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Before reading on, if you’re not already familiar with Dollar General and its business model, please refer to the prior writeups for a comprehensive description of the company and its competitive landscape. To minimize repetition, we will aim to solely focus on the latest developments and their impact on the long-term value of the business.

As many of you are aware, DG has recently faced challenges characterized by weak sales and diminishing margins. We assess these disruptions as temporary, with the fundamental business model and competitive strengths remaining robust. In particular, we believe that on a normalized basis (adjusted for these temporary setbacks), the company should be able to earn materially higher margins in its business and same store sales should remain positive once the company laps the current reduction government support for low-income consumers and the company returns to historical operating standards. Consequently, the depressed share price presents a compelling entry point for a high-quality low-cost compounder.

ANALYSIS OF CURRENT CHALLENGES

MACRO CAUSES

The current macro environment is highly unusual as DG's primary consumer base is under significant strain due to reductions in SNAP benefits and decreased tax refunds, while the broader population remains economically healthy. Additionally, the labor market continues to be tight. In essence, negative trends that typically occur at distinct economic phases are now coinciding, creating a particularly adverse environment for DG. Details below:

SNAP reduction

In 2016, the company reported that 6% of its sales came from SNAP benefits – if we assume this continues to be the case (which is conservative as SNAP greatly increased during COVID and should have grown as a % of sales), the reduction of ~20% in SNAP in 2023 should result in a ~150bps in lost sales.

Labor shortage

Labor costs have been elevated since 2017 (with the exception of 2020/2021), coinciding with a tight labor market. SG&A over this period has averaged north of 22%, compared to the 21%s from 2011 to 2016 where unemployment has been substantially higher.

Rural population disproportionately impacted

Rural customers, who make up about 70% of DG's store base, are disproportionately affected compared to urban customers. An interview with management in September 2023 highlighted stronger performance in urban stores, while a Family Dollar commentary from Q2 2023 noted that higher-income customers trading down appeared more frequently in urban settings. “It appears that the trade down from a higher income customer it’s coming more in the urban environment than in the rural environment”.

Consumer confidence remains high

Despite these challenges, overall consumer confidence remains high, which paradoxically hurts DG as they are less able to attract trade-down consumers.

OUTCOMES OF THE MACRO ENVIRONMENT

These macro challenges have led to operational issues across various areas of the business.

Low store standards

“I would tell you that the amount of out of stocks we have in our store are probably some of the largest that I've seen in the 15-plus years I've been here.” – earnings call Q3 2023

Low store standards have been a result of both labor issues (which is caused by both macro and management missteps) as well as supply chain issues (management missteps primarily). This issue is a major focus for the company and is being remediated currently. Supply chain issues have been largely resolved with the opening of new DCs and significant labor investments have been made ($50M in 2022 and $150M in 2023). This should be a problem that can be resolved reasonably quickly. According to the CEO, 90% of the out-of-stocks are domestic SKUs with only 2-4 weeks in lead times.

High shrink

High shrink levels are well reported across all retailers. This is clearly a broad macro issue, however, it may be exacerbated by DG’s labor staffing shortage and to some extent the onboarding of self-checkouts.

DG reported that it is facing 100bps of margin impact from shrink in 2023 and this is expected to continue till H2 2024. DG has described that shrink is elevated across store levels (i.e. high and low performing stores are experiencing elevated shrink) which strengthens the fact that the elevated levels are driven by macro environment more than execution issues (i.e. even well-operated stores are experiencing high shrink). DG has said that its shrink is more linked to steal for need rather than resale as you would expect from low-price items.

Inflation and its impact on capex and D&A

Capex and D&A as a % of sales has been elevated – the main driver of this is the inflation on the cost to build and remodel stores. For example, steel prices have been elevated since mid-2021: “In terms of CapEx, that is up a bit this year… Really includes the impact of pretty significant inflation, particularly when you think of steel.” – Q1 2023.

This is macro-driven, which under normal circumstances DG should be able to pass through to the consumers but given the confluence of factors currently the company is unable to pass these increases in cost to the consumer.

Unfavorable mix towards consumables

This is a result of the pressure on the consumer and the lack of excess cash to spend on discretionary goods. Currently 19% of goods sold are non-consumables, compared to 24% since 2010, and 22% in 2018 and 2019.

Inventory write-downs

Tied to the factor above, sales of discretionary goods have slowed materially as a result of the weakness in the consumer along with company mismanagement of the company’s supply chain. Company has written down $95M of inventory in H2 2023.

MANAGEMENT ISSUES AND OUTCOMES

Apart from macro headwinds, the company has also made mistakes across several strategic and operational facets of the business. Below are the key management mistakes and issues that have impacted recent results.

Execution issues from supply chain in 2022

In 2022, the company transitioned to handling the delivery and management of fresh goods in-house, a process previously managed by external suppliers. This shift was poorly executed, leading to significant supply chain disruptions, excessive waste, and low inventory levels. The scarcity of distribution centers exacerbated these issues, forcing the company to rely on external temporary facilities. While this approach has begun to stabilize in H2 2023 and is expected to improve as more company-owned distribution centers become operational, the transition has led to $95M in write-downs as described earlier, although not all are attributed to mismanagement. The resolution of these issues is underway but will require several quarters to fully reflect in store conditions.

OSHA violations and reactions

There has been an elevated level of OSHA oversight. We believe that there was some fault from the company (as it failed to increase labor training and volume) but it’s clear that the regulatory scrutiny had increased. DG initially onboarded a zero-exception policy – any store manager found in violation was let go. This created an unnecessarily high volume of turnover at the store management level. The no exception policy has since been removed as the negative impact of high turnover has offset the benefit of the reduction in violations.

Labor investments

The labor market tightened substantially coming out of COVID as the competition for low-wage workers increased. In retrospect, the company responded too slowly and failed to adequately invest in labor for new initiatives. As discussed earlier, the company has since invested in labor (total of $200M in 2022 and 2023) and management believes this amount will be sufficient going forward.

Under the previous leadership, the company predominantly allocated labor investments to "smart teams"—flexible groups designed to temporarily support various stores based on immediate needs. However, the current management has shifted this strategy, directing labor resources directly to individual stores. This approach has been endorsed by experts as more effective, arguing that while smart teams provide temporary relief, they do not offer long-term solutions. Consequently, once these teams are withdrawn, underperforming stores often revert to their previous levels of performance. Implementing permanent staff improvements at individual stores is viewed as a more sustainable solution to store operations.

In recent periods, staffing both at the store level as well as the management level has improved, with both more hours allocated to stores and a reduced number of stores managed by regional and district per head. Our channel checks suggest that DG remains competitive in talent acquisition. In addition, as a refresher on the value of the business model, many of its stores are situated in rural areas where it often stands as one of the only local employment provider for hourly workers. This unique market position allows Dollar General to realize cost efficiencies unavailable in more saturated employment markets.

Executive turnover

The issues highlighted previously have led to considerable turnover among senior management, particularly within the supply chain and retail management teams. Failures in supply chain management resulted in the termination of several senior executives, while challenges such as stringent OSHA regulations, a demanding work environment due to understaffing, and a fiercely competitive labor market have impacted middle management.

Additionally, recent leadership changes have seen Jeff Owen, who was promoted from COO to CEO in 2022, dismissed from his role. Todd Vasos, the previous CEO who had retired, has since returned to lead the company.

Jeff Owen's tenure was marked by significant communication issues with the market, consistently painting an overly optimistic picture, which ultimately eroded stakeholder confidence. His responses to emerging problems were often delayed, addressing them only when they became critical, and sometimes not until they had escalated further. It’s unclear if Jeff was the cause of the issues because surely a significant number of issues were embedded prior to his promotion (Jeff only succeeded as CEO in Nov 2022, and stayed for one year. Todd was special advisor until April 2023, and then had a two-year consulting agreement with the company and continued to sit on the board throughout the entire period). Nevertheless, we view the return of Todd as likely positive as his previous track record has been consistent, and the profitable DG business model has already been established. Throughout his tenure he has demonstrated the ability to continue the business successfully on its trajectory.

In reviewing the recent challenges faced by the company, it is clear that management missteps have played a role. Nevertheless, in the absence of the severe macroeconomic pressures currently being experienced, the company likely would have delivered satisfactory results, and the existing issues likely would not have been perceived as critically by the market.

The company has a long-standing record of effective execution, and there is little evidence to suggest that there have been fundamental shifts in its operational framework—the core value proposition and competitive moat of the business remain intact. While issues such as supply chain management and the integration of the new retail team are material, they are addressable and we expect them to be resolved over time, although some patience will likely be needed for conditions to fully normalize.

Below we will briefly go over facets of the moat of the business and explain why they continue to remain relevant today.

KEY FUNDAMENTAL FACTORS THAT ARE DEFENSIBLE THAT REMAIN TRUE

No disruption from competition

Across the board, retailers are citing generally rational pricing, though 2024 is expected to be somewhat more promotional. DG’s pricing remains attractive relative to peers with no substantial change in gap to competitors over time.

Regarding the significant investments by Family Dollar - there is only a 25-30% store overlap with DG’s stores within a one-mile radius. Consequently, this overlap should have a limited impact and is unlikely to have significantly contributed to DG’s recent performance. Moreover, Family Dollar has experienced a decline in comp sales after its initial investments, which further underscores that broader macroeconomic factors are predominantly influencing the recent weak performance.

Additionally, there are no material disruptions from emerging technologies that are fundamentally challenging DG’s business model, which involves small stores in rural areas with few alternatives. Our assessment of technologies like drone delivery suggests that these methods are currently not cost-effective. Significant regulatory changes would be necessary before such innovations could meaningfully impact DG’s operations. It is likely that any substantial impact from these technologies will be far in the future.

Store economics / new store math still sound (though down from historical levels)

New store economics continue to be strong, though down from historical levels due to elevated costs in recent periods, which again, are tied to the fact that DG’s consumers are particularly weak and unable to fully absorb the increase in costs.

“As a reminder, we monitor the following 5 metrics of our new store portfolio, including performance against pro forma sales expectations, new store productivity compared to the mature store base; cannibalization, which overall has remained consistent and predictable; cash payback, which we continue to expect in 2 years or less; and new store returns, which we expect to be approximately 18% on average in 2024. I want to note that our expectations for new store returns, while still very strong, are down modestly from our historical target of 20%-plus. This change is being driven partially by higher new store openings and occupancy cost.” - Q3 2023.

Store remodels continue to drive strong returns. “We also continue to see strong performance from our remodel stores, which drive comp sales lifts between 8% and 11% for our DGTP format and average returns, which continue to be greater than what we see from our new stores.” - Q3 2023.

There remains significant room for continued expansion

Company continues to believe that the whitespace is ~12K stores and 80% of new stores will be built in rural communities. DG’s track record in assessing and evaluating real estate opportunities within the US has been exceptional.

Broad-based recession will continue likely to be positive

Low-cost retailers typically demonstrate a significant amount of resilience in downturns. In addition to becoming the store of choice as consumers across the board tighten spending, elevated unemployment levels will benefit staffing and reduce the competition for labor.

No issues with cost advantages

DG remains a top 5 retailer for most of its leading CPGs and top 3 for a good number of them. Therefore, it continues to benefit from substantial benefits from procurement.

ADJUSTED/NORMALIZED RESULTS

Below we lay out the adjustments for macro factors that are ongoing that are impacting the results in Q4 2023. We estimate margins normalized for shrink and mix this quarter to be 7.9%, compared to 5.9% actual. In reality, there should be further expansion from the sales lost due to the ~25-30% decline in SNAP in the quarter. If we added back those sales and added back COGS pro rata (but kept SG&A constant), we’d get to 8.3% OPM. In addition, the company should have had ~$40M of estimated negative impact this quarter from markdowns. We are leaving that out in normalized margins since management commented that promotional activities are higher in 2024 so the two may net out. Keep in mind that these figures do not include the impact from company-led operational improvements, which would improve SSS and margins. The adjustments made here solely reflect the impact of macro factors. Therefore, it's possible that normalized margins could improve once the company regains its operational stride, although the investment's success does not depend on this improvement.

Adjusted margins

Lastly, to pay tribute to our late vice oracle Charlie Munger, we say to ourselves “invert, always invert” – so why can’t margins stay at these levels forever?

There need to be structural changes in order for margins to remain at these levels, as opposed to historical levels. These structural changes simply do not exist. For example, bears will point to structural increase in competition (e.g. Temu’s US entrance) but this simply isn’t the case. There has not been a material increase in competition in rural towns for small baskets of largely consumable products. And as we’ve discussed previously, changes in technology have not had a substantial impact on the business. The far more likely reason for the depressed margins is macro headwinds along with self-inflicted execution issues.

The other source of potential downside in the investment is the possibility that DG is simply going to be less effectively operated going forward – we believe that this is a possible though small risk. The same CEO that has been running the company for nearly a decade has returned to the business. The issues at hand are challenges that are not atypical in retail and have been faced by DG in various forms in the past. The company’s new growth initiatives are all largely incremental. And while retail is a hyper competitive business where moats are difficult to sustain and grow, DG is uniquely positioned thanks to its store format, location, and scale.

Overall, we view the current headwinds as temporary and the current share price as an attractive entry point for a business that is otherwise very well positioned, with a long runway for growth.

Catalyst

Execution and macro