Three months ago, Dollar General (NYSE:DG) was cruising, reporting double-digit mid-year improvements in both revenues and net income, along with expanding gross margins and industry-leading same-store sales performance. Today, the deep-discount retailer hit a speed bump, posting a 9% drop in net income to $71.1 million ($0.22 per share) from $77.9 million the year before (including a one-time $7.8 million pre-tax inventory adjustment gain) and missing estimates by three cents per share.
There was nothing wrong with the top line, which registered an 11.5% increase to $1.88 billion, aided by continued rapid expansion (703 new stores opened year to date) and a solid 3.4% gain in quarterly same-store sales. Dollar General's comps continue to outpace rivals such as Dollar Tree (NASDAQ:DLTR) and 99 Cents Only (NYSE:NDN), which both reported slim fractional gains for the quarter.
Unfortunately, a pronounced shift in the sales mix toward low-margin consumables and away from higher-margin discretionary items has left a smaller percentage of those revenues filtering down to the bottom line. Sales of consumables such as food and milk surged 16.2%, while sales of home products fell 2.1%. The shift was responsible for about half of the decrease in gross margins, which fell 120 basis points, to 29.5%, from 30.7% in the prior year. Family Dollar (NYSE:FDO) reported a similar trend recently and warned that it would hurt its results, which are due later this month.
Unfortunately, the drop in gross margins was compounded by a jump in selling, general, and administrative expenses, which rose 14.1%. Several reasons for the increase were cited, including higher rent and utilities and increased customer debit card usage. As a result, operating income dropped from $131.3 million to $114 million on operating margins that fell to 6.1% from 7.8%. Dollar General, though, is not the only company to report a sharp drop in profitability, as operating margins at Dollar Tree fell from 9.1% to 7.4% during the quarter.
As with its peers, many of Dollar General's low-income customers are struggling to cope with high gas prices, a factor cited several times by Wal-Mart (NYSE:WMT) and others. On the other hand, when discretionary income is pinched, inexpensive prices on everyday items begin to look even more attractive, which should help generate traffic -- especially now that nearly 7,000 stores have installed coolers to stock milk, eggs, and other staples.
With expectations for 730 new stores next year (including 30 of the larger, more fully stocked Dollar General Markets) and strong results from its existing store base, the company should have little trouble growing sales. Of greater concern is this year's earnings outlook, which management trimmed back to $341 million to $350 million, at the low end of previous guidance. Even that reduced forecast still represents a 13% to 16% improvement over the $301 million earned last year. Going forward, per-share earnings should be enhanced by an ambitious new stock repurchase program. Despite this morning's slowdown, Dollar General still appears to be leading the way in the deep-discount realm.
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Fool contributor Nathan Slaughter owns none of the companies mentioned.
