Why Bigger Is Not Always Better

Harsh is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Dollar General (NYSE: DG) is one of the most resilient stocks that I’ve ever seen. It has a tendency to bounce back if it falls for some reason, like we have seen so far this year after the company had crashed in December last year after cutting its guidance. A similar thing happened earlier this week after Dollar General released its latest results.

The stock dropped around 9% after Dollar General reduced its earnings guidance for the current fiscal year, but popped more than 3% the next day as some investors might have looked at the drop as an opportunity. Ideally, even I would’ve recommended buying the stock as I had done last year, but Dollar General seems to be in a bad habit of trimming down its guidance.

In addition, the company’s results weren’t quite convincing, as it missed the revenue forecast and met estimates on the bottom line. A closer look at the performance in the quarter reveals worrying trends, and for this reason, I think that Dollar General might not be the best pick among dollar stores despite having the widest network.

Time for an exit?

Dollar General’s margins have been under pressure of late, which is why the company has had to reduce its guidance. A combination of various factors such as payroll tax increases, tax refund delays, and an increase in inventory markdowns lead to a decline of 89 basis points in gross margin. The company’s product mix seems to be taking a turn for the worse, as consumers are buying lower margin items while sales of non-consumables, which carry higher margins, have been under pressure.

The outlook for non-consumable sales isn’t too bright either even though Dollar General witnessed slight improvements in this category at the beginning of the current quarter. But then, the company doesn’t seem quite confident regarding this category and it will be too early to make a call on where non-consumables are going. However, Dollar General is still confident of recording sales growth of 4%-5% this year on the back of better performance in the later half.

However, even if Dollar General manages to achieve its full year target going forward, its margins might continue to remain under pressure due to the above mentioned reasons and the fact that the company is counting on sales of tobacco products to drive sales growth, but they are lower-margin products. Sales of tobacco products are expected to improve going forward, and the average basket size should go up as well, but the impact on margins will be clearer going forward.

With more than 10,600 stores, Dollar General is the biggest among the dollar stores, but quite clearly, the company is facing margin challenges as low-margin items are driving sales. In such circumstances, I believe that investors should look elsewhere in the sector and book the gains that they have enjoyed from their Dollar General investment this year.

Another one to avoid

Going by size, Family Dollar Stores (NYSE: FDO), is the second-largest dollar store chain with around 7,600 stores. But then, if you are already invested in it, I’m sure you would be cursing your stock picking skills as it is the worst performer in the segment, declining around 3% this year while its peers have recorded solid gains.

The issues with Family Dollar are a reflection of what Dollar General is going through -- delayed tax refunds, payroll tax increase, gas prices, etc. Management didn’t inspire much confidence over the previous conference call as it trimmed the earnings forecast for a second time this year. Its same-store sale growth of 2.9% in the previous quarter was well-below its own guidance of 4%-5%.

Similar to Dollar General, Family Dollar is also counting on tobacco products to improve sales, and consequently, lower margins can be expected from this company as well. Thus, if you’re avoiding Dollar General, there are some great reasons why Family Dollar should be avoided as well, even though it had dropped more than 2% after Dollar General had released its results.

Small and happy

Thus, even the second-largest player in the sector doesn’t cut it, and this brings us to Dollar Tree (NASDAQ: DLTR), the smallest of the lot with around 4,700 stores. Despite being the smallest, Dollar Tree has been the best performer of the lot, appreciating close to 23% this year. The company’s methodical growth strategy and solid execution make it the best pick among dollar stores.

The most important driver behind Dollar Tree’s success is its keen focus on offering $1 merchandise and strategic product assortment. The company has been expanding smartly, focusing on store productivity along with expanding its coverage. In addition, its e-commerce platform, Dollar Tree Direct, has been growing at a fast clip and witnessed a 23% improvement in traffic in the previous quarter.

Being the smallest of the lot, Dollar Tree has a lot of room to grow and is doing so quite strategically, and has avoided selling tobacco like its peers in order to keep its margin in good health. Thus, if there is a stock which seems worth buying among the three, it has to be Dollar Tree.

The bottom line

It’s evident that bigger is always not better. While Dollar General might have performed well so far this year, I think it would make sense for investors to hit the eject button as Dollar Tree looks the superior option. And, the less said about Family Dollar the better. Dollar Tree’s solid execution and its share repurchases should continue to be tailwinds going forward and continue to push the stock higher.

More ideas

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Harsh Chauhan has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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