3 Reasons Dollar General's Stock Could Fall

Dollar General has outperformed the market since the Great Recession ended, but there are three reasons it could disappoint in the year ahead.

Aug 20, 2014 at 5:16PM

Dollar General (NYSE:DG) stock has been on a tear since the recession ended in 2009. Its shareholders have reaped an 84% higher five-year return than the S&P 500. High unemployment and discouraged job seekers leaving the workforce likely contributed to dollar stores' rise over the last five years, not to mention Dollar General's recently announced bid for Family Dollar added to the rise. However, three key issues could crimp Dollar General's stock return going forward. Although no single threat guarantees that Dollar General's stock price will fall, shareholders should not dismiss the possibility that lower returns could be on the horizon.

Dg Exterior

Source: Dollar General.

1. Intensifying competition

Competition is the single biggest threat to Dollar General's long-term earning power. Small-format discount chains compete primarily on price and proximity to consumers. Price competition will likely intensify as Wal-Mart steps up its efforts to conquer the niche. The world's largest retailer expanded its small-format store base by 42% last year to 407. Although it is a far cry from matching Dollar General's footprint, Wal-Mart's established supplier relationships, distribution hubs, and retail know-how could allow it to expand rapidly and become a formidable competitor to Dollar General in the coming years. At the very least, Wal-Mart's presence will keep pressure on industry pricing as competitors vie for price-conscious consumers' business.

Aside from price competition, the industry also faces heightened competition for viable locations. Retailing is all about location, location, location. Stores that are closer to targeted consumers receive the most business. Dollar General estimates there are 14,000 potential locations that have yet to be exploited in the U.S, giving the dollar store segment room for growth.


Source: Wal-Mart Stores.

However, the big three dollar store chains are already adding 1,500 stores per year. Wal-Mart plans to add 270 to 300 small-format stores this year, thereby increasing small-format store growth by 18% to 20%. This adds competition for the best locations and quickens the pace toward market saturation. As a result, Dollar General's long-term growth potential may be more limited than it would have been had Wal-Mart not invested in the space.

2. Economy leaving the poor behind

In one sense, a poor economy is good for Dollar General. The company serves low-income households that seek low prices rather than prime brands. When the economy tanks and unemployment rises, more Americans fall into Dollar General's customer profile.

However, sustained high unemployment and stagnant wages could be problematic going forward. Bloomberg reports that average annual household income declined $275 from 2008 to 2012 for the bottom quintile of wage-earners. Higher inflation and sustained high unemployment rates could cause Dollar General's customer base to cut back on higher-margin purchases and focus only on the essentials. Reductions in government food assistance programs would exacerbate the decline in customers' spending power. This would have a negative effect on Dollar General's profitability, thereby reducing the value of its shares.

3. CEO change

The CEO's track record and management philosophy is a key part of any investment. Dollar General's current CEO, Richard Dreiling, has served in that role since 2008, giving investors a six-year look at his capital allocation and operating style. Dreiling has announced that he will retire by the end of May. His retirement plan will be pushed back to May 2016 if Dollar General successfully acquires Family Dollar. In any case, Dreiling has committed to leaving despite his not having a clear successor.

Dreiling took over Dollar General at an opportune time; the Great Recession was getting under way, sending more customers to the discount channel. Since 2008, Dollar General has expanded its store count by 38% and has grown sales 80%. Given the current economic environment, it is unlikely that Dreiling's successor will repeat this success.

Instead, the new CEO will have to learn his new role while managing a company that is coming under increasing competitive threats in a hostile economy. This is a tall order for even a seasoned CEO -- and may even explain Dreiling's departure. Shareholders should reserve judgment until a successor is announced, but the prospect of an unseasoned CEO coming on board in a tough environment is a negative.

Foolish takeaway

Dollar General is a highly profitable discounter with a long runway for growth. It has the potential to outperform the market in the years ahead, but there are also reasons it might underperform. Wal-Mart's investments in the discount segment intensify competition, stagnant wages and high unemployment threaten to reduce customers' spending power, and a change at the top of the organization is taking place as the company heads into a potentially difficult period for discounters. Investors should take these concerns into account before deciding whether or not to invest in Dollar General.

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Ted Cooper has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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