No. of Recommendations: 27
As long as we're throwing around reports: As reports go, I found this Oct 13 Deutsche Bank note, based on a call with a former VP, more helpful than most:
Darkest Before Dawn; DG Expert Call Key Takes
Yesterday, we hosted an expert call with a former DG Division Vice President (oversaw 2,500 stores in seven states) to dig into key topics including recent operational challenges, shrink, competition, and store growth. While we acknowledge near-term volatility, we maintain our long-term positive bias toward the name.
Our expert reinforced our overall constructive view of the long-term potential at both DG and the dollar store channel, noting that unit growth goals are reasonable and the initiatives in place are solid. While he acknowledged short-term headwinds, the most pressing being the need for additional investment to improve store standards across the chain, he sees nothing broken structurally at DG in the longterm. Our expert highlighted that adding more field leadership would have more impact in improving the business. Although we are still concerned that operating margins may remain constrained in the short- to medium-term, we see DG returning to its previous growth algorithm with improvements in labor and store operations. We reiterate our Buy rating but recognize that patience will be needed.
Key takes from our call include: 1) more investment is likely needed to improve existing stores; 2) unit growth plans remain achievable with the right level of operational support; 3) top-line growth is possible with improved in-stock levels and customer service; 4) competition is most acute from FDO, as it implements elements from the DG playbook to gain share; and 5) current DC plans may not be enough to support planned unit growth.
What Drove Current Challenges...
Our expert, who left DG in early 2023 after six years with the company, sees the current challenges stemming from changes in the scope of responsibilities for field management starting in February of 2022. District managers saw increasing breadth of coverage and job complexity (more initiatives to implement including DG Fresh, NCI, BOPIS), with store responsibility increasing from 15-17 stores up to 25- 27 stores without a corresponding increase in resources. In addition, a heightened (and strict) focus on improving store standards without providing additional resources damaged employee morale and led to higher levels of turnover. This left the company without critical institutional knowledge, specifically in key store management and field leadership roles. As a result, prioritization of important, urgent, and critical tasks fell short.
Keeping Competition Under Control
Competition has grown increasingly strong for retailers as consumers become more value-oriented and price conscious. While DG has lost share recently to peers, our expert does not see a long-term effect on the company. He sees the greatest risk coming from FDO, which has made some of the biggest changes in store conditions, such as improving the shopping experience and raising gondola heights (we note, Rick Dreiling implemented the same changes at DG a decade ago). WMT, on the other hand, has invested in price, private label assortment, Walmart+, and more. While our expert is of the view that newness from such programs may have a short-term impact on shopping patterns, he believes shopping habits of DG's core customers (those who shop on a weekly basis) will be largely unchanged, highlighting they generally shop at WMT only ~once a month. Our expert highlighted that while there may be some impact from e-commerce sites like Temu, it is not likely to be drastic. Dollar stores attract a specific customer with a fixed budget, and this customer has a largely need-based shopping list. Although dollar stores may feel near-term pain, our expert believes the initial excitement will taper and more customers will return to normal shopping patterns.
Getting the Top-Line Back on Track
DG's top-line has fallen below historical ranges in the post-pandemic period, as market share shifted toward competitors. Our expert noted 1) DG can gain share back from WMT; and 2) both DG and FDO can grow within the dollar store segment. Recent headwinds from turnover and cultural changes have impacted store standards potentially leaving sales on the table. Part of the effort in regaining share and rebuilding top-line, our expert highlighted, will come from a renewed emphasis on the customer experience and service. DG's core, rural customer prefers a "local" store feel as opposed to a "corporate" feel. Further, our expert noted the company should focus on driving the value message while increasing basket size through multi-unit pricing. We believe that as labor investments work through the system, workload will reduce, and employees will have more time to interact with customers.
How Many Labor Hours Are Needed
A lot of debate has taken place around the level of investment needed for labor hours. After initially investing $100M (by our calculation, this translates to seven additional hours per store per week), management upped its level to $150M. Our expert highlighted the current amount is enough to bring stores that perform well back to the historical DG standard. Alternatively, he is unsure if the investment is enough for underperforming stores. For example, stores that are behind on freight/ delivery and having trouble managing rolltainers, will potentially need more investment to catch up with operational standards. Further, as there is increased demand for consumables, additional labor hours will be needed to make the stocking process more efficient, in addition to the expansion of DG Fresh. In our view, additional investment will likely be needed above the $150M in order to ease workload stress, boost morale and get underperforming stores back on the right track.
Runway for Unit Growth
Our expert noted considerable white space remains to add new units and does not feel DG needs to slow its growth plans. While it is more expensive to open and maintain stores, internal investment for new stores is good and the returns are "great". Additionally, DG has a strong real estate team and is going after the right sites to make these stores successful. Thus, 1,000 stores seems reasonable, according to our expert, however, management needs to ensure they are supporting associate growth, developing the people and the culture with the same care and attention as the new units. All in, our expert sees unit growth remaining a key contributor to EBITDA, noting if DG is not opening new stores another retailer will, collecting that market share along the way. While unit growth can remain the same, our expert noted a need for additional DC support. The current DC build plan implies 1,000 stores per DC, however, considering the scope and complexity of the initiatives DG has in place, the 760 store per DC may be better to adequately support the store base. Lastly, our expert is positive on the company's move into Mexico, noting the right leadership is in place, but sees additional near-term expansion unlikely as DG focuses on its current geographies.
Looking Forward...
DG has been a consistent compounder over time. Although it's running into operational challenges, our expert noted, and we agree, that these issues are not structural. Employees are challenged with: 1) elevated workloads due to lack of labor hours, 2) less competitive wages relative to peers; and 3) compliance culture which creates a distraction from day-to-day activities. Internal changes are necessary, specifically retaining field level employees and improving morale of store managers and hourly workers. The company can continue to grow units, but also needs to focus on employee development. Our expert noted the labor market has started to loosen and as the company looks to invest in labor hours, it needs to get back to being the employer of choice in small towns. In our view, as labor challenges abate, operational stresses should improve, leading to a better shopping experience and ultimately boosting the top-line.
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