'll shop at Walmart as well, but the core, all right, right next to me, I got to run, pick up a few items type stuff. In 2016, and still so today, Dollar General has greater than 50% market share within the dollar store channel. So this includes the big three, which is Dollar General, Dollar Tree, and Family Dollar, plus a lot of mom and pops out there.

They have greater than 50% market share, so they are dominating this market. And like I said, there's the big three that dominate as well, Family Dollar and Dollar Tree have sizable businesses. If we look at Dollar Tree and Family Dollar combined, they did about $28 billion in sales in 2022 versus $37.8 billion for Dollar General. So if you combine both of those, they're pretty close, but on their own, they're not nearly as big. However, if we go for a more direct competitor, Family Dollar is the one that is actually

trying to go after the same market that Dollar General is. it has more of a rural focus, while Dollar Tree is going to be generally in more densely populated areas. Now, it's not 100% of the time like that, but a lot of the times, that is how it works. Last quarter, and I think this is important, this is maybe the number one reason why the stock is down. Family dollars, comp sales grew 5.8%, while dollar generals were essentially flat. And I think we can maybe talk about other competitive threats. There's the Walmart question, which I think a lot of people may misunderstand, but also is going after some of the same lower income consumers.

There's the Amazon potential threat. And then there's the online discounters, which is big today with the TMU threat that seems to be flooding the market. So Ryan, any thoughts there? And did I mention that Dollar General's had a full flat comp sales, right? So I reiterate that Dollar General's flat last quarter, family dollar, 5.6%. So any thoughts in there on the competition, which is very important for them? Yeah.

And actually Walmart Grocery, which they don't break it out explicitly, but they kind of gave some commentary on the conference call that you can kind of back into, I think had double digit comps. So positive. Are you sure they're really a direct competitor though? walmart grocery because the you know dollar general doesn't really have fresh items i i mean it's 80 consumables yeah but it's not fresh produce it's not i don't i mean you have this in the anecdotal there's like some i mean there's some uh i think there's a reason too that alex

our friend always comps the two the they always he always compares the comp sales and maybe it's not going to... They're not necessarily competing in the direct town. They're not going to put a 100,000 square foot store in a town with 20,000 people. But I think if you can get more from a Walmart run, so say you're a town that's 40 miles away from a Walmart, if you can get more than that, you might be eating some share off the edges from Dollar General. yeah i think that makes sense but the one thing is dollar general always they keep saying that they're gaining share so i don't know maybe they're both gaining share generally and obviously last quarter they didn't gain you know the comp sales weren't the same but i don't because okay

the walmart's invested a lot in grocery they've done pretty well um and at the same time dollar general's consumable business has grown a ton i think it went from like 12 billion or so in 2012 to, what, 80% of almost $40 billion today. So here's the big question. Has the Walmart competition changed in recent years, do you think? I don't think so. I think maybe I'm coming around more to your view that this recent turbulence has not been caused by Walmart.

I don't think Amazon and Timo are really competitors. I mean, you think about the items that they're purchasing here, $15 to $20 basket size. Is that something that you need to buy on Amazon? It doesn't really make a lot of sense. Some of these items are $3 units. You don't want to pay for shipping and handling for that. If anything, Amazon is more of a competitor to Walmart in rural areas, I would say, right? For like, you know, subscribe and say big, big basket purchases.

Yeah. And I don't think Timu is that big in the consumables space. It's mostly the discretionary items, really things people just absolutely don't need. And, you know, like, I don't know. If you've gone on Teemu, you know what I'm talking about. It's not, it's certainly discretionary. Yeah. And you could definitely see them getting hurt by this in the discretionary category for at least a short while.

But unless Teemu's unit economics change, which they're, we don't have good data, but the math that people are doing is that it's really, really bad. it's not sustainable so i don't know maybe is it family dollar do you think that's the big what's what's causing this problem for them you know maybe it's just one a couple quarters where comp sales are a little different but maybe it's more so that the consumer is just pulling back on dollar general spending now i think you would see that at family dollar as well but maybe i don't know maybe family dollar has like an easy comp set an easier comp set i don't know it's hard it's really hard to like pin it down and i think that's what has investors worried is because we're going to go back and forth on this on the earnings

too like there's a lot of things going on here part of it's when we talk about margins part of it's the mix shift but it's hard to pin down what exactly is going wrong yeah exactly yeah i I'm in the same boat. And I think that's a big question we're going to discuss for a little while longer here. And then I have that question saved for the end. So maybe as we discuss this, we might change our opinions, but we'll see. Let's move on to management though. Very interesting section. They have, as Ryan mentioned, a relatively new CEO in Jeffrey Owen. Owen has been with DG since 1992. Seems to just have steadily worked his way up in the company. He was previously the COO since 2019. The CFO is new, joined the company in 2019 as a VP of finance

and became a cfo in may of 2023 so basically the two big leaders here are very new to taking the ranks i think that's key context now if we look at the management incentives and executive compensation which is a big important thing here they're very typical in the structure compared to other large companies but with some strange twists i think we should hit here so the as we talked about a lot they have a base salary annual bonuses and then long-term equity awards so the annual cash bonuses are based on adjusted ebit targets not ebitda ebit so that is earnings before interest and taxes now what gets adjusted out of ebit a few things here any cost due to a change in control which should be you know mergers acquisitions whatever disaster related charges

lifo adjustments i don't think that's a huge one but again having that in there kind of concerns me it gives you wiggle room to adjust right uh for any unplanned event that exceeds 30 million dollars in cost plus a few other things all these adjustments seem a bit loose to me it gives them a bit of a flexibility that i don't necessarily like now if you look at look at the actual numbers here. In 2022, the company had a target of $3.65-ish billion for adjusted EBIT, and that's to hit their bonus payments, right? They generated $3.9 billion in adjusted EBIT, so got their bonuses. But in 2022, its gap operating profit was $3.3 billion. And if you subtract out its decently sized interest expense of $211 million, it's EBIT,

EBT, which is earnings before taxes, is $3.1 billion. So I think a highlight for that is that they don't get paid unless they hit 90% of their adjusted EBIT target. So if the company's doing really poorly like they are right now, they're probably not going to get their bonus. But I don't think in general, this seems like a good metric for the annual bonus. Now, what about their long-term performance stock units. They are based on adjusted EBITDA and adjusted return on invested capital. I'm not going to go through all the details here, but there's a lot of adjustments, right? And the adjusted ROIC or return on invested capital is a bit strange. Plus the ranges for the bonuses are a bit tight at about 20% to 22%, which

you can adjust that fairly easily right to hit your bonus i think you know what i mean you can do a little bit of financial engineering to get those so as we all know incentives are important for maturing businesses that need to find what to do with their capital right and this is especially true for a capital intensive business such as dg you know they're investing as we'll talk about in mexico pop shelf all these new initiatives for fresh items coolers frozen stuff and i think having the incentives aligned here is very very important and i'm pretty disappointed in seeing this uh i guess you know another arrow uh another score for the compensation consultants right i'll Link in our sub stack, a great tweet from Mostly Borrowed Ideas, who is a synonymous account that does great work, did great work on Dollar General.

He explains this even further because I know it's a bit complicated. But Ryan, what do you think about these poor incentives? And then maybe I'll talk about what would be an ideal one, hopefully, for DG. Well, do you know what the total compensation was? no but i don't necessarily i don't think i necessarily care as much about that because it's a large enough business it's not going to be too relevant although there were some numbers on how the old ceo got a lot of pay for the pandemic period but now he's gone i just would be worried about these are the things that are definitely targeting right

because they want to hit their bonus their base salary is not that big they always talk about aligning incentives right 90 is at risk well 90 is on bad metrics yeah i think one of the things that frustrates me about having really any sort of adjusted target is that it's almost this when you think about the executives versus the employees it's like the for the but not for me where the employees are getting paid out of the cash the business has all right like they're not getting they're not getting bonuses based on adjusted numbers whereas the executives can kind of massage it to give themselves better pay whereas i don't know the employees just don't get that benefit i i don't know i don't think this would entirely keep me out like this wouldn't

be the maker break from yeah yeah it concerns me it's definitely something to watch but But yeah, it's not the end of the world. I don't think it changes the fundamentals of the business, but I think it changes where management's kind of push kind of the levers on the scale here. Now, what do you, I mean, a lot of people have heard us complain about these bad ones. What would be a good incentive structure? I think most of the time, free cashflow per share is the ideal one to do. But for DG, which is going to be more capital intensive, they might have some good, free

cashflow might be depressed if they're investing a lot into new stores. I think the best option would be using a return on invested capital that's just a standard invested capital, and then the return being gap operating profit minus interest expense and taxes, because the interest expense is real here. You can't eat adjusted EBIT as a shareholder. And I would say if a manager can maintain, say, pick a number, return on invested capital greater than 15% on average for three years, they should get a fat bonus. Not until they've been there for three years and have managed that right.

And if they don't get it, they get their base salary. I think that makes sense. But hey, all the compensation consultants disagree with me. Yeah, I don't think we need to feel sorry for their base salaries either. These are very handsome base salaries. Right, right. They're not in that $40,000 or lower bracket either. And then I didn't have any of the ownership in there.

I forgot to put it in, but that's because there wasn't anything relevant. not much insider ownership and just the indexes owning the thing a notable stuff yeah i think the best thing to track would be the discrepancy moving forward between their what they report for adjusted ebit and their true ebit like if that continues to grow so that management keeps getting paid out it's a big issue i guess so right i think i would say that's the biggest thing to track the discrepancy there, but let's move on. Let's get to earnings. I think this is where it gets a little interesting and we can raise some questions and maybe try to point some fingers at potential causes, but just to put some overall numbers on it, Dollar General generate,

well, over the last 12 months, they've generated $39 billion in trailing 12-month revenue. So just under 40 billion. They generate 31% gross margins, which is better than a lot of discount retailers it's better than walmart in general and i'm guessing in the grocery division and that has actually stayed pretty flat relative to pre-covid the gross margin has despite operating margins coming in they've been able to maintain high gross margins so it kind of tells me that they might not be discounting to keep customers when they could like if they're seeing negative comps but keeping gross margins high i almost wonder if it would be better for them to drop prices on some of the things because i mean gross margin has come in

a tiny bit i think that's probably from the consumables mix changing since the discretionary items have a little higher margin but yeah it's hard to tell sorry so so operating margins over the last 12 months have been eight percent basically and it's it's lower this quarter has been coming down that's the lowest it's been in 15 years they typically average between nine to 10% operating margins. So what's happening here? I think I pulled this quote from our friend Alex Morris, the science of hitting, it's his sub stack. He covers dollar general in a lot of depth. I recommend checking it out, but I'm going to pull this quote here. He says, the problems arise as we move down the income statement. Specifically, dollar general is likely to report 2023 EBIT

margins of less than 7% by far its worst result over the past 15 years. This reflects sustained margin pressure from a number of sources, consumables, mix shift, which that's just just to describe that a little more. People are buying less discretionary items, and typically dollar general gets a little higher margins on the discretionary items as opposed to the consumables where it's the most competitive. Anyway, so consumables, mix shift, shrink, which is that theft or damaged goods aspect, product cost inflation, so just higher costs from suppliers, as well as incremental labor

investments, sales, general, and administrative deleveraging against lackluster comps. These factors have culminated in a significant hit to profitability. So I think there's a couple of questions here that we need to answer if we're going to potentially invest, which is, I guess, and we didn't even talk about this, but store count for the longest time has been growing at like seven, seven and a half percent. They've been growing comp sales pretty strongly as well. That's allowed them to be a remarkable compounder. And EPS is up tenfold since 2010 because of that kind of two-pronged approach along with buybacks.

So the three questions I have, and I think this determines our investment, is do we think they can continue to increase store count at, let's call it, low single-digit to mid-single-digit percentage? Do we think they can get back to 9% to 10% operating margins? And do you think the pressure on comp sales will last? yeah the first one store count this decade they can probably do low single digit it seems like there's plenty of room left to hit that 30 000 store mark i don't think that's a huge concern i know some people have that but it's going to mature pretty quickly here they're not they i don't think there's room to double their store count unless they really get successful in mexico but that's a long-term thing that we'll talk about uh the margins i don't think so i think i would

I have doubts that it can even stay at 8%. I mean, if we look at their kind of the couple years before COVID, they were facing the same problem. The margins are not too different today than they were then. Yeah, I don't, I really, I would have, I have low, low confidence they can get back margins to 9%, 10%. And then comp sales, I think it depends if we're in a recession. I think they can probably get back to inflation levels, right?

but i think that question is all determinant if we're in a recession and recession is positive i guess you know the thing that intrigues me is like you would think some of the comp sales lag or some of the struggles recently would just be due to the tough environment for their consumer but this point has been brought up a number of times the consumer is always in a tough spot These are hourly workers, they're low-income earners. It shouldn't, I would feel like their habits shouldn't be changing that much, aside from maybe moving more to the consumables mix. Yeah, they talked about the SNAP benefits coming off, which I guess can be a one-time

hit, but the analysts, I think, are way off base talking about the health of the consumer because they want, generally, they want the consumer to be unhealthy. I'll show a chart later, they do better during recessionary periods. In 2008, I'm pretty sure during the GFC, a lot of people that were higher earners started to trade down, started to come into the dollar general stores that maybe previously wouldn't. What are your thoughts on those questions? I think the comp, I mean, it kind of gets into the competitive advantage question because I still think, and now we haven't looked at Dollar Tree or Family Dollar, but I still think they're pretty insulated from competition. so my thought is as long as there isn't some huge recession or you know a really really bad economic environment they should get positive comp sales i know you want do we want a recession

we want a recession maybe no we do look at this chart i have lower 2004 these are comp sales 2004 3.2 2005 2.2 2006 3.3 2007 2.1 now kkr the bio and revamp stuff right but i think it's pretty clear that the recession had impact here 2008 9 2009 9.5 2010 4.9 2011 6 so i think you want we want to recession if you're a dollar general like specifically for dollar general recessionary period better i think it matters how it comes like if it's a consumer spending i mean maybe now at this point because they're not lapping big discretionary spending yeah it would benefit them but i think discretionary spending probably goes even lower which is their higher margin items and if recession gets any worse

uh yeah i mean for comp sales sure or excuse me margin sure but comp sales you know like look it was the biggest deflationary bust since the great depression and they saw nine percent comp sales two years in a row all right i just something doesn't it feels like they're spending less today like their consumer feel it feels like their consumer spending a little bit less today because they're pinched doesn't that kind of did you not have that takeaway from the conference callers or did you think it was more competitive well i think that the core consumer that stuck around with them is getting the stimmies running off the snap benefits are done which is hitting them on the one-time thing right but no one's trading down yet because the health of everyone

else is still good but if we hit a recessionary period we'll see a bunch of people trade down think i feel like the trade downs will move i don't know with amazon and stuff today it feels like a lot of the trading down would go there well here's the here's what happened so you have the the month-to-month spenders right and when there's just an example at the end of the month you're a little bit more cash pinch you can go to walmart uh or on amazon and you can buy a roll of toilet paper for uh or costco for i guess costco's not is more urban that's what a 12 pack right or 24 pack and it's more it's cheaper on a unit cost basis but you can't afford that because it's the end of the month now and you've had to trade down

a dollar general you can buy a pack of two toilet papers cost per unit tire but that's the only one you can afford yeah i get that but i don't think that's what's happened i don't think that's what would happen with the trade down environment like the people that are making more than 70 000 that would that would have traded down in 08 and 09 i think maybe they start go they're probably shifting more to amazon instead of the luxury purchases at whole foods or whatever well they're you're not gonna get anyone that's ever shopped at whole foods but it's like it's the ones on the border and they're moving down to the the core dg shopper i mean it's pretty clear in the data that they do well in a recessionary period if you look in 1991

11.2 percent i didn't believe that was a recession although i had to remember my history correctly there okay so let's say i don't know all right so then what's the cop sales problem right now yeah that we're not in a recession and the core incomes consumer that had you know doesn't the non-trade down so the people that are always in the 40 000 that grow that that people and again 40 000 changes from inflation but those people are not like that that that slice of the pie isn't growing their percentage of the population isn't growing right now because the middle class or whatever is still doing great in

a recession a lot of people like those people during the gfc traded down but then right now they're hitting for these lower income people stimmy ran off right so discretionary's down we've seen that in the data their comp sales non-consumables are likely much higher which is their core stuff but lower margin so that's why margins are compressed and they're also getting hurt by the snap benefits and because they price than family dollar so i think the biggest concern from an operational standpoint is probably family dollar and some of those other places that they can go to but from a macro perspective i think it's pretty explainable and i wouldn't be too concerned

yeah i just don't know if i agree and i think there's reasons the analysts are asking those questions both at the conferences and the conference calls like maybe they're over obsessing about it but it doesn't feel it doesn't feel like you can just explain it away with family dollars winning you know yeah I think you can explain it with

I mean we'll see like I'm not super confident here but let's get to the balance sheet and we can revisit this in a second but they have a lot of they have minimal cash decent amount of debt So $7 billion in total debt, almost all of it's fixed rate. A lot of it's due after 2027.

The weighted average interest rate on that is 4.5%. They've done, like Brett mentioned earlier, $3.9 billion in trailing 12-month EBITDA. So really less than two times net debt to EBITDA ratio, very manageable, very low interest rate. So all in all, I thought the balance sheet was pretty simple. There's some interesting stuff going on with the inventory that I kind of had a hard time piecing through because there's been a slight jump in per store inventory volumes, but there's also been shrink issues, and I just don't know if I'd look at it and think it's that big of an issue. They said they're going to blow through a little bit of it in Q4, so we'll see what happens. Or excuse me, the second half of the year. Yeah, it didn't seem that out of line in terms of the inventory jump. So I didn't call anything out specifically, but they talked a little bit about it on the conference call. So maybe worth keeping an eye on because for a business like that, or a business like this, inventory balances is going to have a huge impact on cash flow in the short term and potentially the long term if they have big markdowns.

So I guess let's hit the valuation real quick and we can kind of revisit it later. Yeah. So just for reference for everyone, I think the most important question here is going to be the margin, right? And margin is related to other things, but at its core, I think a big question for investors is what sort of profit margin, whatever you want to use. I just used operating margin, gap operating margin, and I just took enterprise value divided by operating margin. And I put it at 8%, which is their actual for the last 12 months. And I did

seven, six, and five. So trailing 12 month, if we do an EV to operating income at an 8% margin, it's at nine and a half. I'll have a table in the newsletter with a little bit, some more numbers here. Then if we go down to 5%, they're trading at 15 times earnings. And that's before taxes and interest payments. So if margins slide more, the stock might not be that cheap. And if margins stay a little more elevated, closer to the 8% now, or maybe even 7%, the stock might be cheap. I think that's really it. All right.

Anecdotal evidence. We live near a big city, so don't think I've ever been to one of these, but maybe on a road trip, I'll stop by at some point. Ryan, any thoughts here anecdotally? No, really, I don't think I'm the target customer. And I can't remember the last time I went to one. And a lot of the dollar stores, to me, they seem basically interchangeable. Like I don't really have any sort of, like if I'm going to a dollar store, I don't really

think like, oh no, I got to go to Dollar General before Family Dollar or whatever. So it's not a big difference to me. What I think about, sometimes we use this anecdotal evidence as more of just a gut reaction to the business. My thought here is I think there's a scenario five years from now where we look back and think that was a weird unexplainable blip in comp sales yeah that solved it that just kind of worked itself out because i really do i mean unless family dollars just encroaching on every one of their stories and beating them on price on everything which i don't think they're not and

they're not exactly overlapped right all right we'll look at them next week but i guess or i mean exactly overlapped on like not all the locations are in the same 20 right right on the same talents yeah i would say unless family dollar is absolutely killing them they're still pretty insulated from competition so it's kind of feels like this weird unexplainable blip maybe a new management team is just bad like could be yeah could be uh future growth opportunities though i really didn't have any because the model is so simple here i mean there's stuff they need to right size in terms of like the supply chain but i don't have any you know i don't have any wisdom there what about the 2000 tractor fleet they have now they have their own tractors i did not know

that oh i guess seems a bit strange we can maybe talk about private label here they talk about that as being a margin driver maybe yeah they've they are opening some stores in mexico but it seems like very little momentum it's really new well they said they were doing well but again it's irrelevant today i think that's a good mark to go after though there's a lot of low income payers a lot of people like i've been to mexico there's a lot of stuff like this i mean there's some competitors there in oakso and stuff but and it's not i think it's called the me me super dollar yeah well it's just yeah some other banner but i don't know i've never seen i've never seen a management team that entered a new market and said yeah it's going really

poorly we're done that's true yeah so it kind of feels like well autozone in brazil oh no no they said it was going well in brazil no they said i believe they said that they have terrible unit economics at the moment but they think they'll get solved oh maybe i'm conflating it with mexico but the mexico had better than u.s brazil much worse but yeah it i don't know i don't really have any big future growth opportunities here because the recipe is so simple yeah it is interesting i think mine counterintuitively is going my future growth opportunity is going to be getting rid of some of their i would call dumb strategic initiatives they have right now there's pop shelf which i think is very we didn't hit on that yet but it's

a separate brand, purely discretionary items, so no consumables, right? And it's sort of like five below. Maybe it's more rural focused. And I think it maybe is more attuned to not just kids, but older people as well. But I think that's just a tough market to go after and really not smart. We'll see. Hey, prove me wrong. There's this thing called DG Media, I believe. I think is going to be a waste of expenses. There's all this focus on fresh produce, coolers, freezers in the stores. I don't think that's their core competency and it sounds expensive. There's a DoorDash partnership, which makes zero sense to me because of where their stores are located. I would hope that they pull back on some of these things and invest more into the store

labor, which seems to be the big issue. A lot of the stores being run down, not as well run, and maintain or regain the value proposition they've lost in some of these stores. I do like the Mexico thing, though. Seems pretty smart. All right. Highlights and lowlights. Let me go first here. Highlights.

Well, I talked about this a little bit earlier, but I think for the most part, they're insulated from competition, right? The online competition doesn't seem realistic because people are making these purchases on an as-need basis, typically for their family on the way home. They don't want to wait and they don't want to pay shipping fees to get stuff to buy a $3 item. The other part is they still generate good unit economics in their stores. So it's not, I think that raises the floor for this investment because it's not like you're getting, like if they just kept their existing store base and margins contracted a little, they're still generating enough cashflow to cover their debts. they're still generating enough cash flow to you know make this okay and maybe at one point start buying back some stock but it's not going to be a wonderful investment it's just to say that you know it won't be as good as people expected in the past low lights for me though feels like they're

getting a little closer to store count saturation we've seen store count growth simmer down even prior to COVID, kind of 2017, I believe is when it started to slow on a percentage basis. That's to be expected. The other part for me is Rick Drilling going to Dollar Tree. I can't think of a person who knows how to steal market share from Dollar General better than him. He's the best person for that job. Was it really recent or how recent was that? I want to say four or five months ago. Wow. Yeah. He was, he was the, I believe he was on the board and then January, January, 2023. Sorry. Continue. Okay. They fired or they had their CEO resign after the dollar to dollar 20. It's kind of funny. They made him, this is what it felt like. They made that jump from their dollar menu. I guess you want to call it that, to $1.25 and everyone was kind of outraged by it,

but they kept it. They fired the CEO, they brought in someone new and they said they broke the buck and they're like, well, that was the old management team, but they haven't walked it back. So it feels like they might be in a good spot now. I feel bad for the old CEO though. The current management team at Dollar General to me is probably the biggest low light. they don't feel very convincing. We've seen no proof of them getting the results you would want as a shareholder. And when I listened to them on conference calls and at that recent conference, I can't remember what it was. It's commentary that I hate and wince at as a shareholder, where it's like, we feel really good about some of the initiatives that are going on under the

hood. We put, oh yeah, our supply chain has been a huge issue. Don't worry, we put a team on it. like yeah we're just just identifying problems doesn't mean anything like they called out some of the problems and like we feel really good about this moving forward and it just felt like they weren't being they weren't very accountable i just came away kind of not liking that team yeah i don't have confidence in them but hey prove us wrong i think yeah they talk about stuff like oh we're working through it we're working through and it's like well you guys just need to pay your labor a little bit more, right? It's not a hard problem. I don't know. Investors might not like that.

Yeah. Well, they need to do it. My highlights, core business, like Ron said, in the core geography is strong mode. It's very tough to get another sizable general store in these small towns that are going to be profitable, right? So people are incentivized to stay away. There's no reason anyone would want to do this. I like the history of buybacks. Shares are standing down 31.5% in the last 10 years. And I'm sure if the company had stayed public for longer with that other management team, it would have been continued. But with the buyback program, with the levered buyback program, things can go poorly. As in the 2000s, we saw the company deteriorate, which I think is a bit concerning for me with a new management team coming in now,

and then the company getting a take under from KKR. Third one, counter cyclical. I would look this chart i will have in the investor day that we've been discussing uh same store sales growth accelerated in 2008 and 2009 and that was during a deflationary bust um i'd also know here i just just noticed this is that in 2000 during the peak of the dot-com bubble 0.9 that was their worst historically from 1990 to 2015 so that's interesting as well lowlights uh we already talked about it don't trust management uh wouldn't be surprised if margins continue to compress i kind of think that's a good thing though because they probably need to invest into their stores more some of them look pretty atrocious anecdotally what do you think what do you think keeps margins

low just the fact that they under invested in labor and the fact that it was just a one-time bump in discretionary items during the pandemic if we look at pre-covid margins were trending downwards from 2014 to 2019 so i would think that continues and as more of the they're investing more in consumables right so and maybe it has been just the overall like mix shift from 2014 onwards i think a lot of people don't want to attribute it purely to the mix shift lapping covid But I'm guessing consumables has grown as a percentage of their sales since 2014 and beyond. Yeah, I didn't make that chart yet, but I definitely should for the newsletter. And then labor, too, right?

I think they underinvested recently. They need to bump wages up, hire more people. There's been a lot of complaints from people that visit stores saying, hey, these CMU's are staffed and there's just a bunch of inventory laying around. And then the other low light, Ryan mentioned the competition for a family dollar. is getting better and I didn't even know the thing about management when I wrote that down so that makes it doubly concerning and then debt costs are going to rise as higher

interest rates continue now. They managed it fairly well but right now interest rates are higher so that's the facts that we were given. Okay this has been a long episode but let's close it out with bull case bear case. Ryan final thought or second to final thoughts here The bull case is that

the current headwinds are overblown comp sales return margins let's say stay at seven to eight percent if they get back to nine or ten percent you're in you know perfect territory as a shareholder and then they can kind of reinstitute the buyback so i i didn't even run the numbers but if you believe that store count can grow by a little each year little on a percentage basis they can return to positive comps and they do get those margins back it works here it's above our hurdle rate which is like 15 i'm sure of it yeah i mean yeah you'll eventually get to 50 billion revenue 60 billion revenue slap on seven percent

operating margin on 50 billion revenue three and a half billion right i'm getting that correct and then look at the ev today i mean you'll probably do fine plus if it keeps growing in the future. Yeah, the same thing. If margins don't deteriorate a ton, I think you probably work out to solid returns here. And eventually, if cash flow is consistent, they eventually start turning back on the buyback at this cheapish multiple, which again, it's not that cheap if margins deteriorate a lot. But I think revenue growth, pretty easily achievable here. They're going to ride through with inflation. Yeah, it'll work. Fair case though, I think, is there's been a permanent change

in the discount retail landscape. I think that's the bear case. Either from their input costs, which would be labor plus supplies, right? Or competitive stuff, right? I keep saying right too much on this episode, but what do you think? Is that true?

Has something permanently changed here? I don't know, but I do think that is the long-term bear case. If something has permanently changed that is hurting their competitive position and it's kind of the slow grind down in comp sales or comp sales are lower than inflation every year, they're going to have a hard time at their stores. There's going to be top line and bottom line pressure because the labor wages are going to have to go up. So I think that is the long-term concern. I'm not 100% sure that's the case. and I think that's why we're doing Dollar Tree

as our next episode. Yeah, hopefully we can get better context there. Final thoughts though, more or less interested, Ryan? I'm more interested. I don't think you can invest in this unless you do thorough research on Dollar Tree as well because I think it's really important that you have to understand the competitive set

before you can really determine what the problems are right now going on at Dollar General. So more interested. We'll see after next week if I'm still more interested. Yeah, that's going to be a fun one. Yes, I agree with that as well. I'm more interested, but I am uncertain on whether there's been a permanent change here or whether this management team is really hurting Dollar General's prospects and taking

them in the wrong direction. All right. This was a long one, but hopefully anyone that listens got a lot of we had some good debate this episode, and hopefully there was a lot of good information out there for everyone. And if you want more of that, we have the sub stack, which you can subscribe to for free. I'll have all our charts, show notes, everything else, and links to other resources that we used for Dollar General.

It's been a highly covered stock as of late. All right, let's get to the disclosure. We are not financial advisors. Anything we say on the show is not formal advice or recommendation. We are general partners at Arch Capital and clients may hold securities discussed in this podcast. Thank you, everyone. Again, we'll see you next time.

We'll be right back.