Dollar General's (DG -0.41%) shoppers are feeling more financially stressed. The value-focused retailer recently announced surprisingly weak Q2 earnings results that showed mounting demand pressure. Wall Street punished its shares in response, pushing them to a 40%-plus decline so far in 2023.
Investors might feel tempted to jump into the stock given Dollar General's strong market position and cheap valuation. However, there are at least two new reasons to feel cautious about this business today. Let's take a closer look.
1. Weak sales trends
In early June, management said the tough sales environment had been "more challenging than expected" after comparable-store sales growth slowed to below 2%. The situation has only worsened in the subsequent weeks.
Comps were flat in the second quarter, which ran through early August, missing Dollar General's reduced forecast. Customer traffic was down for the period, but average spending rose slightly. Sales fell in all of the chain's discretionary categories, including apparel and seasonal products.
The good news is those declines were mostly offset by higher sales in its consumables division. Still, revenue trends weren't up to management's -- or Wall Street's -- expectations. "We are not satisfied with our overall financial results," CEO Jeff Owen said as he sought to highlight Dollar General's progress at reducing inventory levels to better match up with demand trends.
2. Declining profitability
Gross profit margin fell to 31% of sales from 32% a year ago, reflecting increased pressure to cut prices. Dollar General relied on more promotions to protect market share this quarter, and profitability also took a hit from the tilt in demand toward consumer essentials like food products. This merchandise carries lower profitability than the chain's other items. Like its peers, Dollar General also reported an uptick in shrinkage, which includes theft.
DG Operating Margin (TTM) data by YCharts
The combination of slower sales and declining profit margin put significant pressure on Dollar General's bottom line. Operating profit fell 24% year over year to $692 million, in fact. Rising interest expenses added to the slump, with net income dropping 31% year over year to $470 million.
The path forward
Management is taking the right approach in response to this tough selling environment. By using aggressive promotions, it can maintain its market share while keeping inventory moving through the system. These efforts should position the business well for a growth rebound once the cyclical downturn ends.
Yet investors will likely see worse operating results, at least through the rest of 2023. Dollar General lowered its outlook for the second straight quarter in late August, saying comps will now likely be flat for the year. The company entered 2023 projecting gains of around 6% before lowering that forecast to a range of 3.5% to 5% in early June.
Earnings trends have been even more significantly impacted. Rather than rising by as much as 6% (as originally predicted), profits per share should now decline between 34% and 22%. That shift was jarring for shareholders and likely reflects a sustained effort by the management team to slash prices so that inventory levels can be brought down significantly.
Dollar General isn't abandoning its wider growth ambitions and it is still expanding its sales footprint with new stores. The stock likely won't start recovering lost ground, however, until customer traffic trends stabilize and profitability begins rebounding. Value investors should stay away from the retailing stock for now because there's a good chance that Dollar General will struggle for several additional quarters before its recovery path becomes clearer.
