Dollar General Fails to Show Me the Dollar

December 2, 2004 - TheStreet.com: Street Insight

• A turnaround seems unlikely, as the numbers are even worse than they appear on the surface.
• It feels like there is a disconnect between management, the stock market, analysts that were on the call and reality.

I'm getting tired of hearing about the improvements management boasts about qtr. after qtr. and not seeing results. Last quarter I truly hoped that things could not get any worse for Dollar General (DG), but they did. I was a big believer in a Dollar General turnaround, but I think I was wrong.

I think the numbers are even worse than they appear on the surface. Sales grew 11.5% -- not a spectacular number and below my long-term expectations. But it seems this is the least of DG's problems. Cost of goods sold (COGS) went up 1.2% -- a huge increase considering the razor-thin margins in retail. If you think problems could not get any worse -- well, they do. SG&A costs went up 0.54%, operating profits shrunk from 7.8% to 6.1%, inventory turnover was down and operating cash flows were almost wiped out by a huge increase in inventory.

EPS came at $0.22, a decline of 4.3% over last year -- and this is after the company bought back nearly 9 million shares of its stock, lifting EPS by 2.6%. EPS was also helped by a lower tax rate and lower interest expenses.

It feels like there is a disconnect between DG management, the stock market, analysts that were on the call, and reality. Management was talking about the great improvements it is making as if the company did not have one of the worst quarters ever. Analysts are completely ignoring the issue of rising inventory and the collapse of profit margins. The stock market is fixated on the decline in oil and completely ignoring DG -- the stock did not budge at all, even though company missed earnings estimates by close to 15%.

Although management has being talking about improvements that it has made over last 10 months, all I wanted to do was yell: "Show me the money!" They bragged that they have improved apparel merchandise and that sales of jerseys were very good, but then they said that overall apparel sales were disappointing. I am getting tired of hearing about the great improvements that management is boasting about quarter after quarter and not seeing the results.

What am I missing? Dollar General's problems are likely to be similar to Wal-Mart's (WMT). High energy costs are having a very negative impact on low-income consumers, which makes perfect sense. Low-income consumers are not enjoying the fruits of the housing market appreciation. Higher gasoline and heating oil prices are having a significantly larger impact on low-income consumers since they are taking a larger bite out of discretionary income. Also, higher health care costs are impacting low-income consumers disproportionately more than everybody else. I believe the aforementioned factors are responsible for weaker-than-expected sales growth.

The inventory increase is also a big concern. Management indicated that inventory will likely decline next year, but something is wrong about substantially rising inventory levels for a company that just spent millions of dollars on inventory management and automatic replenishment systems. From my past experience, a decrease in inventory turnover is a precursor to larger problems down the road. No Longer Sold on Dollar General December 2, 2004 - TheStreet.com: Street Insight

• I was a big believer in the company, but management has lost all credibility in my eyes.
• As of this morning, I am out of Dollar General.

I mentioned on the second quarter Dollar General (DG) conference call that I will be putting DG on probation.

I was a big believer in Dollar General and I stated my position several times on Street Insight. However, management lost all credibility in my eyes after the last two conference calls. Though valuation is not very high, in my mind it doesn't price in all current developments.

DG stock's indifference to yesterday's developments is puzzling to me, but I'll let future shareholders sort it out. As of this morning, I am out of Dollar General. Vitaliy N. Katsenelson, CFA Copyright TheStreet.com