Category: Featured

In-depth analysis or commentary on companies, securities, or the economy

How is Dollar General Only in the “Fourth Inning”? $DG

Reading Time: 6 minutes

“We have turned the clock back. We’re actually now only in the fourth inning. We see a tremendous runway ahead of us there”

CEO Todd Vasos didn’t mince his words. I’ve never invested in Dollar General stock before (to my detriment) because I thought the growth and reinvestment story had come to a close. That was wrong.

Despite being brick-and-mortar focused, they continue to excel in basically any operating environment. Their unique real estate strategy, where they set up low-cost buildings in rural towns as the one-stop-shop at affordable prices, is key.

I’m filing this post under my competitive strategy series because clearly Dollar General is a stellar retailer with unique strategy – and the stock has delivered excess returns.

Since the beginning of 2015, I’ve watched store count grow from 11.8k to ending 2020 with over 17.1k stores. That is a 46% increase!

Dollar General stock benefitted from this growth despite being an “old school” business — no FANG here, but with FANG-like returns. Coming from brick-and-mortar retail, no less.

They don’t appear to be overloading the system either. Going back to 1993 – Dollar General hasn’t had a year when SSS comps have declined.

So if you invested in Dollar General, you’d have benefitted from

  1. Growing stores
  2. SSS Comp increases
  3. Margin enhancement from this operating leverage
  4. A high ROIC / highly cash generative model (even now, Dollar General mgmt estimates the stores are a 2-year payback)

Ok, again. I missed all of that growth. How could one possible invest in Dollar General stock now? Especially with the dawn of e-commerce, is it rational to expect the company can continue to perform?

There are still a bunch of reinvestment opportunities at very high rates of return. I will outline six different ones the company is targeting:

  • DG Fresh – Increasing stock of perishable & frozen items. Self-distributing these products as well to control costs
    • This really started in earnest back in 2013 as DG increased the amount of cooler doors in their stores.
    • At the end of 2012, DG stated they had about 11 cooler doors per store. By the end of 2018, they had 20 doors per store. They expect to install 60k in 2020!
    • Dollar General continues to view this as the #1 sales driver going forward (again driving that one-stop shop mentality).
    • DG Fresh also entails distributing these items themselves to help lower production costs and improve in-stock position, enhancing their competitive positon.
  • The Non-Consummable Initiative (NCI) – Selling such as home decor products, seasonal items, or party items just as some examples.
    • These are higher gross margin and increase transaction amounts, which helps operating leverage on stores.
    • Seasonal items that rotate also helps the “treasure hunting” aspect in retail shopping.
  • New Store Formats (Popshelf). DG has about 17k locations… but that doesn’t mean it can’t use its infrastructure set in place for a new concept. Popshelf is a new store concept targeting suburban women, with products priced under $5 in the  seasonal, home decor and beauty products, as well as cleaning supplies and party goods.
    • This stemmed from the NCI work the company did.
    • Dollar General doesn’t take any decision lightly, so I think this could be a real opportunity and the US could easily support thousands of these stores.
      • As an aside, and call me crazy, but I could BIG as a DG acquisition target.
      • Popshelf reminds me of Big Lots, though I guess Popshelf doesn’t seem to be targeting furniture.
      • There would be immense synergies, with BIG benefitting from DG’s low cost distribution as well as scale on corporate costs.
      • Big Lots is still smallish with only 1,400 stores, but still has all the public company costs, back-office costs, HR, accounting, legal, etc. All of these could be scooped under the DG umbrella. It would give DG 1,400 more stores in a concept it wants to target.
      • BIG also trades at less than half the multiple DG does, so it would be highly accretive to DG.
  • Smaller format stores (<6,000 sq ft) for urban areas where Dollar General doesn’t currently target
  • Private label / Increased Foreign Sourcing. 
  • Other “Core” continuous improvement items like lowering “shrink” (i.e. theft), zero-based budgeting, etc

These are six items outside of tech-enabled strategies like Buy Online, Pickup in Store (BOPIS) or the ability to scan items on your phone to expedite check-out (both of which DG has been talking about for years).

Let’s put some math behind the go-forward opportunity

DG clearly has been a COVID beneficiary. I mentioned before that DG has had tremendous SSS growth over its history, but with expected SSS of +16% in 2020, I fully expect 2021 SSS may decline for the first time.

However, DG currently has more cash than ever on its balance sheet ($2.2BN). The next highest the company has had pre-COVID was $600MM back in 2011. It’s basically been around $200MM since then.

This tells DG has $1.6BN-$2.0BN of cash to invest. It means that they can pull forward many projects they have planned.

I estimate the unit economics for a new Dollar General branch based on what they’ve disclosed (the 2016 Investor Presentation was a big help) and what I know about other retailers. Clearly the returns are pretty good.

But what this really tells me is that each $1 that Dollar General invests is worth about $10 at maturity. This assumes no growth after year 10.

Said differently than above, $1.6BN to $2.0BN invested in the company’s growth will likely translate into >$16BN of value. The current market cap is $51BN.

Coincidentally, DG’s pre-tax ROIC on tangible capital averages >50% over time based on my numbers.

If they invest $1.6BN to $2.0BN at these kinds of returns (perhaps a big IF), that could mean a $800MM-$1.0BN uplift in operating income (estimated by assuming a 50% ROIC). For a company that did $2.3BN in operating income in 2019 – that is very meaningful!

Sure, they could also use that cash for share repurchases or dividends, but like my post on Big Lots, clearly the optionality for DG, and growth, has been enhanced.

While they do have 17k stores, their goal is 25,000 locations. So $1.6BN investments, when a new location just costs $250k to open, leads to 6,400 stores right there…

Remember, DG performed very well during the great recession due to a trade down effect as the consumer wanted to save costs. This led to them having more cash than competitors to expand and reinvest in the business.

As you can see in the chart below, this is when EPS really started to ratchet up.

DG doesn’t look optically cheap today. Currently it trades at roughly 16x 2021 EBITDA and 21x EPS. That’s what used to be called a “growth” multiple. However, they have several growth avenues and you’re backstopped by earnings that actually go up in recessions. So you have growth + stability in cash flow, which drives a premium valuation.

One thing I like to look for in a stock is a doubling of EPS over 5 years. It helps me gain comfort in the multiple I am buying in at (the multiple can be cut in half and I still wouldn’t lose money). This would be tough given where we are buying in at DG (coming off of a peak COVID earnings), but they will have so much capital to deploy with many avenues. I have EPS 70% higher from where it will end 2020 due to store growth, modest SSS growth, modest margin expansion over 2019 levels and share buybacks. Assuming shares trade at 20x FCF in 5 years, I think you can earn a 14.5% IRR. 

I can’t talk about a retailer without addressing e-commerce. If you think about Dollar General’s footprint, it is immense and its generally where e-commerce is still underpenetrated (i.e. rural areas).

However, that also means DG is best positioned with their distribution capabilities to attack that market. Much like they segmented rural areas for brick-and-mortar retail, they could do the same thing in e-commerce. They are the anti-Whole Foods, if you will, which many believe Amazon acquired to enhance their platform.

IFF Receives Approval for Dupont’s N&B Business: Waiting for the Right Entry Point $IFF

Reading Time: 4 minutes

When I first heard that IFF was buying Dupont’s Nutrition and Biosciences business, I gagged. I had known IFF from my time covering chemicals and knew it as a “secret SAAS business”, if you will.

For example, IFF provides scents and fragrances to perfume manufacturers. I like luxury brands, given “secular growth”, and IFF seems like an excellent “pick-and-shovel” play. In other words, I don’t have to pick the perfume that is going to win, I can just pick the underlying technology that should grow as the rest of the markets grow. A rising tide can lift all boats.

That’s not all IFF does – it also makes fragrances for household goods, detergents, and makes flavors as well. IFF used to be split ~50/50% between Flavors and Fragrances. IFF acquired Frutarom, which specialized more in the “natural” taste and scent market and also catered to small-to-mid sized companies, which also seemed to be a longer-term growth story (though in my view, this is really a GDP-ish business. I’d be buying for the stability + high ROIC).

I do view the ROIC here as “best-in-class” and like that IFF still seems underappreciated by the market. This isn’t a Sherwin Williams or something that is discussed everyday (yet).

As you can see below, to me, IFF had the “sexier” product portfolio as opposed to N&B.

I say this coming from experience covering Ashland. Ashland is a chemical producer that can be described as “specialty” (as opposed to “commodity”). Typically, this means high margins, limited capital intensity, lower volumes, and limited exposure to raw material changes like some commodities (e.g. ethylene).

But Ashland always had SOMETHING go wrong. They would spend several quarters talking about how great their personal care business is, and then next thing you know the profitability in that segment gets whacked and they’d have a big miss. And it turns out that Ashland’s components are certainly lower volume, higher margin business – but it is still highly competitive and subject to price cycles much like commodities are.

IFF’s core portfolio, especially fragrance, struck me as the better business. I recognize many of the Ashland constituents within the former Dupont’s business (cellulosics, guar). This is also clear through looking at gross margins (though not a perfect analysis), IFF’s historically 45% GMs compare to N&B with 36%.

That being said, from what I could glean from the proxy, N&B ROIC was still very good (they did ~$1.4BN of EBITDA on $3.6BN of tangible capital). N&B + IFF will also be way more diversified so a guar gum collapse wouldn’t kill them.

And that got me thinking that this deal could be much better than I expected. After all, N&B competes with Chr. Hansen (a beloved stock in the “compounder bro” universe) and it trades at 26.5x 2022 EBITDA at the time of writing… Chr. Hansen is a niche producer, though. N&B + IFF isn’t, so your company profile is “diluted” if you will… but scale matters too.

IFF & N&B just received approval to merge (its be a long, drawn-out process to get all the approvals). About a year ago in December 2019, the two announced they would be merging via a Reverse Morris Trust in a transaction that valued Dupont’s N&B business at 18.4x  2019 EBITDA, or 15.2x post synergies. This is a high multiple, but when you think about Chr. Hansen, the ROIC these businesses earn, and also think about the synergies between the two businesses, it makes sense.

While I like the business, the tough part will be integration. This is a massive transaction and sometimes analysts on Wall Street forget that pushing two huge companies together isn’t as easy as it looks on paper.  As I noted above, these companies kinda  operate in similar markets, but not really.

The interesting thing about the long, drawn out process is that the combined company has had to put out S-4s (which detail everything about the merger) along the way. We just got another S-4 on December 22, 2020. Unfortunately, both companies have reduced what they were expecting for 2021+ EBITDA. I don’t typically put much faith in these proxy projections anyway because they are typically inflated to get a deal done. In this case, I’d trust it more now that its come down and 2021 is closer to reality from a timing perspective.

IFF already had issues integrated Frutarom (and the latter had a bribery issue that had to be addressed), so it does concern me that they want to do a big deal again.  To emphasize the point, my take from the proxy was the IFF would do anything to acquire N&B. It just wanted to make sure it was the winner. That typically doesn’t work out well…

The concern is that N&B and IFF will be so distracted merging, that competitors can emerge and take share. This would not surprise me in the slightest.

The company will also be ~4.0x levered, which the market typically hates even if you’re a good business  (footnote: I don’t hate this).

The set-up here seems attractive… to wait for a better day. Right now, the stock is pretty richly valued. Results are coming down. And while this is a high ROIC business, I think there are too many “hiccups” post-merger that can come out and drive the stock down.

I say all this as a means of preparation for that buying day. I will be watching this one patiently for a good entry point.



New Home Company: Microcap Homebuilder Trading at Significant Discount $NWHM

Reading Time: 4 minutes

I’ve posted two recent “discount to NAV” plays recently, LADR and CET. I also had a disappointing call on CPLG, which thankfully I decided to exit. While I think those names are different than most stories, I am generally wary of “discount” plays and even sum of the parts.

As I stated in the LADR post:

“See, a lot of times investors buy financial assets below book value. But if the assets are earning a low ROE, the book value may be worth a low amount. Or you may not realize that book value for a long, long time (think of a 100 year bond with a 1% coupon when prevailing rates are at 6%… it will take a long time to get “book value”.)”

However, exceptions are allowed. In this case, we have a homebuilder with a strong management team trading at a large discount to book value. Recent trends are really encouraging as well. Somewhat like LADR, homebuilders sell down inventory and recycle it into new inventory. Rinse and repeat. Therefore, I like that we will eventually realize book value at NWHM.

This will be a quick idea and I’m going to start with the punchline first: I think there’s 80% upside on NWHM.

Currently, the market cap is ~$86MM. I like to go to the balance sheet and take out any intangibles and look solely at what liquidation would look like (note, the company does have deferred tax assets to shield itself in a literal liquidation). The company just refinanced $290mm of bonds and reduced debt with the cash on hand.  As you can see, we could liquidate this company and easily earn more than where it is trading.

I’ll also note that the company just authorized a $10MM share repurchase plan, which ~11.5% of the company. They could easily do this will the cash on hand.


Background / Why did the stock get cheap?

NWHM started as an ultra-luxury builder (think $2MM+) in Northern and Southern California. That was a great market to be in just a few years ago, but with taxes increasing a few years ago for high net worth individuals (see state tax deduction limits, mortgage interest deduction limits) this hit the luxury market hard.

It also was the best market coming out of the housing crisis, so it has been strong for ~9-10 years. So recent weakening can be expected.

Lastly, we have COVID. While benefitting housing in general, it isn’t even across the country and there is concern that there will be an exodus from these high cost of living areas.

So you can get a general sense of what drove the stock down.

They also were levered and had bonds due in 2022 that people were concerned about (i.e. maturity wall into a slowing market). Therefore mgmt had been working down inventory, generating cash, and they bought back some stock and bonds at a discount.

With recent strength in the bond market, they were able to refinance those bonds and extend the maturity to 2025. They also have been opening lower-cost communities in Arizona, which is a hot market.  They are trying to get their average ASPs down (not by lowering prices, but by targeting lower cost areas).

While I mentioned luxury was moving slower in recent years, it appears mortgage rates coming down significantly is giving the company a nice bump as well. Take a look at recent absorptions for NWHM.

Why Buy NWHM Now?

First, recent results are improving materially. Q3 and Q4  are typically seasonally slow periods in the market, but the company noted on its latest call that sales are bucking those trends

Second, I think NWHM could be a take-out candidate. While luxury isn’t where most builders are focused, there is a struggle to obtain good lots right now. I think Toll Brothers (another luxury builder) could easily acquire the company and getting it at NAV would be a coup for TOL and for NWHM shareholders right now.

I’ll also mention the Chairman, Larry Webb, is known for selling out of his homebuilder (John Laing Homes) prior to the last downturn at a huge multiple (something like 3x BV).

Lastly, we have a lot more time than we did before now that the company refinanced its bonds.

Where could I be wrong?

Interest rates could move back up and slow home sales materially. We saw this at the end of 2018. Even modest move ups in rates tend to make people “pause” a home buying decision.

There could be impairments, which shoots the discount to NAV thesis in the foot. However, the threshold to actually impair something for a builder is really high. I’ll also say, NWHM has had some impairments, but they haven’t been “50% of book value” meaningful. Lastly, they wouldn’t be talking about moving up price if they were concerned about impairments.

Foreign Buyer in California. This is kind of a “known unknown”. We know that foreign buyers have been scooping up US real estate and actually decreased purchases in 2019. But we don’t really know how much impact it would have if it evaporated. I think this is more of a tail risk.


Is it Time to Buy Big Oil Stocks? $XOM $CVX $BP $RDS

Reading Time: 4 minutes

The energy market is completely bombed out. If you tried to pitch an energy stock right now, I’m pretty sure no one would listen to you. Personally, I don’t know enough to pick a “winner” small cap energy stock, but I think buying a basket of the majors makes a lot of sense.

I know what you’re thinking: “Oh no… now Dilly D is falling for the value trap of big energy… there’s no hope.”

My thesis comes down to three points:

  1. Sector is completely bombed out. No one wants to invest in it. It’s almost toxic. Most people will likely skip this article because they have no interest. Oil prices going negative this year might have been the last straw.
  2. Supply is much tighter now. Shale, which was the growing marginal supply, now has rig count come way down. While COVID was a shock to demand this year too, demand likely will come back much faster than supply. This could lead to a price run-up.
  3. Oil is not going away. People think oil demand is going away due to electric vehicles, yet they don’t realize the chemicals and plastics we enjoy in everyday life are also derived from oil. Also, I don’t think an EV commercial jet will be made anytime soon… jet fuel will continue to be a large source of demand, not to mention emerging markets.

So the bottom line is that I think as the global economy recovers from COVID, supply will be much tighter than people expect. That tighter supply will lead to higher prices (not calling for anything crazy), and that will result in more focus on the sector again.

I’m not going to comment on how oil is now the lowest % of the S&P ever, because I don’t really think that’s relevant to me. It could be a contrarian indicator, or just a sign that the industries return on capital is only good when prices are high. I also think you can control for the risks in energy through position sizing (I don’t plan on having a big position here, but I also don’t want to have ZERO exposure anymore).

Let me work backwards from my three points.

Imagine a chart of global crude oil demand in your mindwhat does it look like? Is it something that flatlines around 2005? Maybe more fuel efficient cars have come and that’s crushed demand?

Up until COVID hit, that would be completely wrong. Yes, so far with COVID, oil demand has been crushed. But I’m not banking on people not flying, not driving to work for long.

With demand so low right now, plus the swath of bankruptcies in shale, US supply has come wayyyy down.

This chart clearly shows the “bubble” that was US shale, which eventually led to an oil collapse in 2014-2016. But now we’re talking about very low levels of supply. We’re talking lows of Great Financial Crisis. The lows of the early 2000s (or pre-Shale Revolution).

US Shale vs. the Majors

The energy sector is consistently called out for not ever generating FCF, but that’s more so related to US shale. I’m speaking more about the majors, where they do actually generate a lot of cash. The majors are also pretty diversified across upstream, midstream and downstream (e.g. chemicals).

But I think FCF in the industry could be much higher if they just stopped spending (re:drilling) every dollar they earn. If you think about having one well, once all the upfront costs are gone and the infrastructure is set up, the costs to keep it going are relatively low. However, you now have a declining asset.

A declining asset generating cash is still worth something. It’s the PV of a declining annuity. I just think the shale industry needs to prove they can generate FCF and have more discipline. I’m not banking on that, so I’m going for the majors.

The majors have the scale, the developed assets, and perhaps need to generate FCF to support the big dividends they’ve handcuffed themselves to. Yes, I still think Exxon should cut its dividend. It’s getting outrageous. But at the end of the day, I may be wrong, but at least I won’t have a ton of downside.

I kind of like this chart. It compares oil price (yellow), XLE price (energy stocks proxy in white), and Baker Hughes Oil rig count (orange). It helps me see “bubble” and then collapse in a classic cycle. For example, if I were to show you a chart of US Housing starts, you could see something very similar around 2005-2006 (around 2.1MM housing starts). Then a collapse and no one wanting to touch housing (around 500k housing starts)… how times change…

Clearly there are risks to this playing out.

The cure for high prices is high prices – meaning as soon as prices go up, shale is coming back.

A second factor is that credit is easy right now. At the time of writing, the yield to worst on the US high yield energy sector is just 6.4%. This was a factor that led to the shale uprising. If credit is too easy, it’s hard for these guys to just STOP F&CK!NG DRILLING. Especially because this was an industry that used to be rewarded solely by increasing production and never really generating FCF.

Obviously, there are a million other reasons why I could be wrong, not the least of which is OPEC. They just announced a small production increase, which seems crazy, but the OPEC countries’ economies are reeling. They need to pump volume at the expense of price sometimes. I still think longer term, they realize what needs to be done and shale (in a way) has already responded.

affirm S-1 Break down: Lessons on Customer Concentration $PTON

Reading Time: 4 minutes

I’m sure you’ve seen it by now. You’re checking out online and you see a notification that says, “Why pay $180 now when you can pay 6 payments of $30…”. I’ve been very tempted to use this, but actually never have. I get tempted because I view it as managing my working capital (pushing my payables), but figure there must be a catch. Most often, I see it offered by a firm called affirm (I guess, like, affirmative covenant). And affirm is out with its S-1 to go public.

If I jump straight to the punchline: a buy on affirm is really a buy on Peloton, too.

If you know Peloton’s exercise bikes, you know they retail for $2,000 to $2,500 for the new bike. You may also know that this pill becomes easier to swallow with the interest free payments. This is actually powered by affirm (see the fine print at the bottom of Peloton’s page).

affirm argues this helps merchants sell at higher price points because the sticker shock is less severe (makes sense).

I’m not buying a $2,500 exercise bike, where cheaper copycats are plentiful, I’m paying a low, low price of $64/month for 39 months!

This is what affirm calls “Merchant Network” revenue. The loans are 0% interest, so there’s not really any interest income, but affirm charges the merchant a fee for conducting a transaction on their platform.

Here’s the thing: You’re buying at what they think will be a $10 billion valuation or 18x core revenue. You’re banking on a lot of growth. With the surge of e-commerce in a year impacted by COVID, people more cautious on liquidity, it should be a major growth year. Affirm did grow revenue 98%, with merchant network revenue up 157% in the Q ended Sept.

But wait – look at affirm’s Peloton exposure. It grew faster than merchant sales. It also grew with Peloton faster than Peloton’s “Connected Fitness Product” sales. This means they are converting more of PTON’s customers. But it also means it accounted for ~70% of affirm’s growth. And if they didn’t convert a higher percentage of PTON’s customers, PTON still would’ve accounted for 60% of merchant revenue growth.

This all begs the question: is that worth paying for? The biggest pushback will be “it is early days for affirm, they’ll convert more and more merchants” but clearly consumers are using the product heavily for Pelotons and mainly for high ticket price items. And there are other competitors in the space (which I discuss at the end of this post).

Let me put it this way: non-Peloton merchant revenue, by my estimate, is just $131MM in the LTM. Is the Peloton business + this worth $10BN?

Oh, and by the way (yes – this is true for Peloton too):

I can imagine in 2023 investors watching on bated breath what will happen to this contract…

What I love about affirm is that they say,

“we believe that companies… that peddle toxic financial products and derive profit from their consumers missteps – like credit cards and other products with deferred interest – will find themselves in the shrinking minority before too long.”

Look, we have usury laws for a reason. I think that is important to protect consumers, especially those that have limited alternatives and can be taken advantage.

But it’s almost as if affirm is calling out earning interest… taking a risk for a return… when in fact, they do this as well… They better not expand into earning higher rates of interest in the future or I’ll call them out.

But isn’t affirm also kind of in this “predatory” boat? You may not be charging high interest, but you are coaxing consumers into making a big purchase they may not be able to resist.

Quick aside here: people tend to have a lot of issues with Credit Acceptance Corp, a name that makes subprime loans to people needing to buy a car. On one hand, Credit Acceptance makes high interest loans – think a 20% interest rate which seems crazy. On the other, these are predominantly loans to people with FICOs below 550. This is an area of the market that no other lender dares go. And Credit Acceptance usually doesn’t collect on ~25% of these loans, too. So yes, they charge a high rate, but without them – a lot of Americans wouldn’t have cars. In other words, if Credit Acceptance was “regulated away” tomorrow to crack down on high interest loans, would that actually make things better?

I’d like to believe affirm is lending to higher quality borrowers that can afford a $2,000 exercise bike and just want the convenience of deferring the payment.

But if you think about it, Peloton is seeing an uptick in customers using affirm. You could argue Pelton wouldn’t have the same sales without a firm like affirm offering a 0% APR loan for nearly 4 years. Aren’t you essentially admitting you know your price gouging customers?

Off the soap box. I see a lot of issues with this business. No question that its growing and I think it will continue to grow in the near term. But thinking 5-10 years out, and bracketing some of the risks, I’m not so sure its worth it.

It seems to me every tech company wants to insource payments / expand into “fintech”. Do you feel comfortable Shopify and Square aren’t coming for this space? What about when you checkout using Google sign-in or more importantly, Facebook, who is clearly targeting payments?

What is the actual TAM here for affirm specifically? Putting aside the other competitors like Afterpay, Klarna, and Quadpay — Does the number one e-commerce player do this or have they partnered with Visa for their credit card and offer equal payments at 0% APR? Hmmm… Surely they affirm is attacking those sleepy incumbents… Maybe Amazon wants to keep that “merchant revenue” for themselves.