Tag: Compounder

Competitive Strategy Series, Featured

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.

Columns, Security Analysis

Why Hasn’t Autozone Stock Re-rated with Other Pandemic Winners? $AZO #COVID19
Reading Time: 3 minutes

I just did a post where I evaluated my holdings of Apple following its recent surge, which looks to be a quite big move for the US’s largest public company. One thing I didn’t really discuss in that post was that Apple may have re-rated recently due to perception of it being a pandemic winner. If your sales have held in well this year, or even increased, you are viewed as either defensive or on a continued growth trek. In turn, your stock has rocketed up.

Here’s a list of stocks that I would say fall into that category. I can’t include them all, but you get the point:

FB Chart

FB data by YCharts

The S&P total return is ~5.5% at this point in the year.  Home Depot is doing well because housing is holding in well, and the pandemic is causing people to reinvest in their homes. Same store sales were up ~24%+! No wonder Home Depot has surged.

The same is true for other retailers, such as Target or Wal-mart, which despite possibly missing the back-to-school shopping season (which is big bucks) they are reporting some of the best comps in years.

So let me take off some of the true high fliers and compare Autozone stock and other auto part retailers to these names.
FB Chart

FB data by YCharts

If you’re having trouble finding the auto retailers on this busy chart – they’re all at the bottom!

This is odd to me. O’Reilly reported +16% SSS comps for Q2 and a 57% increase in net income. Advance Autoparts has a different fiscal period, but they reported 58% increase in EPS on a 7.5% SSS comp.

Why is that? There are several reasons.

  1. In recessions, people keep their car longer and do more work themselves. See my post on AutoZone for some discussion on their comps after the 2008 financial crisis.
  2. After reaching about 7 years in age, cars tend to need more work. The average age of a car in the car parc today is around 12 years
  3. Retailers focused on cleaning products and other pandemic needs consumers would need and auto parts took the back seat. It’s likely that the pure-plays auto stores picked up share

So I fully expect Autozone’s sales to benefit when they report at the end of September. And if this current crisis persists, then their increased comps will likely persist as well.

I’ve been watching street estimates for Autozone. They still sit around pre-pandemic levels. My guess is AZO handily beats these estimates, though admittedly there are some tough comps (believe there were additional selling days in the prior year).

Look, I’m a long term holder at the end of the day and I wouldn’t recommend trading around a  quarter. All I’m saying is you have (i) a high ROIC business that (ii) historically has returned every dollar of FCF to shareholders that (iii) is probably benefiting in COVID where (iv) estimates might be too low. I like the set up.

Columns, Security Analysis

Should you hold Apple stock here? $AAPL
Reading Time: 6 minutes

I’m an Apple shareholder and the meteoric rise in Apple stock has me questioning whether I should hold on or move on.

One problem with this, and why I don’t think Buffett will sell, is opportunity cost. Selling Apple stock to hold cash isn’t really a great option right now. Yes, yes, cash has option value in itself, but the only reason why I’d be selling is my scant perception is that Apple stock has gone up really quickly and so maybe it is “fully valued” at this point.

Personally, whenever I sell a really high quality company due to valuation – that ends up being a bad decision.

Think about what this would mean right now if you count yourself as someone who is a “traditional” value investor (i.e. someone who looks for low P/E stocks) – this means selling a really high quality company to probably go invest in a lower quality company trading at a low multiple. Not a particularly great trade-off in my view. That multiple is probably low because of low growth, low ROIC, high cyclicality or some other reason.

If I stay on this broad topic, I also think the market is rarely so grossly wrong on a blue chip, top component of the S&P500. Yes, we have had instances in the past where everything just gets overbid in a mania (a la, the tech bubble where even GE was trading at 50x earnings). Also there are plenty of cases where the leaders of the S&P at  the start of the decade aren’t there by the end of it. But largely the market is a pretty good weighing mechanism.

In sum, tech bubbles are rare. But the stock market being a pretty good estimator of company value? Not so rare.  One reason why active management is so hard.

Frankly, if you’re reading this and thinking the stock has gone up too much, you’re probably anchoring to when Apple stock traded at 14x EPS and now trades for 30x without really much thought as to why 14x was right / wrong and 30x is wrong / right.

Ok, back to my view on Apple’s valuation. What do we need to believe here?

First, I like to go a look at Apple’s estimates for some expectations investing. I see that consensus is expecting the company to generate ~$75-$80BN of FCF for 2022-2023.

So let’s say they generate $77.5BN and using a short-hand 20x multiple of FCF (or 5% FCF yield), that’s a $1.5 trillion valuation. Wow. That would be a $363 pre-split price compared to $487 price at the time of writing. What else am I missing?

Well cash on hand is something else. Apple has $93BN of cash & equivalents (another $22/share) plus long-term investments (which is essentially Apple’s hedge fund) which is another $100BN (or $23/share). Yes, Apple has $100BN of debt, but they could have $0 of cash, be 2.0x levered and still be high investment grade. I’m not concerned whatsoever about that debt, so don’t view it as unfair to net the cash.

Add the cash together with the value of the business and you get $363 + $45 of cash, for a quick-hand value of $408 / share. Now, all of this was a very cursory estimate. For example, I change my math from a 5% FCF yield to 4% FCF yield, the price I get is $498/share. At this point, it’s hard for me to say that 4% is any worse than 5%.

I traditionally say my equity IRR over the long-term will approximate the FCF yield + the LT growth rate in the stock. So a 10% FCF yield in a low-to-no growth industrial will probably be around the same return as a 5% grower at 5% FCF yield (as long as you have long-term confidence in the FCF ). Can Apple compound earnings at 6% from here for a 10% total return? Maybe not, but all they need to do is 3% for a 7% return. And for an annuity-like business like Apple, that is as Larry David would say – pretty, pretty… pretty good.

Right or wrong, in a world of 0% interest rates, consistent cash generators will be bid up pretty high. Here’s a quick sample of companies and their FCF yields for 2021. Apple comparatively doesn’t seem crazy.

Of course, there are some other drivers for Apple recently.

The core driver for Apple here has to be the upgrade “super cycle.”

    • If you’ve been invested in Apple for a long time, you understand the stock goes through cycles and I’ve written about it in the past. It’s frankly frustrating, but the function of short-termism.
    • To rehash it, Apple’s sales go through a lull as a large proportion of users upgrade every 2 years or so. So there are big booms and then lulls and the Y/Y comps don’t look great.
    • That’s also when people hark back to the good ol’ days of Steve Jobs and say Apple can’t innovate anymore (right, like the iPad, Watch, AirPods and software moves show the lack of innovation…).
    • The story really has always been the same, but bears repeating. You don’t buy iPhone for the phone, you buy it for iOS. It has always been a software company and they continuously expand on that (AirPods being the latest hardware move, health monitoring seeming to be the next).
    • Heading into a new phone cycle is when people start to realize better results are on the come (and I have no back up, but I would say leading up to the launch is great, after launch Apple then starts to underperform again as people typically expect them to announce a new UFO and are disappointed when it’s just a new phone everyone will buy).
    • ANYWAY – the next upgrade cycle could be huge, especially if Apple is able to launch it with 5G with meaningful new speeds. I’ve seen estimates saying that nearly 40% of iPhone users are due for an upgrade. That would be a huge boon to Apple.

Apple’s bundling could create a “services” powerhouse

    • First you need to understand how profitable “service” business are. Apple has 64% GAAP gross profit margins for services. I assume its CAC must also be much lower than other players, again because of the iOS ecosystem
    • Services is growing well and could become a higher and higher % of earnings over time. Services gross profit has nearly doubled since the end of FY2017 and is now $31BN.
    • Something else to think about: Apple grew Service sales by nearly 15% Y/Y in the latest Q. But COGS only rose by 5%. That’s big operating leverage.
    • These recurring revenue streams are not only valued highly, but has a positive feedback loop in keeping everyone in Apple’s ecosystem!
    • Apple next launched “bundling” most recently and this could be a game changer.
    • Apple reported on its Q3 call that, “we now have over 550 million paid subscriptions across the services on our platform, up 130 million from a year ago. With this momentum, we remain confident to reach our increased target of 600 million paid subscriptions before the end of calendar 2020”
    • Those are huge figures in comparison to a Netflix and Spotify which have 193MM and 140MM paid subscribers, respectively.
    • Again, I view this as classic Apple. They changed the game with iTunes and made it tough to compete. The same could be true with whatever they bundle.
    • Apple could bundle Music, TV+, News, Cloud storage, as well as new growth arenas like gaming and perhaps health monitoring. Charging a low price for all these services / month might mean low profit at first, but huge scale benefits. You also drive your competitors down.

Bundle services… Bundle hardware

    • What if you were offered $100 off a product bundle if you bought a watch, iPhone/Mac, and AirPods together? Look, I only have 2 out of the 3, but I’d be tempted.
    • Apple wins despite the discount because they move more hardware and increase adoption of the iOS ecosystem
    • Then they push the software bundle. Rinse and repeat.

Each of these items make it a bit more exciting to be an Apple shareholder, but more importantly, they may be things that current estimates don’t factor in yet. In other words, especially the latter two items here, there could be further upside surprises.

Nothing I can see jumps off the page to me to say, “holy cow – GTFO.” So I’m staying put.

Columns, Investment Philosophy

What Drives Stock Returns Over the Long Term? $AMZN $MSFT $KO $COST $ROL
Reading Time: 2 minutes

We’ve all heard that the value of a company is the present value of its discounted free cash flows. But I wanted to share something I found pretty interesting. What drives stock returns over the long run? It seems pretty clear that it is the growth in free cash flow per share.

 As the tables below show, this one metric has a high correlation with the long-term growth in the stock price. We just mentioned what a DCF is so that may sound totally intuitive. Yet seeing the results are actually quite surprising to me. I say this in the context of the “random walk” stocks seem to follow day-to-day or even year-to-year. In sum, I think if you have high confidence that a company can compound its FCF/share at above market rates, you’ll probably do pretty well.

The second interesting thing is that I’m not showing starting EV/EBITDA multiple or P/E. All I’m showing is the FCF / share CAGR and the stock CAGR. So did the stock “re-rate” or “de-rate” it didn’t seem to matter in the small sample size.

A couple of notes (admittedly may be selection bias) I’m only showing names with long history and I’m trying to avoid some poor returning stocks with finance arms (Ford, GM, and GE) because that clouds FCF. Last, I’m using the end of 2019 to move out some of the COVID related movements.  One thing this doesn’t capture either is dividends collected along the way, but that should be relatively limited in most cases (but I did exclude Philip Morris for this reason).

In closing, I would look for names that you have a high degree of confidence of growing FCF/share at a strong rate. Obviously, the normal investment checklist applies – does the company have a moat to protect those cash flows, does it have a long investment runway, is it in a growing industry, and is it gaining scale to compound cash flows? Clearly, this drives stock returns.

I think if you were to show more commodity names as well, it would show how hard it is to make money over the long term. Not only do commodities have to deal with the larger business cycle, but they often have their own cycles within whatever they are selling (e.g. gold, copper, TiO2, etc. can move around considerably year to year and decide a company’s fate).

Competitive Strategy Series, Featured

Breaking Down McDonald’s Business Strategy $MCD
Reading Time: 3 minutes

Many know the history behind McDonald’s, but if you don’t I highly recommend the movie The Founder. It details how McDonald’s started as a simple restaurant business, but Ray Kroc took it over to expand the business and eventually takes it over. It also gets into the groundwork for McDonald’s strategy it would use for decades to come.

McDonald’s is not in the restaurant business, per se, it is in the real estate business.

As a reminder, this Competitive Strategy series I am doing is trying to unravel why some businesses do better than others, even in highly competitive industries. This post will be brief and mainly focus on this real estate point – to me, it is a truly differentiated strategic decision from McDonald’s.

Why Does McDonald’s Own or Lease the Real Estate?

Typically, McDonald’s will own or lease a restaurant site and lease or sublease it to a franchisee. McDonald’s return on that real estate investment is derived from a fixed % of sales as rent payment from the franchisee. McDonald’s also earns a royalty fee, but the bulk of earnings is actually tied to this “rent” payment.

As you can imagine, this is a unique relationship between franchiser and franchisee.

Here is a comparison of gross PP&E on a group of restaurants balance sheets compared to the number of locations they have. The only names that come even close are Chipotle, which has no franchisees so isn’t really comparable, and Starbucks, which also is mostly company-operated stores.

Think about if you were a landlord and received rent plus a fixed percent of the tenant’s sales. You want the tenant to do well and may even kick in funds to help them (if you think the returns will be favorable to you).

This is the case with McDonald’s. When a restaurant unit needs to be remodeled or needs new capital investment, McDonald’s will typically share some of the expense, which helps relieve some of the burden on the franchisee, while also allowing the company to cycle through new looks and new menu items. This keeps McDonald’s menu relatively fresh and restaurants looking up-to-date.

McDonald’s also does not allow passive investors. This aligns incentives for the store owner to maximize sales and profits (because that is how they derive most of their income) which in turn boosts McDonald’s profits.

As a result, McDonald’s has posted a powerful financial track record over the past couple decades. As shown below, its same-store sales results are pretty impressive when you think about how mature McDonald’s is as a business.

But doesn’t this make McDonald’s more capital intensive?

Yes!

Here is a chart of capex as a % of sales for each of the players:

But that actually doesn’t hinder the company much. Look at its return on assets compared to peers. It actually stacks up quite well, which is surprising when you think about how much more in assets the company has.

What could be the driver of that? Profitability. McDonald’s is just much more profitable than most of its peers. Part of this is scale (can leverage corporate fixed costs well with the number of branches), but also part of it is the way the company has established its fees.