Dollar General (DG -0.41%) operates 19,400 stores that focus on selling low-priced items it thinks customers need on a regular basis. The basic idea is to be convenient and cheap so people keep coming back to shop.
Like every business, Dollar General's performance ebbs and flows along with the broader economy, and from a big-picture perspective, the second quarter wasn't too bad. But a look at one financial metric, which was up 95% year over year, shows there is some potential trouble for the discount retailer.
Dollar General's business is holding up
If you look at the top line of Dollar General's income statement for the second quarter, you'd think the company was doing OK. Sales increased 3.9% year over year. That's not great, but it's not terrible either. The growth was largely driven by new stores. This point comes into focus when you see that same-store sales, which are sales at locations that have been open for a year or more, were down by 0.1% year over year.
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That's not exactly inspiring. But there were some notable cross currents in that same-store-sales figure. For example, consumable products sold well but seasonal items and clothing were weak. This point is important, because consumables, such as toothpaste and toilet paper, are lower-margin products. They are basically the products that Dollar General counts on to get customers back into its stores in the hope that they will buy higher-margin products, such as clothing.
So customers appear to be pulling back in some important ways. That's not great news for Dollar General. The retailer will have to adjust, as it has before, to changing market conditions. That's just how the business works. However, there are increasing headwinds further down the income statement.
Dollar General's costs are becoming an issue
Often investors pay very close attention to revenue and cost of revenue. In this case, that's basically what Dollar General charges its customers versus what it pays its suppliers. Subtract one from the other and you have gross margin. It's a very important number, but it isn't the only important number.
For example, gross margin doesn't take into consideration the cost of actually running the business. The so-called selling, general, and administrative costs show up further down the income statement. SG&A, as it is more commonly known, rose about 10% year over year in the quarter. That's a big change, but perhaps not shocking given the rate of inflation in the world today. If Dollar General wants to keep its employees it needs to pay them whatever the prevailing wage happens to be.
A little further down the income statement, there's interest expense, which also comes out before earnings. This number increased roughly 95% year over year in the quarter. That's a shocking increase and one that should cause investors to pause and take notice. To be fair, the absolute interest cost isn't outlandish, but something is going on that has to be monitored.
There are two factors affecting that number. First, interest rates are rising and, thus, the cost of debt has increased. Second, the company's average debt load was higher. The company estimates that its rising interest expense will remain a notable headwind to earnings, presenting a four-percentage-point negative throughout the year. That's a sizable problem to overcome at a time when a company's margins are under pressure and it has to face higher costs for employees.
A lot of negatives are hitting Dollar General at one time
Dollar General has a long operating history, and it will survive what appears to be an avalanche of negatives hitting its business right now. But a 95% increase in interest costs is a shocking outlier that can't be ignored. It's an exclamation mark highlighting that costs are heading higher at a rapid clip. That's particularly true given that the higher costs, for interest expenses and employees, are likely to linger.
Right now, investors need to look past the top line and examine the changing cost structure of Dollar General's business.
