CONSUMER & RETAIL

33

Dollar General: Resilient and

Defensive Growth
Highlights

Dollar General's defensive business model and robust growth profile have
become increasingly attractive in an uncertain market. In an increasingly
uncertain environment, we believe that stable growth stocks make sense, and
view Dollar General as one of the better positioned top-line growth stories in
retail. We see ample runway to grow square footage by 6-7% until the end of this
decade. In addition, we see 4% comp growth as readily achievable, given the
~200 bp uplift from maturing new stores and store renovations/relocations. As
such, underlying comps need to grow at a fairly modest 2.0% (including inflation)
for Dollar General to achieve 4% comp growth. In the near term, Dollar General
should also benefit from its defensive positioning, as well as product category
mix that is over 70% consumables. We expect this combination of robust square
footage and solid comps to drive 9-10% sales growth for the next several years,
with strong resiliency.
Balance sheet deleveraging and moderate margin expansion round out a
20% EPS growth outlook. Despite significant improvement in gross margins,
we see opportunity for further expansion with direct sourcing, private label
penetration, distribution and improved shrink potentially contributing ~150 bp to
gross margin expansion over the next several years. Expense control has remained
solid with 70% of SG&A growth driven by new store expansion. We expect 13%
annual operating profit growth on 9.3% sales growth over the next five years. In
addition, EPS growth will benefit from much lower interest expense as the
company steadily deleverages following its LBO. We expect deleveraging to
transition to share repurchases as the company reaches sustainable leverage ratios
at the end of 2012. With strong top-line growth, moderate margin expansion and
financial deleverage, we expect ~20% annual EPS from 2010-15.
Valuation remains attractive for a resilient and defensive growth company.
Dollar General has benefited from the rotation towards defensive stocks,
outperforming the S&P 500 by a cumulative 33% in August and September.
However, the company's 14.8x NTM P/E still seems reasonable in absolute terms,
given the prospect for 13% operating profit growth and 20% EPS growth over the
next five years. While we believe the company's defensive growth profile merits a
significant premium versus the market, the company's EPS growth will also
support the stock price, allowing for relative outperformance even in the face of
moderate multiple compression. We note that the while current ~$39 share price
represents a 14.8 NTM P/E and 8.2x EV/EBITDA today, this declines to just
12.7x P/E and 7.1 EV/EBITDA one year from today.

Investment Conclusion

Dollar General is our top pick within our retail coverage, based on its combination
of defensive earnings, robust growth prospects and still-attractive valuation. The
recent 2Q results exemplify the company's growth potential with 5.9% comps, 11%
sales growth, 16% operating profit growth and 25% EPS growth. We view Dollar
General's current strong momentum as largely sustainable, with the potential for
20% EPS growth over the next five years. In addition, current valuation levels
appear reasonable given the market's shift towards stable growth, and the
company's strong EPS growth can support relative outperformance even in the
event of modest multiple compression. We rate Dollar General outperform with a
$44 price target.

34

CONSUMER & RETAIL

We believe that Dollar General represents one of the more robust, resilient and
Robust Prospects for Square
Footage and Comparable-Store sustainable top-line growth stories in retail, with square footage currently growing
at a ~7% annual rate. We continue to see the dollar store space as underpenetrated,
Sales Growth
with the entire sector having the potential for ~32,000 stores. Although the pace of
new store openings has accelerated, we still see significant runway for future store
growth. At the current rate of new store openings, the overall sector would still not
reach 32,000 stores until 2019 (see Exhibit 1).
Exhibit 1

The Dollar Store Sector Has Ample Runway for Future Store Growth

Projected U.S. Store Growth

2010

2011E

2012E

2013E

2014E

2015E

2016E

2017E

2018E

2019E

2020E

Dollar General U.S. Stores at End of Yr

8,828

9,372

10,107

10,707

11,307

11,907

12,507

13,107

13,707

14,307

14,907

466

544

600

600

600

600

600

600

600

600

600

6,785

7,023

7,408

7,808

8,208

8,608

9,008

9,408

9,808

10,208

10,608

Net New Dollar General Stores

Family Dollar U.S. Stores at End of Yr
Net New Family Dollar Stores
Dollar Tree U.S. Stores at End of Yr
Net New Dollar Tree Stores
99 Cents Only Store U.S. Stores at End of Yr

130

238

385

400

400

400

400

400

400

400

400

4,101

4,401

4,701

5,001

5,301

5,601

5,901

6,201

6,501

6,801

7,101

295

300

300

300

300

300

300

300

300

300

300

285

301

330

350

370

390

410

430

450

470

490

Net New 99 Cents Only Store Stores

Fred's U.S. Stores at End of Yr

10

16

20

20

20

20

20

20

20

20

20

653

658

663

668

673

678

683

688

693

698

703

Net New Fred's Stores

Deal$ U.S. Stores at End of Yr

150

160

137

144

151

159

167

175

184

193

203

Net New Deal$ Stores

Total Stores End of Year
New Stores

10

10

10

10

10

10

10

10

10

10

10

20,802

21,915

23,346

24,678

26,010

27,343

28,676

30,009

31,343

32,677

34,012

919

1,113

1,431

1,332

1,332

1,333

1,333

1,333

1,334

1,334

1,335

Source: Corporate reports and Bernstein estimates and analysis.

In addition to new store growth, Dollar General continues to enjoy very solid comp
store sales growth, including expected 5.6% growth in 2011 (see Exhibit 2). While
comp growth is unlikely to reach the levels achieved in 2008-09, when Dollar General
benefited from numerous company-specific initiatives, we believe the company is
capable of achieving 4% long-term comp growth, which would be largely in line with
its historical average rate over the past two decades. More specifically, with 6-7%
square footage growth, the uplift from new store maturity should contribute over 100 bp
to overall comps. In addition, the sales uplift from store remodels (5% benefit) and store
relocations (20-25% benefit) should contribute another ~80 bp. This means that
underlying comp sales need to grow at a modest 2.0% (including inflation impact) for
Dollar General to achieve 4% comp growth (see Exhibit 3). In the near term, Dollar
General should also benefit from its defensive positioning, as well as product mix that is
over 70% consumables. We expect this combination of robust square footage and solid
comps to drive 9-10% sales growth for the next several years.
Exhibit 2

Dollar General Comparable-Store Sales

Growth %

Exhibit 3

New Store Maturation and Renovations to

Contribute ~2 pp to Comps

12.0%

Comp Lift vs.

Comp
LT Avg

10.0%

% Stores

Comp
Contribution
(bp)

8.0%

Underlying Comp

2.00%

0.0%

100%

200

6.0%

New Store Comps

Year 1 Stores
Year 2 Stores
Year 3 Stores

11.0%
7.0%
5.0%

9.0%
5.0%
3.0%

6.5%
6.5%
6.5%

59
33
20

7.0%

5.0%

2.8%

24.5%

22.5%

2.8%

4.0%
2.0%

Total New Store Lift (bp)

Source: Corporate reports and Bernstein estimates.

FY10

FY11E

FY09

FY08

FY07

FY06

FY05

FY04

FY03

FY02

FY01

FY00

FY99

FY98

FY97

FY96

FY95

0.0%

Remodels
Relocations

111

Total Company Comp

Source: Corporate reports and Bernstein estimates and analysis.

14
64
3.9%

CONSUMER & RETAIL

Margin Expansion and

Financial Delivering Should
Drive ~20% EPS Growth from
2010-15

31.8%

32.0%

31.2%

29.4%

28.0%

25.8%

29.5%

28.7%

29.4%

28.3%

30%

With operating margins reaching a new historical peak of ~10% in 2010, the
potential for further margin expansion is a key controversy. Gross margins
improved significantly over the past several years as new management
implemented a strict line review process, leveraged its negotiating power versus
vendors, improved the quality and penetration of private label, and significantly
reduced shrink (see Exhibit 4). However, we expect gross margins to decline
modestly in 2011, which reflects some modest inflationary pressure, as well as
elevated markdowns on seasonal home and apparel in the first quarter.

Dollar General: Percentage Gross Margins

28.4%

35%

27.5%

Exhibit 4

35

25%

Exhibit 5

A $2 Billion Direct-Sourcing Opportunity

Could Add 87 bp to Gross Margins
Direct
Before
Savings Sourcing
100
100
57
-5.7
51.3
43
48.7
43.0%
48.7%

Revenue
COGS
Gross Profit
Gross Margin %

20%
Gross Margin Chg.

15%
10%
5%

2011E

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

0%

Source: Corporate reports and Bernstein estimates.

5.7%

Direct-Sourcing Contribution
Incr. Direct-Sourcing Opportunity
DG Sales (FY10)
% Penetration

2,000
13,035
15%

Gross Margin Benefit (bp)

Contribution to DG GM %

570
87

Source: Corporate reports and Bernstein estimates and analysis.

Dollar General has identified direct sourcing as the largest potential contributor
to gross margin expansion over the next several years, followed by increased
private label penetration, and then distribution and shrink. The company has cited
the opportunity to directly source an incremental ~$2 billion of retail sales over the
next several years, or an additional 15 pp penetration on the company's current
sales base. The 10% cost savings from switching to direct import implies gross
margins of 49% versus the 43% Dollar General earns on traditional private label.
This suggests an incremental gross margin contribution of 87 bp (see Exhibit 5).
Management has cited private label as potentially the largest contributor in
2011. Dollar General earns a 43% gross margin on private label brands, which is 17
pp higher than the 26% gross margin on national brands. The company has
increased private label penetration of consumables from 17% in 2007 to 21.6% in
2010. With consumables representing ~72% of Dollar General's total sales mix,
another 200 bp increase in penetration would contribute ~24 bp to total company
gross margin (see Exhibit 6).
Exhibit 6

We Expect an Incremental 200 bp Private Label Penetration in Consumables to

Contribute ~24 bp to Overall Gross Margins
% Consumables

Consumables

100%

% Total Revenue

GM Differential

GM Contribution

71.6%

Private Label (2010)

21.6%

15.5%

1700 bps

263 bps

Private Label (2015E)

23.6%

16.9%

1700 bps

287 bps

200 bps

1.43%

1700 bps

24.3 bps

5yr Private Label Opportunity

Note:

Private Label
Gross Margin

43%

Source: Corporate reports and Bernstein estimates and analysis.

National Brand
26%

GM Differential
1700 bps

36

CONSUMER & RETAIL

We estimate that distribution and transportation represents 5% of Dollar

General's sales, in line with industry norms. A 4% savings would imply 20 bp of
gross margin expansion (see Exhibit 7). In addition, Dollar General sees further
opportunity to improve shrink from current levels. In aggregate, we believe there is
opportunity to expand gross margins by ~150 bp over the next several years (see
Exhibit 8). We remain more conservative than that in our explicit modeling given
the potential for offsetting headwinds, including commodity cost inflation in 2011
(we have built in 26 bp of gross margin contraction in 2011). However, this gives
us confidence in the company's ability to expand gross margins at a moderate rate
from current levels.
Exhibit 7

Potential Distribution Cost Savings

Assuming 5% of Sales

Potential Distribution Savings

%
M USD

Exhibit 8

GM Impact

We See the Opportunity for Dollar General

to Expand Gross Margins by ~150 Bp

2010 Gross Margin

bps

32.0%

Potential Sources of Benefit

3.0%

$20

15 bp

4.0%

$26

20 bp

Private Label

24 bp

5.0%
6.0%
7.0%

$33
$39
$46

25 bp
30 bp
35 bp

Logistics

25 bp

Shrink

25 bp

Direct Sourcing

87.bp

Total Gross Margin Opportunity

162 bp

Gross Margin Expansion Modeled

12 bp

2015 Gross Margin

Source: Corporate reports and Bernstein estimates and analysis.

32.2%

Source: Corporate reports and Bernstein estimates and analysis.

Dollar General has also made progress on expense control, and has
consistently leveraged expenses since the end of 2008 (see Exhibit 9). Management
has stated that 70% of SG&A growth is driven by new store growth, along with
significant investments in private brands, sourcing and merchandising. The
company is now implementing labor-management systems in the stores, as well as
centralizing procurement for non-resale items. In addition to the cost initiatives, we
also expect Dollar General to achieve underlying expense leverage from the solid
comp store sales growth. In aggregate, we forecast Dollar General to achieve 13%
annual operating profit growth on 9.3% sales growth over the next five years.
Exhibit 9

Dollar General Has Consistently Leveraged SG&A Since the End of 2008

12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%

Sales per Sq. Ft. Growth (Rolling 4Q)

2Q11

1Q11

4Q10

3Q10

2Q10

1Q10

4Q09

3Q09

2Q09

1Q09

4Q08

3Q08

2Q08

1Q08

4Q07

3Q07

2Q07

1Q07

4Q06

3Q06

2Q06

1Q06

4Q05

3Q05

2Q05

1Q05

-2.0%

SG&A per Sq. Ft. Growth (Rolling 4Q)

Source: Corporate reports and Bernstein estimates and analysis.

Dollar General's earnings growth profile will also benefit from financial
deleveraging following the company's LBO. Lease-adjusted EV/EBITDA exceeded
6.0x immediately following the acquisition, but has since declined to 3.2x on a

CONSUMER & RETAIL

37

trailing four quarters basis. We forecast Dollar General to approach a steady state
level of 2.5x at the end of 2012, at which point the company will likely begin to
repurchase its own shares.
The combination of expense leverage and share buybacks should be significant
contributors to EPS growth over the next five years. We expect Dollar General to
achieve approximately 20% annual EPS growth from 2010-15, based on 9.3% sales
growth, 3.6% operating profit growth, with leverage from interest expense and
share repurchases contributing the remainder (see Exhibit 10).
Exhibit 10

We Expect Interest Expense Leverage and Eventual Share Buybacks to Help Drive
20% Annual EPS Growth Over 2010-15E

25%
20%

3.6%

15%
3.6%

10%
5%

-0.6%

4.0%

19.8%

9.3%

0%
Sales

OP %

Int. Exp.

Tax

Shares

EPS

Source: Corporate reports and Bernstein estimates and analysis.

Valuation Is Attractive for a

Defensive Growth Company

With the increasing uncertainty around the economy and financial markets,
investors have gravitated towards companies with resilient business models and
stable growth profiles. With its defensive positioning, robust growth prospects, and
margin opportunities, Dollar General clearly benefited from this rotation, with the
stock outperforming the S&P 500 by a cumulative 33% in August and September.
However, the company's 14.8x NTM P/E still seems reasonable in absolute terms,
given the prospect for 13% operating profit growth and 20% EPS growth over the
next five years. While we believe the company's defensive growth profile merits a
significant premium versus the market, the company's EPS growth will also support
the stock price, allowing for relative outperformance even in the face of moderate
multiple compression. We note that the while current ~$39 share price represents a
14.8 NTM P/E and 8.2x EV/EBITDA today, this declines to just 12.7x P/E and
7.1x EV/EBITDA one year from today.

Exhibit 11

Dollar General: Valuation Multiples at ~$39 Stock Price

DG NTM Valuation Ratios @ ~$39 Share Price

3Q:11E
NTM P/E

4Q:11E

1Q:12E

2Q:12E

3Q:12E

4Q:12E

1Q:13E

2Q:13E

3Q:13E

4Q:13E

14.8

14.3

13.7

13.2

12.7

12.1

11.6

11.0

10.6

10.0

EV / EBITDA NTM
EV / EBITDAR NTM

8.2
8.2

8.0
8.0

7.6
7.7

7.3
7.5

7.1
7.3

6.8
7.1

6.6
6.9

6.3
6.7

6.1
6.6

5.9
6.3

FCF Yield (Levered)

Unlevered FCF Yield

4.8%
4.2%

5.5%
4.9%

5.3%
4.7%

5.6%
5.1%

5.7%
5.1%

6.1%
5.6%

6.3%
5.7%

6.7%
6.1%

6.9%
6.2%

7.5%
6.7%

Source: Corporate reports and Bernstein estimates and analysis.

Our current $44 price target embeds a 1.3x relative multiple versus the S&P
500 (14.7x absolute PE) on our forward EPS one -year out (3Q:F12-2Q:F13), and
we show the sensitivity to different assumptions in Exhibit 12.

38

CONSUMER & RETAIL

Exhibit 12

Dollar General: Price Target Sensitivity

Forward EPS

Target Price Sensitivity to Earnings and Multiple

25%
20%
15%
10%
5%
Model
-5%
-10%
-15%
-20%
-25%

$3.71
$3.56
$3.41
$3.26
$3.12
$ 2.97
$2.82
$2.67
$2.52
$2.37
$2.23

-25%
11.0x
$41
$39
$38
$36
$34
$33
$31
$29
$28
$26
$25

-20%
11.8x
$44
$42
$40
$38
$37
$35
$33
$31
$30
$28
$26

-15%
12.5x
$46
$44
$43
$41
$39
$37
$35
$33
$32
$30
$28

Price to Earnings (based on 3Q12-2Q13 EPS)

-10%
-5%
Base
5%
10%
13.2x
14.0x
14.7x
15.4x
16.2x
$49
$52
$55
$57
$60
$47
$50
$52
$55
$58
$45
$48
$50
$53
$55
$43
$46
$48
$50
$53
$41
$44
$46
$48
$50
$39
$41
$46
$48
$44
$37
$39
$41
$44
$46
$35
$37
$39
$41
$43
$33
$35
$37
$39
$41
$31
$33
$35
$37
$38
$29
$31
$33
$34
$36

15%
16.9x
$63
$60
$58
$55
$53
$50
$48
$45
$43
$40
$38

20%
17.6x
$65
$63
$60
$58
$55
$52
$50
$47
$44
$42
$39

25%
18.4x
$68
$65
$63
$60
$57
$55
$52
$49
$46
$44
$41

Source: Corporate reports and Bernstein estimates and analysis.

Exhibit 13

Dollar General: Income Statement ($ Million)

2011E
2006

Net Revenues

2007

2008

2009

2010

2010-15E

1Q11

2Q11

3Q11E

4Q11E

2011E

2012E

2013E

2014E

2015E

CAGR

$9,170

$9,495

$10,458

$11,796

$13,035

$3,452

$3,575

$3,571

$4,130

$14,728

$15,860

$17,286

$18,760

$20,312

6,802

6,834

7,383

8,116

8,858

2,364

2,427

2,461

2,797

10,049

10,799

11,752

12,736

13,779

9.2%

$2,368

$2,661

$3,075

$3,680

$4,177

$1,087

$1,148

$1,111

$1,333

$4,679

$5,061

$5,533

$6,024

$6,532

9.4%

SGA

2,120

2,227

2,446

2,672

2,887

750

798

796

833

3,178

3,388

3,651

3,904

4,171

7.6%

Operating Income

$248

$435

$629

$1,009

$1,289

$337

$350

$315

$499

$1,501

$1,673

$1,882

$2,120

$2,361

12.9%

Cost of Goods Sold

Gross Profit

Interest Income

(7)

Interest Expense

35

Miscellaneous Income / (Expense)

(9)
263

(3)
392

(0)
346

(0)
274

(0)

(0)

(1)

(1)

66

61

51

52

(2)
229

(9)
165

(11)
162

(7)
161

9.3%

(8)
161

$220

$180

$239

$663

$1,015

$269

$289

$264

$449

$1,272

$1,518

$1,731

$1,966

$2,208

Income Taxes

82

58

92

233

368

103

108

100

171

482

577

658

747

839

Net Earnings

$138

$122

$147

$430

$646

$166

$181

$164

$278

$790

$941

$1,073

$1,219

$1,369

16.2%

EPS - Basic

$0.46

$1.32

$1.89

$0.49

$0.53

$0.48

$0.81

$2.31

$2.75

$3.25

$3.94

$4.68

19.9%

EPS - Diluted

$0.45

$1.30

$1.87

$0.48

$0.52

$0.47

$0.81

$2.29

$2.72

$3.22

$3.89

$4.62

19.8%

YoY Change

n/a

44.1%

14.1%

24.9%

23.0%

25.1%

22.1%

19.2%

18.1%

21.0%

18.7%

Earnings before Taxes

187.9%

16.8%

Source: Corporate reports and Bernstein estimates and analysis.

Valuation Methodology

We rate Dollar General outperform with a $44 price target. We set our price target
using a 1.3x relative P/FE multiple against our forward EPS estimate, four quarters
hence (currently 3Q:12-2Q:13) of $2.97.
The closing prices for Dollar General and the S&P 500 on Tuesday, October
11, 2011 were $39.01 and 1195.54, respectively.

Risks

Near-term risks include unanticipated weakening of the consumer spending

environment, a heightened promotional environment or more intense price
competition from large competitors. Longer-term, the primary risks center on
Dollar General's ability to execute its multiple initiatives to remerchandize the
assortment, increase private-label penetration, shift sourcing to direct foreign
vendors, and manage inventories efficiently. Any failure to execute these initiatives
would pose a risk to our forecast for margin expansion, earnings and our price
target. Additionally, our top-line forecast is predicated on solid same-store sales
growth and a steady expansion of the store base. Weak sales growth would pose a
risk to our forecast and price target, while inability to secure real estate and open
stores is also a risk to our estimates and price objective.

Colin McGranahan
Peter Choi, CFA

colin.mcgranahan@bernstein.com
peter.choi@bernstein.com

+1-212-407-5824
+1-212-969-6228

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