Dollar General (DG -3.12%) stock has fallen sharply this year as the company reported underwhelming earnings numbers. Profits are down, and the discount retailer expects continued headwinds as economic conditions weigh on its consumers.
Shares of Dollar General are now down more than 58% year to date. And because of the sharp decline, the stock's dividend yield has climbed to 2.2%, an abnormally high level for the company. Is the dividend still safe?
How strong are the company's earnings?
A good starting point to evaluate a dividend is the company's bottom line. If its per-share profits are light, then it may be difficult for a business to justify paying anything out to shareholders. That's especially true for a growing business such as Dollar General, which is normally busy upgrading and opening more locations.
When the company reported its fiscal 2023 second quarter earnings in late August, it released updated guidance for the full fiscal year, which ends in Jan. 2024. Dollar General projects that its diluted earnings per share will fall between $7.10 and $8.30, which would be a decline of at least 22% from the previous fiscal year. Currently, the company pays a quarterly dividend of $0.59, which equates to $2.36 per share over the course of a full year. Even at the company's weakest guidance of $7.10 in full-year earninings, that would put its payout ratio at 33%.
The caveat, of course, is whether Dollar General's earnings will deteriorate even further. And while there is still plenty of buffer with respect to earnings, investors should also consider free cash flow.
Does Dollar General generate enough free cash flow?
Since free cash flow excludes non-cash items, it can give investors a more accurate representation of a company's ability to pay dividends. The metric also factors in capital expenditures, which are important for a growing company such as Dollar General.
The chart above shows how much free cash flow is left after the company has paid dividends. This paints a troubling picture as it shows that over the past year, on average, Dollar General has spent $102 million more on dividends than it has generated in free cash flow. In some periods, the company has even generated negative free cash flow.
You may wonder why there is such a huge difference between its reported earnings and cash flows, and it ties back to those capital expenditures. Over the past 12 months, Dollar General has invested nearly $1.7 billion back into its business. That's more than three times what it has paid out in dividends during that same stretch -- about $503 million.
This is a company that invests heavily into its stores. During the quarter ended Aug. 4, Dollar General said it opened 215 new stores and also remodeled 614 locations.
If this trend of low free cash flow continues, it could give management a reason to consider reducing the dividend or perhaps even cut it entirely. The company has only been paying dividends since 2015, so there's not a long track record here to maintain, which is part of the reason I wouldn't be surprised if the company made a change to its dividend policy assuming its financials (specifically free cash flow) don't improve in the near future.
Should you rely on the dividend?
Dollar General's dividend yield isn't terribly high, but it could be in jeopardy. The danger is if things deteriorate further at its business and the company needs to invest more money into its operations. Such a situation would force management to make difficult choices. This is primarily a growth-oriented company, which is why the dividend may prove to be a necessary casualty.
This can still be a good growth stock for investors to buy and hang onto for the long run, but income investors, particularly those looking for steady payout growth, should avoid the uncertainty at Dollar General.