Dollar General (DG -0.41%) operates a chain of over 19,000 stores offering consumers low prices for everyday needs. The business model is generally expected to hold up fairly well throughout the economic cycle, since the retailer's customers go to the conveniently located stores for essentials. However, second-quarter 2023 financial results show that there's some weakness here that investors need to watch closely.
Dollar General customers are still spending
From a big-picture perspective, Dollar General's top-line results in the second quarter weren't terrible. Specifically, the company's sales increased 3.9%. The two big drivers of this advance were new store openings and increased demand for consumables. That would be everyday items, like toothpaste and toilet paper, that people need regularly.
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Consumables are a really important part of Dollar General's business model. They are the products that keep customers coming back again and again. New stores, meanwhile, expand the footprint and each new location helps boost the top line. But all the news wasn't good in the quarter.
For example, the company noted that it was seeing less customer traffic at its stores. And same-store sales fell 0.1%, which isn't huge. However, it isn't a good sign, either. Overall, larger spending per transaction helped to offset these negatives. But there was another trend in the mix that was incredibly important.
While demand for consumables went up, Dollar General saw declining demand in its home, seasonal, and apparel categories. These are more discretionary items and hint that there's a pullback happening among the company's consumers. Moreover, the larger transaction size and lower traffic combination could be a function of consumers heading to the store less often, which would require more to be bought per visit. Not the best outcome for Dollar General.
Margin is what you need to watch today
So there are a lot of moving parts, as always, in this retailer's financial results. But what was, perhaps, most interesting is that Dollar General's gross margin fell 1.26 percentage points in the quarter. That means that the business's profitability is under pressure and investors need to pay close attention to this fact.
Essentially, the consumables the company sells are priced aggressively in order to bring customers back to the store. Thus, they are less profitable than other products the company sells. Dollar General hopes that while in the store for basics like deodorant, customers will buy other items, like clothing and seasonal items, on which it has higher margins. This isn't happening right now and that's a problem.
Also, as noted, the company's average sales are up, but if that's just a function of buying more low-margin items during less frequent visits, it speaks further to the financial stress Dollar General is seeing. As it stands, the company chose to reduce its full-year 2023 sales growth guidance to a range of 1.3% to 3%, down from 3.5% to 5%. And same-store sales are now expected to end the year between a decline of 1% and a rise of 1%, worse than the previous expectation of a 1% to 2% increase.
Clearly, management is worried that things will get worse, not better, over the near term. If gross margin remains weak, or weakens further, the downtrends management is projecting could get compounded into even weaker bottom-line results than the current call for a year-over-year earnings decline of as much as 34% (which was updated radically from an expected decline of at most 8%).
Things could get worse before they get better
It's pretty clear based on the downward guidance revisions that Dollar General is worried about the business trends it is facing. A big problem is the compounding effect of the negatives, particularly the decline in higher-margin product sales. (That said, rising interest rates are another issue to watch.) If you own or are monitoring this low-price retailer, make sure you keep a close eye on margins and the subtle, but important, shifts driving the current weakness in the company's results. Fixing the problems may take longer than management hopes.
