Does a Dollar General IPO indicate a frugality bubble?

Tom Taulli notes on BloggingStocks that private equity firm KKR is in the late stages of planning an IPO for Dollar General, the country's largest chain of small discount retail centers. KKR, along with the private equity arms of Goldman Sachs (GS) and Citigroup (C), acquired the company in July 2007 for a total of $7.1 billion. The timing of a potential IPO speaks volumes about what is in demand on Wall Street -- namely the "frugality trade" -- and the cashing out of a smart seller should be a warning sign to individual investors.

In a difficult market, the valuations placed on an IPO are usually low enough that private equity owners will wait until investor enthusiasm returns. Although the markets have generally been terrible, there are still pockets of demand, and few people are more intimately acquainted with institutional sentiment than private equity firms. While the June 2007 peak of the private equity bubble saw 21 IPOs -- including that of Blackstone (BX) -- the first half of 2009 has seen only 14. But KKR apparently feels that this is the best possible time to sell Dollar General; looking at hot areas of the market and the company's turnaround over the last two years indicates why this might not be so surprising.

Private equity firms typically buy a company using high amounts of leverage, or borrowed money, and set out to increase profitability before taking the company public again to pay off the debts. In the year before Dollar General was bought out (which coincides with their fiscal year-end 2007), the company had $9.17 billion in sales and earned $138 million in net income. In the last twelve months, sales have reached $10.8 billion and earnings have climbed to $185.3 million, according to filings analyzed by DailyFinance.

Ultimately, net income does not tell the whole story, because it introduces the cost of servicing the debt used to finance the deal. Interest expense increased more than ten-fold under private equity. Operating income, which excludes financing costs, more than doubled to $580.5 million from $248 million in the last two years. Most of the gains came from higher same-store sales, as cost-conscious consumers searched out bargains.

The boost in results comes as the private equity firms operate the company with no tangible equity. Before the buyout, the company had $1.8 billion in shareholders' equity, no intangible assets or goodwill, and an insignificant amount of long-term debt. Now, Dollar General has $2.9 billion in shareholders' equity, but more than $5.6 billion of that is intangibles. Additionally, they have a debt burden of $4.1 billion.

How this deal is received by market participants will show how much institutional demand there is for the frugality trade -- a trend that might not have run its full course, but certainly has seen plenty of attention. McDonald's (MCD) and Wal-Mart (WMT), after all, are the only Dow Jones Industrials components to post gains over the last two years. If a offering does come to market, it will be a sign that one of the only things Wall Street is paying up for right now are companies benefiting from the "trade down" mentality, an area is likely to be richly priced and destined for future underperformance.

James Cullen edits and writes at He is the Vice-President of the Boston College Investment Club, which owns GS, but has no personal position in the stocks mentioned above.

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