No. of Recommendations: 8
I presume these are the 4 factors affecting gross profit:
-shift to less profitable consumables;
-increased promotional expenses (what the CEO calls "increasing our investment in markdown activities") ;
-increased front-end labour expenses (to control theft);
-continuing increases in theft (21 basis points worse than last year), despite their effort to combat it,
or 5, if you include slight decrease in inflation-adjusted same store revenues.
I don't see why any of those is going to get solved.
I'm not sure any of these will get solved, but there are potential partial 'solutions' on all four.
The shift in sales mix has been discussed. I would add a small note: if you look at the quarterly data, you'll notice the drop really ramps up in Q2, 2023, and continues from there. A key part of the story, in my mind, is the removal of the pandemic era SNAP benefits (March 2023). The majority of DG consumers are in sub-$35k households (something like 60%). While the SNAP increase isn't returning, it is further evidence that some of the drop in non-consumables/discretionary spending is likely attributable to the sub-$35k consumer being more strapped than normal, due to the end of certain pandemic related benefits, and other related factors (inflation etc). (Is WMT better at stealing DG's sales, especially with respect to non-consumable sales? Yes, probably, but I also think the effect is being overstated with respect to DG's main consumer base. I would speculate that a separate issue here is that WMT looks like they are stealing the 'trade down' consumers that have historically traded down to dollar stores in the past. That's a real problem, and I don't know how it gets fixed without substantial investment in the quality of DG stores.)
So a partial solution is a return to a less constrained sub-$35k consumer. If this happens, it is likely to be a tailwind for non-consumable sales, and soften the need for markdowns.
Management wasn't exactly transparent on shrink, but they but did suggest on the call that they expect the issue to be a tailwind starting in 2025, due in part to the lag that attends shrink hitting the reporting. Beyond increasing front-end labour, the solutions appear to include the reduction of high-shrink SKUs, the continuing reduction in inventory, and an increase in store relocations/closures. Maybe runaway shrink is the new normal, and it may well get worse from here, but anything resembling a reversion to even close to normal shrink would be a decent tailwind.
Labour inflation and staffing troubles more generally is a big part of the story and I don't see it being an easy fix. That said, this is partly a cyclical issue. DG's margins are typically most compressed when unemployment rates are at their lowest, or shortly thereafter (see 2006-08, and 2019), due in part to increasing labour/SG&A costs during those time periods. We've had historically low unemployment for a couple years now. It appears the situation may now be reversing.
FWIW, Morningstar estimates mid-cyle operating margin at 7.2%. Down from their previous forecast of 8%:
We lowered our fair value estimate on Dollar General to $130 from $145, following its lackluster second-quarter results and uninspiring outlook. The firm continues to grapple with a weak spending environment as same-store sales growth of 0.5% landed below our estimate for a 2.25% gain. Operating margin also suffered a 170-basis point drop to 5.4% (versus our 5.7% forecast) amid intensifying promotional activity, wage growth, and headwinds from shrink. The outlook for fiscal 2024 looks to be increasingly uncertain as abating fiscal stimulus and elevated price levels appear to be pinching the wallets of Dollar General’s core low-income shoppers, prompting management to slash its full year guidance. To better align with management’s updated EPS outlook for fiscal 2024 of $5.50-$6.20 (from $6.80-$7.55), we reduced our forecast for full-year same-store sales growth to about 1% (from 2.5%) and lowered our operating margin forecast to below 5% (from 5.75%). We also think Dollar General’s trajectory for margin recovery looks increasingly arduous as it grapples with continued wage growth and makes necessary store investments. As such, we reduced our midcycle operating margin forecast to 7.2% (from 8%). Longer term, we expect Dollar General to post mid-single-digit top-line growth. We foresee the firm’s growth algorithm being driven by 2%-3% same-store sales growth (roughly consistent with its prepandemic trends) and modest store expansion. However, given the seemingly crowded footprint of dollar stores (Dollar General, Family Dollar, and Dollar Tree collectively operate over 37,000 stores), we anticipate future store growth to be more subdued. We forecast Dollar General to expand its existing footprint from 20,000 stores to around 25,000 by the end of our 10-year forecast (versus nearly 9,000 additions in the previous decade), equating to average annual growth of 2.3%. We expect Dollar General’s profitability to remain compressed in the near term as the retailer seeks to normalize its inventory levels and same-store sales growth moderates, limiting its ability to leverage selling, general, and administrative costs. As such, we don't forecast operating margin to reach 7.0% until fiscal 2028 and 7.2% (our midcycle forecast, which is about 120 basis points below 2019 levels) until fiscal 2029. Sluggish comparable sales growth, more-intense retail competition, wage growth, and necessary investments to improve working conditions at existing stores are the primary reasons for our reduced profitability outlook. Dollar General’s current store base appears to be stretched thin and contributes to our forecast for elevated capital expenditures over the following decade (at about 3% of sales).
