Dollar General (DG-US) - It's a trap!

I sold DG last week for a small loss. The road ahead will be hard and there are just easier stories out there.

After spectating DG for some time, I bought a small starter position in June. It is not often that you get a chance to buy a compounder like this 35% from its highs. Historically it has paid to buy the dips on DG, so I figured I would buy now and ask questions later. This time it has not paid, at all. My average was ~$185 and I sold my stock last monday at $168. I know that some of my subs also follow the stock so I thought I would collect my notes and write up a few paragraphs.

I am a long-term believer in DG and their track-record really is world-class. But they have some issues which I found to be bigger than I’d originally anticipated after doing some more work. I think it will take some time to right the ship. The company faced similar problems back in 2016, and the result was a significant and prolonged margin hit, one which the company never really recovered from (margins peaked in 2015, other than one-off Covid boom margins). One could reasonably argue that the current situation is tougher than 2016.

That said, I also want to make the point that whilst I am selling the stock, DG isn’t broken - it is still a perfectly fine business than can produce SQFT growth and has produced a sensational return on capital over a very long time. After the recent haircut, the stock is trading at ~16x forward EPS. Investors will probably do fine owning the stock today with MSD top-line growth profile and LDD EPS growth as they did back in 2016. However, to get really excited, you need to believe that margins are going to rebound pretty quickly to 9%+. I don’t feel confident about that right now.

Contents

1. Cyclical issues

   1. General Macro and non-consumable uncertainty

   2. SNAP roll-off and Tax-Rebates

   3. Shrink issues

2. Execution/idiosyncratic issues

   1. Freight, warehousing and logistical issues

   2. Ill-timed price investments

   3. Ill-timed labour investments

   4. Merchandising Errors and inflated inventories

   5. Distractions from PopShelf and other initiatives

   6. Management Turnover

3. Competitive concerns

   1. The Family Dollar situation

4. Is this a broken story? Let’s look at history…

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Cyclical issues

1. General macro weakness and uncertainty in non-consumables

We don’t really have to overcomplicate this and it isn’t really that big of a big concern. Goods spending has slowed and that has hit DG’s core customer disproportionately. In addition, consumers have been trading down to private-label and/or cheaper alternatives. Non-consumable discretionary items hold as high as ~2x margin to certain consumables and that has come under pressure, so they are very important to the company’s margin profile. It is also facing an extra headwind as people over-indulged on certain categories such as home and seasonal goods during the pandemic.

Non-consumable sales/SQFT are elevated relative to the last cycle’s trough, but there has been signficant inflation in the economy, so it is hard to draw comparisons with certainty.

There are also questions around the strength of the company’s recent non-consumables initative (essentially a merchandising refresh). Historically, when the company has done a merchandising refresh, it has been followed by a few quarters of success, and then continued to recede. This is the fourth non-consumables refresh since the GFC - it has long been a thorn in the company’s side, and every time they have proclaimed to have finally figured it out. The jury is still out if the recent increase in non-consumable sales/square-foot was structural or a temporary hit.

Ultimately, spend is cyclical. It will be under pressure for some time and then come back and isn’t that big of a deal, other than to say that pressures might persist a little longer than past cycles for the above reasons.

2. SNAP roll-off and Tax-Rebates

This is a bit of a bigger deal. In March, the SNAP benefits being recieved by some 30m US residents enrolled in the program began to roll-off. During Covid, an emergency allotment of ~$95/month was implemented. It ended for a number of states last year, but up until March 2023 was still being implemented by 35 states.

Howard Jackson from HSA Consulting (source: Guidepoint call) gave the following analysis to help quantify the SNAP impacts for DG.

In 2022, the Covid emergency supplement was ~$37bn on total SNAP spend of ~$118bn. There was an increase to base levels of ~12.5% between 2022 and 2023 plus another 4m people put on the plan, but that emergency allotment is now gone, meaning that total snap spend for 2023 will be around $103-106bn people. Howard estimates that ~10% of Dollar General’s sales come from SNAP benefits, meaning that the impact of SNAP benefits alone could have dragged on DG’s comp by ~1-1.5%. This is a pretty big deal and it is important because SNAP is not cyclical - it isn’t coming back.

The other factor that is impacting spending is tax refunds. They were increased in 2021, and in 2023 returned to 2019 levels. This included a decline in Child Tax Credit from $3,600 to $2,000, the Earned Income Tax Credit of $1,500 to a maximum of $530 and Child and Dependent Care Credit from a maximum of $8,000 to $2,100. It is hard to measure the impact, but given DG’s customer demographic, these sorts of changes can have a material impact. In a similar sense, this is not cyclical and will not come back next year.

3. Shrink Issues

Shrink is not a new issue and is not confined to Dollar General. However, DG is coming off a period where shrink was very low, and 2023/24 margin pressures from shrink are not temporary but are likely reverting to a more ‘normal’ level. DG’s current labour situation, which is widely reported to be inadequate (understaffed, generally) further complicates the issue as lower staff hours are directly correlated to shrink. This issue appears to be here to stay and will continue to put pressure on margins.

Execution issues

1. Freight, warehousing and logistical issues

In mid-2022, the company announced that it would expand its warehousing capacity by adding three new facilities. By the end of the year, things weren’t going to plan and they took a $40m hit in Q3. Channel checks that I conducted on the business suggest that this was just due to poor execution - the company didn’t expand its capacity enough, for one reason or another, and got caught without capacity.

Issues outside of the company’s control had also contributed. Most merchandisers in 2022 suffered from a phenomenon where in 2021/early 2022 they couldn’t get product, so double/triple orders were placed, and then supply chains eased all at once leading to too much product in the channel. This compounded DG’s woes as they got caught with too much inventory and not enough space to store it.

It’s not a structural problem, but it is the first amongst many execution issues from the company’s new management team.

2. Ill-timed labour investments

Dollar General has been criticized significantly in the last couple of years for inadequate levels of labor caused by supposed labor hour cuts in 2022. Whilst this is anecdotal, the reports of labor shortages at Dollar General have been widespread, and have even attracted attention from the OSHA leading to hundreds of stores being fined for unsafe conditions, generally caused by a lack of labor to stack shelves. There have also been labor strikes recently.

Dollar General has been victim, as have most, to the Great Resignation and labor shortages that occured across the economy in the wake of the pandemic. DG is widely reported to be one of the lowest wage payers in the country - a conertstone of their ability to offer low-prices.

However, labor shortages have created significant issues in out-of-stocks and employee churn, which have forced the company to make ‘$100m of investments’ in labor - i.e. hire more people and put wages up. The so-what of this is that labor investments are happening at the same time as the economy is weakening, which will lead to further margin pressures. Given the state of the stores in recent times and increased OSHA fines, this might not be temporary, either - it might signify, in-fact, that the company was over-earning in recent years as a result of not having enough staff in stores, which had reached breaking point.

In 2016, the company took a similar investment in labor which, amongst other things, led to significant margin pressures - pressures that lasted for years. This could be, and in fact appears to be, a similar situation with real medium-term margin implications.

Some have also speculated that the recent $100m is not enough. With nearly 20,000 stores, $100m only represents ~$14/day per store in labor investment. That is roughly 1-2 labor hours per day. It just illustrates that any investment in labor will have significant impacts on the company’s bottom-line.

2. Ill-timed price investments

The biggest shock for the market from the April results was that DG had a comp of ~2% vs Walmart and Family Dollar at 6-7%, suggesting significant market share losses. The most common disgnosis for such discrepancy in comps from people in the industry is that the company’s pricing was not right. Walmart and Family Dollar made significant investments in price in 2022, but Dollar General didn’t.

The company told the market on the December 2022 earnings call that:

“where we're at in price, we don't see a need to invest.”

And then on the the Jun 2023 earnings call, after the comp was reported:

“First and foremost, we are taking action to provide even more affordable solutions and lower prices for our customers. We are doing this in a targeted fashion on the items that matter most, as we believe we can be even sharper within our established target range.”

The company blamed the SNAP roll-off, macro-weakness and weather for its lower comp, but what seems clear is that its pricing fell out-of-line with Walmart, which led to market share losses. This has had a considerably impact on margins, causing a downgrade which implies EBIT margins this year of ~8%.

It’s curious why the company didn’t invest in price and has left industry participants puzzled, as well. Perhaps they didn’t expect economic conditions to deteriorate quite like they have. In either case, it is another misstep from new management that the market has not taken to forgivingly.

3. Merchandising Errors and inflated inventories

The company keeps telling us that inventories are only inflated due to product cost inflation, but I just don’t buy it. Inventories/SQFT were up 14.7% YoY in the most recent quarter against a comp of just 2%. At a time when the company is investing in price, either they are about to see a very significant margin pressure from COGS, or they just have too much inventory.

Channel checks including expert calls from Guidepoint suggest that the company is sitting on a whole bunch of seasonal and home goods inventory. This is partly as a result of over-ordering and inability to distribute it with supply chain issues, and now they are stuck with it as discretionary spend has slowed. This inventory will likely need to be marked down and cleared at some point, which will drag on margins.

Much in the same way as they did with labor and price, the company has refused to acknowledge the issue on earnings calls, suggesting that it might be a skeleton in the closet for further downgrades. It is another misstep in execution and communication.

4. POPShelf

PopShelf is a new initiative from Dollar General. The pace at which they have ramped up the store is really something to see. The company debuted the box in 2021 and hoped to have 1,000 stores by 2025.

Unsurprisingly, that has been pared back citing economic conditions. Explained to me by an ex-employee as a ‘Todd Vasos Baby’ (outgoing CEO), it is unclear what the future holds for PopShelf. In any case, it’s possible and in fact likely that the company got false-positives from PopShelf as the launched the covid during a hobby-spending boom. Its recent pausing suggests that the box is not quite performing as hoped.

It isn’t ultimately so important for the company today in terms of footprint, but it has been slated as a big future growth driver as the traditional box will begin to reach saturation.

This adds to the list of execution issues from the company - ramping a new concept discretionary retailer into the peak of an economic boom.

5. Management Turnover

Much of the recent execution issues can probably be explained in part by management turnover. In late 2022, Todd Vasos (CEO) stepped down, and shortly after, his CFO resigned with no real explanation. Did they step down because they foresaw issues on the horizon? Well, now it is seeming more and more likely.

In addition, Family Dollar recently promoted Rick Drielling (ex-DG veteran) to CEO of Dollar Tree. Rick was largely responsible for building DG into what it is today, and is planning to roll-out the same playbook at Family Dollar as he employed at FD. Rick has also hired a handful of his ex-bench from DG, including John Flannigan and Larry Gatta, who were instrumental in DG’s success.

Recent management turnover and execution issues have created a crisis in confidence for investors, and the stock has de-rated as a result. It will take some time for the current management team to win back investors’ trust.

Competitive concerns - competition from Family Dollar

I’m not going to write about this at length, mostly because it doesn’t concern me so much. Generally, DG and FD’s footprint doesn’t really overlap that much. Also, FD and DG compete with Walmart and other local grocers, not really eachother. Generally, DG is used as a fill-in trip between larger shops at Walmart and tries to price within 2-3% - you get the convenience with a little bit of a higher price, but you don’t mind because you’re just going to buy a few items.

When prices fall out of step with Walmart, people notice, and they are no longer willing to pay the higher price for the extra convenience. DG’s customers are extremely price sensitive - mostly because they need to be. To say that the company’s comps have been weak because of competition from FD is for the most part misleading, especially considering that DG tends to be more rural whereas FD leans more urban. The comp discrepancy has to do with DG vs Walmart, not DG vs FD. Yes, they have lost share to Walmart, but it isn’t because FD has been re-invigorated.

Where I would be more concerned is on new builds. For years, FD has not been focussed on growing footprint. However, FD will likely start to build new stores, meaning that competition for real estate might become higher at the margin. Again, their different focus areas will limit this competition somewhat.

I would temper expectations for square footage growth in the future as a conservative measure to adjust for this, but I certaintly wouldn’t see a re-invigorated FD as some sort of existnetial threat to DG. Walmart did over $600bn in sales v.s. DG at less than $40bn. That is the real competitor and that is the real TAM for FD’s invigoration.

Is this a broken story? Let’s look at history…

There is no reason to think that the DG model is broken. They will continue to grow squarefootage and comps at a modest rate over the medium term. There is good reason to believe that DG is going to face lower profit margins going forward. And to underwrite an investment at today’s price, you need to believe that margins will get back to 9%+ sooner rather than later.

In 2016, the company faced a confluence of issues including general macro weakness, SNAP reductions as well as labor and price investments. It led to significant margin pressure which, really, never quite recovered.

Whilst, yes, the company has invested in a number of other initiatives to increase margins such as private-fleet, there have also been a number of detractors to margins such as higher consumables mix today v.s. 2016. In hindsight, it appeared that 2016 was a reset to a more sustainable base, as opposed to a one-off margin hit.

The current situation is similar. SNAP is permanent and economic conditions are not likely to improve immediately. The company is seeing cost pressures from labor, and at the same time it is having to cut prices to maintain market share. My fear (and suspicion) is that the recent adjustments from the company are akin to a 2016 ‘reset,’ or a departure from the over-earning years from 2020-22 which shan’t repeat.

Dollar General’s business quality comes into question in times like these. Whilst return on capital is phenomenal, the company ultimately is a high-fixed-cost retailer and sells to a customer who is brutally price-sensitive. The ability to protect margins in times like these is simply out of DG’s control. And it is hard to see how such external pressures abate in the near-term.

Conclusion

At 16x P/E, I am relatively unenthused by the stock unless they can expand margins, which just doesn’t seem likely in the current scenario. With ~MSD top-line growth, capital return + sales growth on a constant multiple should lead to a ~11% return, which just isn’t good enough to get me excited. For now, I watch.