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We initiated our coverage on Dollar General Corporation (DG - Analyst Report) with a Neutral recommendation and a target price of $59.00. This was based on the company’s better-than-expected results and its prudent efforts to drive growth. However, the stock remains vulnerable to a gross margin pressure and macroeconomic challenges.

Why Neutral Recommendation?

Dollar General’s commitment toward better price management, cost containment, private label offering, effective inventory management, merchandise and operational initiatives will likely drive sales and margin growth.

Further, this Zacks Rank #2 (Buy) stock has displayed impressive comparable-store sales growth over the years. The company’s comparable-store sales remained robust despite unfavorable macroeconomic conditions mainly due to competitive pricing and attractive store expansion strategies, including remodeling and relocations. Fiscal 2012 marked the 23rd consecutive year of comparable-store sales growth

Moreover, Dollar General has been actively managing its cash flows and returning much of its free cash to shareholders through share repurchases. The company has also been making prudent investments related to store infrastructure; store openings, expansions and relocations; and improvement of distribution centers in to increase revenues.

Dollar General is currently witnessing steady top and bottom-line growth as evident from its strong second-quarter fiscal 2013 results. The quarterly earnings rose 11.6% to 77 cents a share, while net sales increased 11.3% to $4,394.7 million. This was primarily due to robust performance at the Consumables category.

We also remain impressed by the company’s positive earnings surprise history. In the last 10 quarters, Dollar General surpassed the Zacks Consensus Estimate 8 times with an average beat of 4.2%.

Looking ahead, Dollar General continues to project fiscal 2013 earnings in the range of $3.15 to $3.22 per share. The current Zacks Consensus Estimate for the year is $3.23 per share. Total sales are expected to rise by 10% to 11% year over year, while same-store sales are expected to increase by 4% to 5%.

On the flip side, we remain concerned about the increase in gross margin pressure due to rise in sales of low margin carrying products and higher inventory shrinkage. For fiscal 2013, management expects gross margin to remain under pressure and to contract 90 basis points when compared with the prior year.

Moreover, the stock remains sensitive to macroeconomic factors and competitive pressure. The company could face market cannibalization if it further expands in the geographies where it already exists.

Other Stocks to Consider

Apart from Dollar General, other stocks worth a look in the retail sector include Citi Trends, Inc. (CTRN - Analyst Report), DSW Inc. (DSW - Snapshot Report) and Kirkland's Inc. (KIRK - Analyst Report). All these carry a Zacks Rank #1 (Strong Buy).

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