Summary
- Free Cash vs. Growth and the effects on share price.
- Share buybacks, Dividend and retained earnings.
- How will the addition of a dividend effect Dollar General's current valuations?
Over the past five years, many of the discount retailers such as Dollar General (NYSE:DG), have been on a robust run. As Dollar General is up over 178% over the past 5 years, a few questions begin to arise. Is this the time to invest? What are some of the strengths moving forward? and what are some of the headwinds that Dollar General will face?
DG data by YCharts
On March 12th, Dollar General released their Q4 and 2014 annual report. Within the report, Dollar General stated they delivered an EPS of $1.17 which was an increase of 16%. They stated that Q4 sales increased by 9.9% and Q4 same store sales increased by 4.9%. From a full year's outlook, Dollar General reported that sales increased by 8% and same store sales increased by 2.8%. As indicated by the chart above, the market was very satisfied with these numbers.
So, even though the general economy is slowly recovering, I believe, people are still looking to save money and are seeking places to find good prices for everyday items. With this in mind, Dollar Generals' management has made some very bullish moves over the past few months to continue to feed off of this trend. Management has constructed a plan that represents a balanced approach to their obligations regarding delivering value to shareholders and growing the company. They intent to do this by investing in future growth as they are looking to add over 730 stores in 2015 and return capital to shareholders through share repurchases and dividends. According to the FY 2014 annual report the plan includes:
- Share Repurchases of $1.3 billion.
- The Initiation of a Quarterly Cash Dividend.
- Continued Expansion, Including three new states.
As the three issues above need significant capital to move forward analyzing the company's free cash as well as retained earnings will give us an idea of how much it will cost the company and how much is left over for expansion, shareholder return and debt repayment or in other words, fundamentally what will the future look like.
Free Cash
Analyzing cash flow metrics is crucial because it strips away certain accounting effects and should provide a clearer picture of the current reality of the business operations. As free cash is Cash Flows From Operations - Capital expenditures it is an indicator of how much cash the company is bringing in versus how much is needed to grow the company.
- 2012 - $1.050 billion - $515 million = $536 million
- 2013 - $1.131 billion - $572 million = $560 million
- 2014 - $1.213 billion - $538 million = $675 million
- 2015 TTM - $1.315 billion - $374 million = $941 million
DG data by YCharts
So, as the chart above indicates Dollar General has been able to increase their free cash over the past number of years. Also noted in the chart, there is a distinct co-relation between the company's free cash and the stock price. Now, as the company is looking expand by adding approximately 730 new stores in 2015 and looking to continue this pattern in 2016, how will this affect the free cash estimates over the next two years.
Free Cash Estimates 2015 and 2016
As cash flow from operations is EBIT + Depreciation - Taxes we come up with a 2015 estimate of $1.419 billion. The $1.419 billion in cash is managements estimate in growth of 7% - 9%. If we calculate 8% growth next year we get $1.419 billion.
$1.419 B - $525 million = $894 million
In 2015 management expects, Capital expenditures to be in the range of $500 million to $550 million. With this cash management plans to open approximately 730 new stores in 2015. This is expected to increase the square footage growth by ~6%. Along with the 730 new stores management is expecting to relocate or remodel 875 stores.
So in 2015 as I have an estimate in the $894 million range, this is lower than FY2014.
Free Cash FY 2016
$1.508 B - $575 million = $933 million
In 2016, management plans to extend the growth by accelerating new store openings to 7% square footage growth. By this figure we estimate ~$550 to ~600 million in capital expenditures for FY 2016.
Over the next couple of years, I have the free cash coming off the current highs of $940 million. As the company has an extensive plan for growth over the next couple of years that include 730 new locations in 2015 and an accelerated plan for 2016, this will have an impact on the capital expenditures which in turn will affect the company's free cash.
Shares Outstanding
As the chart below indicates, management has been very active regarding share repurchases.
DG Shares Outstanding data by YCharts
- 2012 shares outstanding = 345 million
- 2013 shares outstanding = 334 million
- 2014 shares outstanding = 324 million
- Current shares outstanding = 303.42 billion
Dividend
On March 10th 2015 the Board of Directors approved the initiation of a regular quarterly cash dividend to shareholders. The first quarter dividend of $0.22 per share will be payable on April 22, 2015 to shareholders of record of the Company's common stock on April 8, 2015.
As Dollar General now offers a dividend this should have a positive effect in the number and type of investors that are interested in the company. Having stated that, How will the introduction of a dividend effect the company's retained earnings?
Retained Earnings
As retained earnings is the portion of a company's net income which is kept by the company instead of being paid out as dividends to equity holders, it is an indication of financial strength. A healthy amount of retained earnings allows management to invest into areas where the company can create growth opportunities.
DG data by YCharts
As we can see, management has been able to add to their retained earnings over the past five years. Looking forward now that management has to add the dividend, what will the retained earnings look like?
Net income - dividends = Funds + existing retained earnings = retained earnings.
$1.065 B - $256.76 m (Dividends) = $808.24 million + $2.40 billion (existing retained earnings) = ~$3.208 billion for 2016
Looking to FY 2016, I have estimated that the retained earnings will continue to grow by ~$808.24 million in 2016.
From a fundamental point of view the next couple of years should be interesting for Dollar General. As management is aggressively growing the company, and initiating a dividend this will have an effect on the company's cash flows.
Based on the information above, I believe Dollar Generals Free Cash flow will come off, over the next couple of years. As this is the case I believe this will be a case for the share price to follow suit. Having stated that, as management is initiating the dividend and buying back share, I believe retained earnings will continue to increase.
Valuation
In the section below, I will use a Discounted Cash Flow valuation model to estimate the current value and target price for each share of Dollar General.
I believe using the Discounted Cash Flow valuation model for Dollar General to be fair, because DCF analysis can help one see where the company's value is coming from and can generate an opinion based on that.
| FY2015 | FY2015 | FY2016 | ||
| FY 2015 TTM | 5% growth EBITDA | 10% growth EBITDA | Analyst Estimates FY 2016 | |
| Operating Income | 1,769 | |||
| Taxes | 88 | |||
| Unlevered Net income | 1,681 | |||
| D&A | 342 | |||
| EBITDA | 2,111 | $2,217 | $2,322 | $2,319.00 |
| Free Cash Flow | 941 | 941 | 941 | 941 |
| WACC | 11.17% | 11.17% | 11.17% | 11.17% |
| Terminal Value 11X EBITDA | 23,221 | 24,382 | 25,543 | 25,509 |
| Sum of Parts | $24,162.00 | $25,323.05 | $26,484.10 | $26,450.00 |
| Net Present Value | $21,734.28 | $22,778.67 | $23,823.06 | $23,792.39 |
| Total Debt | 2,639 | 2,639 | 2,639 | 2,639 |
| Cash and Cash Equivalents | 580 | 580 | 580 | 380 |
| Net Debt | $2,059.00 | $2,059.00 | $2,059.00 | $2,259.00 |
| Equity Value | $19,675.28 | $20,719.67 | $21,764.06 | $21,533.39 |
| Shares Outstanding | 303.45 | 303.45 | 303.45 | 303.45 |
| Price Value | $64.84 | $68.28 | $71.72 | $70.96 |
| Current Price | $73.94 | $73.94 | $73.94 | $73.94 |
| Difference | -12.31% | -7.65% | -3.00% | -4.03% |
Even though there are variations in calculating this formula, this model is based off of a terminal value of $19.675 B and a WACC of 11.17%. The terminal value of $19.675 B is based off of the company trading at 11X EBITDA. Using this valuation, I have concluded Dollar General's value to be ~$64.84 per share.
Please note: I have used a valuation slightly higher than the 9.57X industry average. As the company is now offering a dividend, I believe this will increase the trading valuations. As the company will attract new investors who are interested in dividend growth.
EV/EBITDA = Enterprise Value / Earnings before interest, Taxes, Depreciation and Amortization
In the next section, I will use the EBITDA to calculate the EV/EBITDA. The adjusted EBITDA takes into account foreign exchange and share-based payment expenses. The EV/EBITDA ratio is one of the most commonly used valuation metrics, as EBITDA is commonly used as a proxy for cash flow available to the firm. Retail stocks typically have an EV/EBITDA ratio that trades in the 9.0x to 10.0x trading range.
Enterprise Value or EV = Market Capitalization + Total Debt - Cash and Cash Equivalents.
- EV - 22.79 billion + $2.639 billion - $580 million = $24.849 billion
- EV = $24.849 billion
- EBITDA = 2.112 billion
- EV/EBITDA = 11.76
As the Consumer Staples sector often trades in the 9.57x trading range, an EV/EBITDA ratio of 11.76 supports the DCF valuation by indicating at current levels the stock is trading just over fair value compared to the sector average.
As the DCF and the EV/EBITDA both indicate that Dollar General is overvalued, it is an indication that the valuation may have "outpaced itself."
Conclusion
From a investment point of view, the next few years should be interesting for Dollar General. As management is aggressively expanding the company by adding over 700 new stores, relocating and re-facing over 800 stores as well as expanding into new states, this will increase the capital spending. So, as capital spending increases over the next couple of years, I believe the free cash metric will likely take a short-term hit. Having stated that, I believe the with the company's share buy back campaign and the addition of the dividend these will add shareholder value.
As I have stated earlier, as the company is now offering a dividend, I believe this will attract more investors and different types of investors. Because dividends reduce risk, and pays the investor for their patience, this could entice the growth dividend investor who otherwise would not have even looked at the company. So, as the company will attract more investors this should increase the trading valuations.
As of April 7th, Dollar Generals stock was trading at $73.94 - using the Discount Cash Flow Formula above, this indicates that stock is overvalued by ~12%. If we look at the long-term relationship between free cash and stock price, the indication that this metric could come off in the next year or so, which in my opinion would provide a buying opportunity.
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