Investors have gotten increasingly bullish on the U.S. economy in 2023. Inflation is coming down, manufacturing investment is booming, and people are spending gobs of money traveling domestically and internationally. This is a recipe for strong and durable economic growth.
The S&P 500 has recovered 16% this year on the back of these bullish economic indicators, but certain pockets of the economy have been a different story. Discount retailer Dollar General (DG -0.41%) is one of the few companies that seems to be struggling so far in 2023. It reported a weak fiscal first quarter, which sent its stock down 20%. Year to date, shares are underperforming the broad market by 47% in just a six-month time span.
Let's dig deeper and see what problems have plagued Dollar General recently and whether the company is set to get its business on track in the coming quarters.
Data by YCharts.
Slower growth vs. competitors
The core concern investors have with Dollar General is slower sales growth compared with its other discount retailing peers. In the fiscal 2023 first quarter (ended May 5), Dollar General's same-store sales growth was just 1.6%, which marked a big slowdown from 5.7% same-store sales growth in the fourth quarter of 2022 and 4.3% for the full fiscal year. In a vacuum, slowing same-store sales growth is not a good thing, but it will happen from time to time if the discount retail customer demographic faces economic pressure.
But what makes these results even more concerning is the fact that Walmart, Dollar Tree, and Family Dollar did not see this weakness in same-store sales growth last quarter. Walmart's U.S. same-store sales grew 7.4% in its fiscal 2024 first quarter (ended April 30), while Dollar Tree and Family Dollar reported 3.4% and 6.6% comps, respectively (for the quarter ended April 29), all significantly ahead of Dollar General's result.
So what gives? Why is Dollar General struggling compared to the competition at the moment? It looks like product pricing has been leading consumers to switch their shopping habits (at least recently) from Dollar General to Family Dollar. Dollar General runs its gross margin (i.e., the margin it earns on top of product sales) at 30% to 32% compared to Family Dollar at closer to 25%. With inflation hurting purchasing power for individuals, it looks like some consumers have switched their discount retail purchases to the competition.
Is this a short-term blip or a long-term concern?
With inflation coming down throughout 2023, discount shoppers may see some pressure ease on their budgets, which could help Dollar General stop ceding market share.
But management doesn't seem to think this problem will fix itself and now plans to switch up its strategy in order to better compete on pricing on key items, according to the latest earnings call. This could bring gross margin closer to Family Dollar's over the next few quarters.
From a bottom-line perspective, gross margin compression would lead to operating margin compression, all else being equal. Dollar General's operating margin had been declining for years until COVID-19 sent profitability to record levels. With the pandemic largely in the rearview mirror, the bottom line is trending downward once again.
Over the last 12 months, Dollar General reported $3.3 billion of operating income on $38.4 billion of revenue, or an 8.7% margin. If that figure were to slip to 7% on the same revenue base, operating income would dip to $2.7 billion, a sizable hit to profitability. Such a scenario would mark a low point for the company, but its operating margin did fall to just 6.9% in Q3 2018. It's not unrealistic if management is forced to be increasingly aggressive with the shift to its pricing strategy.
However, it is probably the right move over the long term to ensure Dollar General retains shoppers.
Is the stock cheap? It depends ...
With a current market cap of $37.4 billion, Dollar General stock looks cheap with its price-to-earnings (P/E) valuation of less than 16, which is significantly cheaper than the market average. But that doesn't tell the whole story.
It looks like investors are worried margins will continue to erode in the next few quarters, which will put a dent into earnings even if sales growth reaccelerates. Analysts expect the company's earnings per share to fall about 6% in the current fiscal year.
The stock looks cheap only if the company's operating margin holds steady in the coming years. If pricing pressures continue, Dollar General could end up being a value trap.
