Dollar General suffers.
Net income for the 13 weeks ended August 4 plunged 39.8% to $45.5 million, or 15 cents per diluted share, meeting the consensus estimate of analysts polled by Thomson Financial. Net sales rose 9% to $2.25 billion.
The top-line growth came from a net year-over-year increase of 466 stores as well as a 3.2% rise in same-store sales. Management attributed the same-store improvement to recent additions to several merchandise departments, coupled with increased promotions, including advertising circulars. Sales increases were generated mainly by highly consumable items and seasonal merchandise.
Shifting attention to operating results, though, gross margin contracted by 146 basis points to 27.17%. Management blamed a variety of factors for the contraction, including the continuing shift in the sales mix away from home products and basic clothing, which generally carry higher average markups. In addition, the increased promotional activity carried increased markdowns, while average markups on inventory balances at the beginning of the quarter were lower than those at the beginning of the fiscal 2005 quarter.
At the same time both the shrinkage rate and transportation expense rose, while markups decreased because of increased volume in highly consumable goods, including national brand products, which generally feature lower average markups.
Aggravating the margin deterioration was an 82-basis-point jump in selling, general and administrative (SG&A) expense to 23.59% of sales. Executives point to higher advertising, utilities and store occupancy costs as a percentage of sales, as well as increased administrative salaries, costs associated with reorganizations of the merchandising and real estate departments, and the expensing of stock options. These trends were partially countered by a decrease in the accrual for incentive bonuses. The year-over-year increase in the SG&A ratio also reflects a $2.6 million reduction of employee benefits expense in the prior-year quarter, which was due to an actuarial adjustment for health claims.
Under the combined pressure of weakening gross margin and ballooning expenses, operating profit plunged 33.4% to $80.6 million, or 3.58% of sales, representing a drop in operating margin of 228 basis points.
The decline in operating results was compounded by a 42.9% leap in net interest expense to $7.4 million, largely as a result of higher borrowings related to increased inventory balances. Finally, Dollar General's effective income tax rate for the quarter was 37.9% versus 34.8% a year ago.
Year-to-date net income tumbled 33.7% to $93.1 million on an 8.9% gain in net sales to $4.40 billion. Operating profit for the 26 weeks skidded 29% to $161.9 million, while net interest expense skyrocketed 43% to $12.2 million.
In the face of these sobering results, management offered a detailed post mortem on the performance while discussing contemplated changes in a number of areas. First, it acknowledged that inventory grew beyond planned levels during the quarter for a number of reasons, most notably to ensure adequate merchandise levels to support promotional campaigns undertaken during the period.
"Although the company believes the advertising circulars aided sales, the sell-through of the promotional inventory was below expectations," management declared in a statement. "The majority of this excess is highly consumable inventory and is expected to be sold in the normal course of business."
Management noted that major planogram changes implemented in the quarter added more national brand offerings. And while it believed that the new items broadened the appeal of the stores, the company nonetheless plans to eliminate some of the poorer-performing new products during the second half.
Finally, seasonal inventory--including automotive products, grills and accessories, and back-to-school goods--increased during the quarter, but back-to-school sales in July fell short of management's expectations.
"The company is implementing plans to reduce current inventory levels and to better align inventory growth with sales increases by the end of the year," management concluded.
In addition to implementing changes in its inventory management practices, management has decided to reexamine its established store locations in light of improvements made to its real estate processes and policies over the course of the last year. The result may be an increase in the number of store closings, relocations and remodels.
In light of the foregoing moves, it is no surprise that Dollar General declined to present earnings guidance for the third quarter and withdrew its previous forecast for the year.
"While management continues to anticipate improved same-store sales results over prior-year levels, we also expect consumer discretionary spending to continue to be negatively affected by high fuel prices and by higher interest rates as well," the company states. "In addition, the likely continued aggressive marketing and discounted pricing by competitors in the back-to-school and holiday periods increase the uncertainties regarding the company's sales and gross margin in the second half of the year."
As of August 4 Dollar General operated 8,178 stores, including 50 Dollar General Markets. During the course of the first half the retailer opened 294 new units (including six Dollar General Markets), relocated 37 outlets and shuttered 45.
Plans for fiscal 2006 call for the opening of some 800 new Dollar General outlets and up to 25 Dollar General Markets. However, as a result of changes in its real estate practices, the pace of openings has fallen behind plan.