Over the past three years, the debt load at Dollar General Corp. (DG, Financial) has soared. That may be a concern for investors, especially value investors and those who like safe balance sheets.
Not that the discount retailer is in any danger, but debt is often connected with business failures. When interest rates are rising, it can be an even bigger challenge. As the discount retailer observed in its 10-K for the year that ended on Feb. 3, “In 2022, as interest rates rose, our interest expense rose as well.”
This 10-year chart shows long-term debt increased from $2.19 billion at the end of calendar 2019 to $7 billion at the end of 2022.
Dollar General had no short-term debt at the end of calendar 2022.
Why did it increase its borrowing?
The short answer is that it spent more than it earned (net income for the year ended Feb. 3 was $2.41 billion). That was less than the amounts spent on buybacks, dividends and capital expenditures.
At the top of the list of expenditures is $2.7 billion for share repurchases. The cash flow statement shows it bought back 11.6 million shares.
Also in the category of returns to shareholders was the payment of $494 million for dividends. That was up $102 million over the previous year.
Capital expenditures, made up mainly of property and plant, grew by nearly half a billion dollars, from $1.07 billion at the end of January 2022 to $1.56 billion in January 2023.
That reflects Dollar General’s continuing brick-and-mortar growth. It added 1,039 net stores during the year to take the total to 19,104. In addition, it renovated 1,795 stores and relocated 127 others.
Why debt?
From my perspective, the capital expenditures make sense. New stores bring in additional revenue and should help the bottom line. Renovations make existing stores more attractive, which should lead to greater sales per square foot.
Dividends, too, are self-explanatory. They make the stock more attractive and will help the company raise new capital if it needs to issue new shares (which it has not done in the past 10 years).
I am somewhat puzzled, though, by the decision to spend $2.7 billion dollars on repurchasing shares. One answer may be in the cost of its debt. The following chart shows how Dollar General’s annual effective interest rate has been coming down—by an average of 12.8% per year.
Last year, the rate averaged 1.32%, which is remarkably inexpensive. It also sets the stage for an excellent weighted average cost of capital versus return on invested capital ratio:
Currently, its WACC is 3.85%, while its ROIC (which includes both debt and equity) is 11.28%. Cheap debt helps make Dollar General a value creator because it turns a dollar of financing cost into $2.92 of returns (11.28% / 3.85%).
By increasing debt and reducing the share count (by an average of 4.06% per year over the past decade), a company can push up its earnings per share. Over the past five years, its earnings per share without non-recurring items has averaged 16.25% per year.
While the strategy of using cheap debt has its attractions, it can also be dangerous. Dollar General has done well so far, with general interest rates in the mid-single digits. However, some of us remember when interest rates jumped into the mid-teens; if that happens again, the company could be hobbled. Similarly, if we have another pandemic that forces the closure of retail stores, there might be problems.
Can the company pay back the debt?
At current rates, Dollar General should have no problem covering its debt. For example, its interest coverage ratio sits at 15.75, which means it generates $15.75 of operating income for every dollar of interest.
It has industry-leading operating and net margins, 8.79% and 6.38% respectively.
It also has enough financial resources to continue growing its brick-and-mortar footprint for some years to come. Management reported in the annual filing that it sees “substantial” long-term potential in the U.S. This past February saw it open its first store in Mexico, as it seriously eyes international expansion.
In addition, Dollar General keeps increasing its sales per square foot. The company noted, “From 1990 through 2020, we achieved 31 consecutive years of positive same-store sales growth. Following unusually high sales results in 2020 during the height of the COVID pandemic, we did not achieve positive same-store sales growth in 2021. However, we achieved positive same-store sales growth once again in 2022.”
There are several initiatives that support that growth. Included on that list is a slow shift from consumables, with lower margins, to non-consumables that have higher margins. To promote the latter, the company is using what it calls the “pOpshelf concept.”
The non-consumable lines include basic health care and beauty products, with their higher margins. The DG Fresh initiative sees it selling some frozen and refrigerated products.
These initiatives and others indicate to me that Dollar General is capable of continued growth, profitable growth that will deliver operating income to make interest payments.
Conclusion
It appears that Dollar General is using debt in a purposeful way to enable profitable growth in the future. It also has the operational growth that gives it the funding needed to meet interest payments. Still, cautious investors will want to look elsewhere, at companies that use other strategies to fund their growth and share buybacks.
