Dollar General's Discount

Deep discounter Dollar General (NYSE: DG  ) turned to deep discounts to fuel sales growth in the first quarter as it awaits shareholder approval of its going-private transaction.

In an effort to minimize the inventory it carries over from one season to the next, Dollar General has instituted a markdown policy the past two quarters that's been clearing out the stockrooms. While net sales were up 5.8%, inventories were down more than 11% in the quarter. Keeping out-of-season merchandise out of the stockrooms has become a conscious policy that allows for inclusion of newer home, apparel, and current-season merchandise.

The discounts, while helping to boost sales, did not have as great an impact on gross margins this time out; blame bigger markups on clothes and other higher margin merchandise, as well as fewer sales of "highly consumable" items like paper, pet products, household chemicals, and health and beauty aids. Although it is Dollar General's biggest segment, those products tend to be lower-margin items anyway and have been included in the product mix to help increase same-store sales. Gross profits rose 8.3% to $633.1 million and the margin increased 66 basis points. In the fourth quarter, the new discount policy had resulted in a 420-basis point contraction.

Clothing was the big seller this quarter and revenues from the segment increased more than 14%, while seasonal items were up more than 8% over last year. You can check out all the metrics in our related Fool by Numbers article.

Of course, the big story with the General is its pending acquisition by private equity firm Kohlberg Kravis Roberts, which shareholders are expected to approve at the upcoming annual meeting. KKR has offered to take Dollar General private in a deal valued at $7.3 billion, or around $22 per share.

When the deal was announced, it was a pretty rich offer. KKR was offering to mark up Dollar General for 25 times normalized earnings and 11 times EBITDA (earnings before interest, taxes, depreciation, and amortization). Family Dollar (NYSE: FDO  ) and Dollar Tree (Nasdaq: DLTR  ) , for example, were selling for just 19 and 18 times earnings, respectively, and the industry was trading around 8 times EBITDA. It's easy to see why shareholders might be enthused to approve the deal.

Yet the deal has increased costs for the discount retail operation and SG&A costs rose to 25.4% of sales. Deal-related expenses amounted to $6.1 million of the $74.7 million total, while the closing of hundreds of stores and other "strategic real estate initiatives" added another $30 million. As a result, net profits fell 27% from last year.

With the soon-to-be new owners probably more interested in Dollar General's cash-producing abilities -- it produced $29.3 million in cash flow from operations -- the decrease in operating profits was of little concern. It's a discount they're undoubtedly willing to pay.

Check out these related Foolish articles for more discounts:

Family Dollar is a former recommendation of Stock Advisor. See why finding companies trading at pennies on the dollar can be a profitable investment with a no-cost trial subscription for 30 days.

Fool contributor Rich Duprey does not have a financial position in any of the stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.


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