Dollar General: 6% NM? No Longer Necessary
Dollar General: 6% NM? No Longer Necessary
At depressed valuations, 6% Net Margin is unnecessary. But what does it have to be?
2024 seems to be the year of Big Retail mishaps, with the likes of Dollar General, Starbucks and Nike all seemingly facing the same problems. To rather unfairly stereotype the issue, one could describe all of them as “Suffering from McKinsey”.
What do I mean by this? McKinsey and the wider management consulting industry is notorious for recommending strategies to CEOs which may seem good on paper, but turn out to be disastrously detached from “on-the-ground” reality. While it may not be entirely fair to blame McKinsey for this, all three of the aforementioned Big Retail companies appear to share the same problem of “chasing numbers at the expense of reality”:
This excellent article explains how Nike’s former CEO had a tech background — and in the search for margins, pivoted Nike’s strategic direction entirely towards Digital during the pandemic years, even at the expense of longtime B&M partners. Once the post-pandemic retail environment made it clear that B&M was here to stay, those partners had already moved on to competitors. Nike just announced his replacement a few days ago.
Starbucks’ former CEO appears to have faced a similar issue as well. He had intended to pivot the company towards a more Digital trajectory amidst the pandemic boom — which while intended to drive more in-app traffic and takeouts with higher margins, had the unintended effect of eating into Starbucks’ ‘3rd Home’ in-store experience. While Starbucks’ problems are more endemic than this, this strategic misstep ultimately hurt domestic performance and Schulz’s handpicked ex-CEO has since resigned.
A few weeks ago, Dollar General’s share price suffered a steep -30% drop owing to poor forward guidance. As we shall see later, a lot of it was due to a similar “chasing numbers from ivory towers” phenomenon in search of promised margins.
The silver lining here is that both Nike’s and Starbucks’ CEOs have since been replaced, and investors appear to be liking it if both of their share prices are any indication. Nike’s share price has popped +5% on last week’s news, while Starbucks’ share price has surged by +25% on similar developments.
Would it thus be wise to write off Dollar General’s business trajectory as completely irredeemable? To understand this, let’s do a deep-dive into their present-day issues — and why a changing of guard could provide an easy fix to all of their present-day malaise, similar to Nike and Starbucks.
Check out my earlier research articles about Dollar General:
Problem: Bean counters in ivory towers
Easy fix: Hire more people
A few days ago, TSOH’s Alex Morris published an excellent expert interview hosted by Tegus with a couple former DG store managers. In light of Dollar General’s recent -30% stock price crash, I felt compelled to give it a listen and found the entire interview enthralling.
To describe it briefly, Dollar General’s (DG) recent woes can be boiled down to being a “classic MBA-ify/McKinsey problem”. That is to say, management has been overly focused on achieving numerical growth targets while eschewing business/operational realities. This is a very common issue that has plagued businesses for eons — and fortunately, there’s a clear roadmap towards fixing it.
In DG’s specific case, management is often held accountable to achieving 6% Net Margins as an ideal operational target. The reason behind this is simple: DG has a very simple Retail business model — and with 20,345 stores nationwide (as of 24Q2), there is little going concern risk in the way of excess competition, including from the likes of Walmart or Family Dollar. I’ve covered this previously in my earlier DG articles, so head over there if you’d like to find out more.
With DG’s revenue growth being pretty much capped simply by virtue of their larger-than-life nationwide scale, what really moves their needle is improving margins. Unfortunately, this reaching for incremental margins has resulted in an all-too-common easy fix: cutting costs independent of wisdom in the haphazard pursuit of earnings growth.
In DG’s specific case, the problem is cutting labor hours at the expense of operational sustainability. TSOH’s interview above is particularly enlightening on this matter, with the former store managers being interviewed shedding light on how DG’s top management has been cutting labor hours to the bone in service of reducing unit costs.
Unfortunately, top management’s insularity from the field while dishing out orders from their ivory tower has blinded them to the highly undesirable knock-on effects of doing so:
For instance, the store managers mention how DG stores actually receive enough inventory — but they’re not being properly stocked on shelves as a result of lack of manpower. This lack of proper shelf stocking drives customers away to competitors, and once they’ve formed an opinion about your lack of inventory, they’re usually gone for good.
Another example provided was the execution of self-checkout. Self-checkout works at places like Walmart because there are adjacent human cashiers having enough eyes on the self-checkout counter to prevent theft — on top of loss prevention staff located at the exit serving as a deterrent. In DG’s case however, they often have only 1 or 2 people manning the register and do not have sufficient manpower to deter shrink. Adding more labor hours would immediately solve this problem.
A third related example provided was on the matter of middle managers — i.e. store managers (oversees 1 store) and District Managers (oversees 20-25 stores). While DG’s rank-and-file employees are relatively replaceable, middle managers are not. It usually takes time to get them up to speed on their responsibilities, and having high turnover in this space is a huge suck on resources, both in terms of time and costs. This is again something that can be fixed simply by hiring more qualified talent, since by far the biggest reason for the high turnover of middle managers is being overburdened by the significantly overallocation of stores.
The sense that one gets while listening to the entire interview is that 90% of DG’s problems can be solved simply by adding more labor hours. At one point in the interview, Alex even asks point blank how many incremental labor hours a typical DG store would need to be in a better place. The store manager provides a bit of context before concluding that the solution to DG’s current woes lies in People: 1) regaining Consumer trust & loyalty and 2) becoming the Employer of choice.
On regaining Consumer trust & loyalty, the lack of labor hours has somewhat tarnished DG’s brand image in the eyes of its usual customers — due to reasons ranging from haphazard store upkeep to lack of inventory. Adding sufficient labor hours will provide an immediate fix to this, simply by making stores nicer to walk in again. And given the commoditized nature of DG’s retail business, there should be no problem attracting customers back into their stores as long as the price is right.
The slightly bigger issue is the 2nd one, becoming the Employer of choice. As a result of this race to the bottom in search of margins over the past few years, DG has garnered a reputation amongst potential workers for significantly overworking its employees — and in general being a bad place to find work. Management needs to recognize the “political” component of attracting part-time workers and becoming a place that people want to work at again. Once again, the simple fix here is to add more labor hours so as not to overburden store employees and store managers.
Moats: UnTouched
The good news here is that all these are relatively easy fixes, since adding more labor hours isn’t exactly rocket science. While the business will likely continue sucking air for awhile as DG transitions to a more sustainable work culture, it actually takes nothing away from all of their structural business moats. With 22,000 stores nationwide, DG remains the largest dollar store chain in the nation with the closest proximity towards rural communities.
As one of the store managers interviewed puts it, the customer’s choice on whether to shop at Walmart vs. Dollar General largely hinges on whether the shopping trip is worth spending gas on a 30-minute drive into town to visit a Walmart. Such trips are worth the effort for bigger monthly grocery trips, as obviously Walmart carries a much larger assortment of inventory. But for those weekly in-between “fill-in” grocery stops, where one parent is only looking to pick up toilet paper or some canned peas, DG’s neighborhood store remains the superior choice simply due to their closer proximity.
Another area that was mentioned as low-hanging fruit was DG Fresh, their recently botched attempt at improving fresh food selection via the introduction of bigger coolers. The store manager interviewed mentioned how the failure of Fresh was actually an issue with execution rather than the legitimacy of Fresh — which as you guessed, once again boiled down to a problem of insufficient labor hours. There were teething issues with restocking which contributed towards shrink, and fresh inventory was not properly stocked on shelves which resulted in spoilage. Once again, these are fixable problems over the long-term simply by hiring to a sustainable level — and Fresh remains a legitimate concept which can help DG push on growth.
Furthermore, the store manager goes on to say that DG actually still has the branding advantage over Family Dollar in these rural communities. Perhaps because the community has grown up with Dollar General as the neighborhood grocery store, there is still a strong brand presence in the hearts and minds of these rural communities. The sense I got from listening to the way he was describing things was that as long as DG could get their s*** together, those old customers would come flooding back, if for no other reasons than good prices and nostalgia.
There are other areas of improvement that were discussed in the interview, such as pivoting away from higher-margin clothing in favor of consolidating the sales focus around what customers actually want — in contrast to what looks good as numbers. If you’ve ever wanted to understand Dollar General’s business, I’d invite you to listen to the full thing yourself.
Suffering from MBA-fitis
In conclusion, not only does Dollar General’s woes not appear insurmountable, they don’t even seem to be particularly problematic over the long-term. This is a classic case of MBA-fitis, where management has gotten their heads stuck so far up their ivory tower that they’ve missed the forest for the trees. This is a tale as old as time in Corporate America, and DG will neither be the first nor the last large business to befall to this sin.
However, it also implies that their problems are quite simple to fix. All they really need to do is to stop doing the wrong thing, and things should resolve themselves quite quickly. As the interview implied, the comprehensive fix really does seem to be as simple as making the necessary investments in labor hours, and also rehabilitating the DG culture and brand in the minds of both customers and employees. While this might be a bigger issue for smaller businesses, it’s something the largest dollar store chain in the country can take their time to fix.
To address the elephant in the room, yes Walmart has recently taken share from DG. Yes, they’ve made investment in areas in which they are “uniquely positioned” to capture, in areas where DG cannot hope to compete (e.g. self-checkout, online pickup). However, that takes nothing away from DG’s main business moat — their close proximity to the target demographic (rural communities). I don’t see how having online pickup is going to convince someone living in rural Arizona to drive an extra 30 minutes just to buy some toilet paper. None of the structural reasons why people choose DG over Walmart have changed.
Also, it’s worth pointing out two other pertinent matters — 1) this is a self-inflicted rut rather than one imposed on them by external circumstances; and 2) the present-day is a terrible macro environment for DG’s target demographic of lower income consumers.
On the former, we’ve already demonstrated how this is something fixable over time. I think it’s worth restraining ourselves from extrapolating current margin performance into perpetuity, and really taking a hard look at what truly moves their needle.
On the latter, it’s worth pointing out that cycles always recycle eventually, and with enough time things will start looking up again for them and their customers again. Economists will tell you that a recession is far from the only possible outcome for 2025, with the recent interest rate cut lending credence to a possible smooth landing. Central banks have a tendency to overextend their hand by playing God with monetary policy — and while such flagrant abuse simply amounts to kicking the can down the road, it also implies that a recession in 2025 is far from the only possible outcome.
If this comes to pass, it would be excellent news for DG’s customers — and by extension, Dollar General as well. If you’d like to learn more about this, check out my recent article below:
All in all, there appears to be a clear path towards the fix, which is also something that DG can simply coast towards. It doesn’t even seem particularly challenging to achieve, especially for the largest dollar store chain with 20,000 stores nationwide.
In the remainder of this article, I’ll be performing a scenario analysis which examines the earnings impact of reinstalling sufficient manpower into DG’s labor base. Given how the majority of DG’s current woes appear to be fixable simply by adding more labor hours, I’ll be examining earnings scenarios in which DG adds incremental employees to their labor pool. We’ll also look at non-worst-case scenarios, where some of the growth opportunities discussed earlier are successfully executed.
Finally, I’ll wrap up this report by taking a stab at their valuation — where we’ll discover how the previously implied 6% Net Margin holy grail is no longer necessary to justify their fair value. Of course, we’ll also be working out what the new Net Margin baseline should be.
Without further ado, let’s start with a review of Dollar General’s recent Q2 results — and understand why the recent -30% crash in their share price was an overreaction.
DG Q2 Results and the -30% Share Price Overreaction
In late August, Dollar General’s share price crashed by -30% on two things: slight misses in Q2 analyst expectations, and a weakening consumer outlook for the remainder of the financial year:
The valuation of its biggest competitor, Dollar Tree, has also fallen by a similar -30% since then. Hence, this is an industry-wide issue (i.e. macro), not a Dollar General specific problem.
Q2 EPS miss of $1.70 vs. $1.79 expected, Q2 revenue miss of $10.21B vs. $10.36B.
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