Performing Strategic Analysis

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1 Dollar General Corp. David L. and Elsie M. Dodd Professor of Finance Columbia Business School Heilbrunn Center for Graham & Dodd Investment Value Investing EMBA October, 2017 October 2017

2 Performing Strategic Analysis Step 1: The firm Identify segments inside the firm What does the firm do? Identify trends and regularities inside the firm Is the firm changing? Is an increasing share of the revenue coming from one segment How? Organically, acquisitions, innovations? How profitable are the segments? Step 2: The industry Identify firms in each segment in the context of dynamics Who are the competitors? If firms are the same, treat each segment as a single industry Is firms are different, treat segments as different industries Identify trends and regularities in the industry Are shares volatile? What is the exit rate of firms in the industry? Is there an entrenched incumbent? Competitive advantages Step 3: The Value Chain Who captures the rets in the value chain? Identify complementors and substitutes Heilbrunn Center 2

3 Performing Strategic Analysis Step 1: The firm Identify segments inside the firm What does the firm do? Identify trends and regularities inside the firm Is the firm changing? Is an increasing share of the revenue coming from one segment How? Organically, acquisitions, innovations? How profitable are the segments? Step 2: The industry Identify firms in each segment in the context of dynamics Who are the competitors? If firms are the same, treat each segment as a single industry Is firms are different, treat segments as different industries Identify trends and regularities in the industry Are shares volatile? What is the exit rate of firms in the industry? Sources of competitive advantage in retail Is there an entrenched incumbent? 1 Economies of scale in marketing and distribution Competitive advantages Number of stores and store concentration Step 3: The Value Chain 2 Customer captivity Who captures the rets in the value chain? Brand, and real estate analysis Identify complementors and substitutes Heilbrunn Center 3

4 THE INDUSTRY 4

The dollar & variety stores in the US Industry FY 2016

6bn 19% 19% 14% 17% 12% 19% Groceries Kitchenware and

Cleaning products Others Profit Annual growth rate

players $3.1bn 2.1%.4% $6.1bn Dollar General (33.

5 The dollar & variety stores in the US Industry FY 2016 Revenue $65.7.6bn 19% 19% 14% 17% 12% 19% Groceries Kitchenware and home furnishings Apparel Drugs, health, cosmetics Cleaning products Others Profit Annual growth rate Projected growth Wages Main players $3.1bn 2.1%.4% $6.1bn Dollar General (33.4%) Dollar Tree (29.2%) Big Lots (7.5%) Dollar & variety stores: Basic statistics Source: IBISWorld, December

6 The dollar & variety stores in the US Company Sales ebit EV EV/ebit Walmart 489,926 22, , Target 69,495 4,969 43, Costco 118,719 3,672 75,481 Dollar General 22,767 2,051 24, Dollar Tree 21,205 1,790 24, Big Lots 5, , Fred s 2,086 (113) Dollar and variety stores, September

7 The dollar & variety stores in the US $50,000 & more, 13.9 Other, $30,000- $49,999, 30.9 $0- $29,999, Median household income Poverty rate 7

8 The dollar & variety stores in the US $50,000 & more, 13.9 Other, $30,000- $49,999, 30.9 $0- $29,999, But recent reports (NPD) emphasize that the ``households with annual income of more than $100,000 make up up to 19% of of the sales at Dollar stores. (Bloomberg, America s Dollar Store Generation has no Shame 2016). Todd Vasos (CEO of DG) said that millenials make up to 25% of the sales Median household income Poverty rate 8

9 Footprint: Major participants 9

10 Consolidation 10

11 Consolidation 11

12 Consolidation: Overlap 12

13 Consolidation: Overlap 13

14 Consolidation: Some comments 1 The merger of of Dollar Tree and Family Dollar Dollar Tree and Family Dollar completed their merger in 2016 As part of antitrust compliance DLTR sold 330 stores to Sycamore partners They were generating about $500m in revenue and $45.5m in operating income Sycamore then turned around and sold 323 of those stores to DG in Fred has 644 stores and it is in some distress: Acquisition target? Would AMZN be interested in DG? Last mile much closer! Remember match the scale of your competitors. 14

15 Industry disruption and headwinds 1. Short term troubles A. Food deflation Prices of eggs, milk and in-home food have been ternding down with a significant effect on revenue and ebit. But food deflation is slowing down and for instnace milk prices are already going up B. SNAP Improving economic conditions and lower unemployment rates Cuts in SNAP program 15

16 Industry disruption and headwinds 2. Long run troubles: It is Amazon and Aldi A. Amazon June 6, 2017: AMZN launches a discounted Prime subscription for customers receiving government assistance: Electronic Benefits Transfer (EBT) card holders receiving aid from programs such as SNAP and the Temporary Assistance for Needy Families (TANF) program The discount would be of $5.00 (from $10.99 to $5.99) Effect? Chain Store Age conducted a quick survey of 500 households with income less than $40,000 26% were already Prime members/ Of those who weren t, 80% would still not be willing to become Prime members 16

17 Industry disruption and headwinds B. Aldi Aldi has already more than 1,660 stores In the USA. In a press release in June of 2017 it announced that is aiming for 2,500 stores by the end of o Trader Joe s DG has more than 14,000 stores in the US and WMT has about 4,700. Aldi Wal-Mart Dixon, IL Moline, IL Galesburg, IL Davenport, IA Dubuque, IA Price of a basket of 15 goods: One pound of tomatoes, one pound of bananas, gallon of milk, one pound of butter, 2 rs of coke, 40 oz of. peanut butter, 12 large eggs, one pound of 80% lean beef, 2 pounds of past, 24 oz. of pasta sauce, 12 rolls of of toilet paper, 6 pack paper towel, 6.2 oz. crest toothpaste, one pound of chicken breast, 20 pods of dishwasher detergent. Source: Nadinta Bose ``Aldi raises stakes in US price war with WalMart, May 11 th 2017, Reuters. Thus in terms of economies of scale in distribution and marketing WMT and the dollar stores retain an advantage. Pricing? 17

18 The retail industry: Short interest Company Short interest as % float August Wal-Mart 3.2 Target 9.9 Costco 3.5 Dollar General 6.2 Dollar Tree 2.6 Five Below 13.8 Kohl's 20.9 Macy's 12.7 Nordstrom 23.5 JC Penney 49.3 Sprouts 9.6 Williams-Sonoma 24 Pier Restoration Hardware March April May June July August Wayfair 16.4 DG: Short interest as % of float March August

19 Real Estate Analysis Wal-Mart FDO DLTR DG Number of locations Median distance to nearest WMT (miles) Number of locations that have WMT within 5 miles 7,864 6,502 13, ,513 5,563 7,230 Share 70% 86% 54% Aldi FDO DLTR DG Number of locations Median distance to nearest Aldi (miles) Number of locations that have Aldi within 5 miles 7,864 6,502 13, ,451 3,154 3,761 Share 44% 49% 28% Source: PiperJaffray, Industry Note, August 20 th,

20 Dollar stores revenue shares (in %) DG FDO+DLTR BIG 20

21 Dollar stores revenue shares (in %) Big lots: Toy liquidators (1994), KB Toys (1996) Pic N Save (1997) Sale of Toy Liquidators and KB Toys (2000) DG FDO+DLTR BIG 21

22 COGS as a percentage of revenues DG FDO BIG DLTR 22

23 Marketing expenses as a percentage of revenues DG FDO BIG DLTR 23

24 Rental expenses as a percentage of revenue DG FDO BIG DLTR 24

25 Rental expenses as a % ebit and rental expeses Rental expenses constitute an important entry in expenses. On the left you have Rental expenses 100 Rental expenses + ebit DG s rental expenses are the lowest in the industry; FDO rental expenses started increasing dramatically in 2011 This is typically what kills retailers! DG FDO DLTR ARO Rental expenses as % of ebit plus rental expenses Source: Compustat 25

26 Operating margins DG FDO BIG DLTR 26

27 THE VALUE CHAIN 27

28 The value chain Consumer goods Food & beverage Fresh produce Retailers Other Groceries Household goods Apparel Consumer electronics Sporting goods Furniture Auto parts Drugs Medical supplies Households 28

29 The value chain Consumer goods Groceries Household goods Food & beverage Fresh produce A. Profitability 1 Economies of scale Distribution Retailers Marketing Other Consumer Sporting Drugs Information Apparel Furniture Auto parts electronics goods Medical supplies processing systems 2 Customer captivity B. Branding DG vs. COKE Households 29

30 The value chain Groceries wholesalers Consumer products Apparel Toys Sporting goods Supermarkets Dollar Stores Mass retailers Households 30

31 The value chain Groceries wholesalers Consumer products Apparel Toys Sporting goods Supermarkets Dollar Stores DG DLTR BIG Mass retailers WMT TGT Kroger Households 31

32 THE FIRM: DOLLAR GENERAL VALUATION FINANCIAL INFORMATION AS OF 2016 ANNUAL 10-K REPORT 32

Dollar General: The daily stock price: 11/13/09 9/25/17 120 100 80 60 40 20 0 11/13/09 2/13/10 5/13/10 8/13/10 11/13/10 2/13/11 5/13/11 8/13/11 11/13/11 2/13/12 5/13/12

33 Dollar General: The daily stock price: 11/13/09 9/25/ /13/09 2/13/10 5/13/10 8/13/10 11/13/10 2/13/11 5/13/11 8/13/11 11/13/11 2/13/12 5/13/12 8/13/12 11/13/12 2/13/13 5/13/13 8/13/13 11/13/13 2/13/14 5/13/14 8/13/14 11/13/14 2/13/15 5/13/15 8/13/15 11/13/15 2/13/16 5/13/16 8/13/16 11/13/16 2/13/17 5/13/17 8/13/17 33

34 DG: Daily Stock Price: 12/08/ /08/2016: Tano buys DG Earnings grew slower than expected Same store sales have been very low Good economic news SNAP 40 34

35 Dollar General: Some basics 1 Stores carry an average of 10,000 SKUs WMT s discount store: 120,000; neighborhood market: 29, % of the stores are in communities of less than 20,000 3 The majority of Dollar General s products are priced at $10 or below and 25% of the merchandise is priced at $1 or less. 4 It is a lease based business: Little in terms of physical capital If you ignore leases, the asset value is going to be biased downwards. 5 6 Intangibles and brand important Countercyclical business 35

36 Dollar General: Real estate SQF (in thousands) Number of stores (right axis) 36

37 Dollar General: Same store sales Same store sales surged in the wake of the Great Recession when low income households were suffering the brunt of the economic contraction Trading down As the economy improved, same store sales growth rates returned to pre-crisis level Countercyclical industry Same store sales (% - right axis) Price 37

38 Balance Sheet Assets (MM) FY2015 FY2016 Liabilities FY2015 FY2016 Cash Current Portion of Debt Inventories 3, ,258.8 Accounts Payable 1, ,557.6 Tax Receivable Accrued Expenses Prepaid Expenses & Other Current Assets Income Taxes Payable PP&E 2, ,434.5 Long-Term Obligations 2, ,710.6 Goodwill 4, ,338.6 Deferred Income Taxes Other Intangible Assets 1, ,200.1 Other Liabilities Other Assets Equity 5, ,406.3 TOTAL ASSETS 11, ,672.3 TOTAL LIABILITIES 11, ,

39 Balance Sheet: The industry Assets (MM) BIG DLTR DG Liabilities BIG DLTR DG Cash Current Portion of Debt Inventories , ,258.8 Accounts Payable , ,557.6 Tax Receivable Accrued Expenses Prepaid Expenses & Other Current Assets Income Taxes Payable PP&E , ,434.5 Long-Term Obligations ,170 2,710.6 Goodwill - - 4,338.6 Deferred Income Taxes , Intangible Assets - 8, ,200.1 Other Liabilities Deferred tax assets Provision for risks & charges Deferred rent Other Assets Equity , ,406.3 TOTAL ASSETS 1, , ,672.3 TOTAL LIABILITIES 1, , ,

40 Balance Sheet Assets (EUR MM) 2016 Adjustments Adjusted Comment value Cash None Inventories 3,258 (12.2) 3,245.8 See Notes Tax Receivable None Prepaid Expenses & Other Assets None PP&E 2, , ,735.9 See Notes Goodwill 4,338.6 (4,338.6) 0 Set to $0 - Recalculate Intangibles Other Intangible Assets 1, ,201.0 None Other Assets None TOTAL ASSETS 11, ,

41 Asset Value: Inventory Dollar General uses LIFO thus we must make an adjustment 2016 LIFO benefit: -$12.2 million Inventories Reconciliation Inventories 3,258.1 LIFO Provision (12.2) TOTAL INVENTORIES 3,245.8 Means inventory is actually overstated on the Balance Sheet 41

42 Asset Value: Plant, Property & Equipment Gross PP&E Breakdown 2016 Adjustments Adj. Comment Land % Appreciation Land Improvements None Buildings 1, , % Appreciation Leasehold Improvements None Furniture & Fixtures 2, ,797.1 None Construction in Progress None TOTAL (gross) PP&E 4, ,736 Land relates to headquarters and distribu1on centers Assume conserva1ve apprecia1on of 20% Buildings relates to distribu1on centers and buildings built on land leases Assume conserva1ve apprecia1on of 10% 42

43 Asset Value: Plant, Property & Equipment Leases February 2016 Accounting Standards Update (ASU) No , Leases (Topic 842) The Board decided that, consistent with all three proposals, lessees should be required to recognize the assets and liabilities arising from leases on the balance sheet Effect on valuation Assets and liabilities: What is the effect on the equity of the entity? It depends on whether the company entered into leases aggressively during a period of strong real estate appreciation Dollar General did not substantially change its lease policy Leasehold interests are reported separately (see footnote 2). Minimal. 43

44 Asset Value: Plant, Property & Equipment ARO DG ARO DG DG and ARO: Number of stores normalized DG and ARO: Square footage normalized by the number of stores in 2002 by square footage in 2002 Source: Annual Reports Source: Annual Reports 44

45 Asset Value: Plant, Property & Equipment Contractual obligation Long term obligation Capital lease obligations (in thousands) $215 $1,164 Interest $89,626 Self insurance $83,293 Operating lease obligations $866,444 Total 1,040,072 DG: Contractual obligations for 2016 Average DG lease characteristics Average sale price of property $1,541,310 NOI $103,088 $ per sqf $100-$150 Building size Lot size Lease term 9,000-12,000 sqf ~1.0 acres years Source: Net lease advisor; NOI is defined as potential rental Income minus vacancy and credit loss plus other income minus operating expenses 45

46 Asset Value: Plant, Property & Equipment From the DLTR annual report: Intangible assets, net consist of three separately identified assets and one liability. First, the Company identified the Family Dollar trade name as an indefinite-lived intangible asset with a fair value of $3.1 billion. The trade name is not subject to amortization but will be evaluated annually for impairment. Second, the Company recognized an intangible asset of $629.2 million for favorable Family Dollar leases and a liability of $164.3 million for unfavorable Family Dollar leases (as compared to prevailing market rates) which will be amortized over the remaining lease terms, including, in some cases, an assumed renewal. Amortization expense of $45.3 million was recognized in 2015 related to these lease rights. Lastly, the Company recognized an intangible asset of $5.5 million for a customer list. The allocation of the purchase price to intangible assets as well as their estimated useful lives is preliminary and may be adjusted. It is quite possible that there is substantial equity in the DG leases. How much? FDO had about 70 million SQF of total store space; DG about 100 Attaching the same multiple of equity gives about $.7bn (100/70.5) 46

47 Balance Sheet Assets (EUR MM) FY2016 Cash Inventories 3,258 Tax Receivable 11.1 Prepaid Expenses & Other Assets PP&E 2,434.5 Goodwill 4,338.6 Other Intangible Assets 1,201.0 Other Assets 21.8 TOTAL ASSETS 11,672.3 Goodwill It is classified as an indefinite Trademarks Impairment analysis FASB ASU Very little information given about the nature of this goodwill entry Significant effect on the valuation 47

48 Balance Sheet Assets (EUR MM) 2016 Cash Inventories 3,258 Tax Receivable 11.1 Prepaid Expenses & Other Assets PP&E 2,434.5 Goodwill 4,338.6 Other Intangible Assets 1,201.0 Other Assets 21.8 TOTAL ASSETS 11,672.3 The qualitative and quantitative assessments related to the valuation and any potential impairment of goodwill and other intangible assets are each subject to judgments and/or assumptions. The analysis of qualitative factors may include determining the appropriate factors to consider and the relative importance of those factors along with other assumptions. If required, judgments in the quantitative testing process may include projecting future cash flows, determining appropriate discount rates, correctly applying valuation techniques, correctly computing the implied fair value of goodwill if necessary, and other assumptions. Future cash flow projections are based on management's projections and represent best estimates taking into account recent financial performance, market trends, strategic plans and other available information, which in recent years have been materially accurate. Changes in these estimates and assumptions could materially affect the determination of fair value or impairment, however, such a conclusion is not indicated by recent analyses. Future indicators of impairment could result in an asset impairment charge. If these judgments or assumptions are incorrect or flawed, the analysis could be negatively impacted. 48

49 Asset Value: Intangible Assets Brand & HR 1 Workforce: About 113,400 Average Salary = $15,000 Estimate Salary Expense = $1.7bn Assume 10% signing bonus 2 Brand Value» $170.1mm 2015 Advertising Expense: $89.3mm Assume 5 years to build brand: $446.5mm Is this reasonable? No; go back to the DLTR annual report. They are assigning $3.1bn to a worse franchise than DG! Let s give it $1.5bn (the average) 49

50 Asset Value of Equity Asset Value of Equity Book Value of Equity 5,406.3 Adjustments: Inventories (12.2) PP&E 2,301.4 Goodwill (4,338.6) Work Force Brand Value 1,500 ASSET VALUE OF EQUITY 5,027 50

51 Asset Value of Equity $20.5bn $5.1 bn Asset Value Market Value September 15 th

52 Income Statement Income Statement FY2016 FY2015 FY2014 Revenues 21, , ,909.6 Cost of Sales 15, , ,107.1 Gross Profit 6, , ,802.5 SG&A Expense 4, , ,033.4 EBIT 2,063 1, ,769.1 Interest Expense Other income expense Earnings Before Taxes 1, , ,680.9 Income Tax Expense Net Income 1, , ,

53 Earnings Power Value EPV: Two ingredients 1 Sustainable opera1ng margins: Current opera1ng margins 9.5% Five year average: 9.9% 2 Sustainable revenues: Current revenues: $20,368.6 mm Five year average: 11.0% 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% Opera1ng Margins 5-Year Moving Average $17,522.3 mm Margins and five year moving average Source: Annual Reports 53

54 Earnings Power Value Earnings Power Value Current Operating Margin 9.6% Revenue 20,368.6 EBIT 1,955.4 Depreciation Charge CAPEX Excess Depreciation 0.0 SG&A Adjustment Total Adjustments Adjusted EBIT 2,392.2 Taxes 35.5% Adjusted NOPAT 1,543.0 Discount Rate 8.0% EPV of Dollar General Business Ops. 19,287.0 Excess Cash 56.1 Debt 2,969.2 EPV of Dollar General Equity 16,

55 Earnings Power Value 16.0% Dollar General is expanding 10-year Growth Average: 14.0% 12.0% 10.0% 9.1% Must account for earnings power with zero growth thus we need to add back some of: SG&A (and R&D when applicable) 8.0% 6.0% 4.0% 2.0% 0.0% Revenue Growth Source: Annual Reports 55

56 Earnings Power Value SG&A A portion of SG&A is used to fuel growth Assume that 10% fuels growth 2015 SG&A Expense $4,367.8mm Thus, $436.8mm adjustment 56

57 Earnings Power Value Taxes & Excess Cash 1 Taxes a) Take income before income taxes: $1,853.0mm b) Add back interest expense: $86.9mm to obtain an EBIT for FY2015 of $1,939.9mm c) Taxes of $687.9mm yields a tax rate of about 35.5% 2 Excess Cash 2015 Cash: $157.9mm Requires minimal cash to operate - say 0.5% of revenues Excess Cash = $157.9mm $101.8mm = $56.1mm 57

58 Summary $16.37bn $20.5bn $5.1bn Asset Value Earnings Power Value Market Value September 15 th

59 Growth: The power of the franchise DG has a franchise associated with 1 Economies of scale associated with marketing and distribution 2 Customer captivity given its locations a. In small communities b. Far away from existing competitors and entrants (Aldi) The company is not an attractive play, neither based on asset values nor on EPV But Potentially attractive return and Countercyclical stock: Risk management 59

60 Growth: The power of the franchise FY Market cap (as of Jan.) Debt outstanding Cash EV FY Dividends Share rep. Interest exp. Debt repayment Distribtns , , , , , , , , , , , , , , , , , , , , , , , , , , , ,133.2 DG: Distributions in millions of $US and enterprise value. A negative number means issuance Source: Factset 60

Growth: The power of the franchise 7 6 5 4 3 2 45 40 35 30 25 20 15 10 12 10 8 6 4 1 5 2 0 2010 2011 2012 2013 2014 2015 2016 Distributions Average 0-5 1977 1979 1981 1983 1985 1987 1989 1991 1993

61 Growth: The power of the franchise Distributions Average Unemployment rate (right axis) Ebit Revenue DG: Distributions yield: Dividends, share repurchases, debt repayment plus interest expense divided by the EV at the beginning of the year. DG: ebit and revenue growth (MA-5) and unemployment rate in the US. Annual: Source: Annual Reports and Federal Reserve Bank of St. Louis. 61

62 Growth: The power of the franchise Thus, based on current five year averages Current distribution average: 4.4% Current rate of growth of earnings: 6.6% About 11% expected rate of return. The PE10 ratio of this company is moderate (about 15 ) compared to the market (about 25) Margin of safety for multiple compression? Would you buy this company? 62

our purpose: 2016 Annual Report Financial Review Live Life Well

our purpose: 2016 Annual Report Financial Review Live Life Well 2016 Annual Report Financial Review Financial Highlights Management s Discussion and Analysis Financial Results Notes to the Consolidated