Buying a struggling stock while it's cheap can feel like you're getting a good deal, but you also need to consider the reasons behind any sell-off. If there are fundamental problems with the business driving away investors, buying in puts you at risk of catching a falling knife. It can be difficult to know when or if a recovery will take place.
One stock that has been hurting badly this year is Dollar General (NYSE: DG). The discount retailer has been feeling the effects of a cash-strapped consumer, and investors are concerned its problems could get worse in future quarters, especially if economic conditions deteriorate. Is this stock in real trouble, or could Dollar General make for a great contrarian investment right now?
Why is Dollar General stock in such bad shape?
Dollar General is down more than 45% in the past six months. Its decline has been so severe the retail stock is now trading near a seven-year low. The boost it received from pandemic-fueled spending is long gone, and widespread bearishness has taken over.
The company has been missing expectations on earnings, and when it last reported quarterly results in August, management said its core customer was "financially constrained." That's cause for concern, given a discount retailer should be benefiting when consumers become more cash-conscious.
Dollar General's struggles could be indicative of other problems. Perhaps shoppers aren't finding enough value at its stores. Same-store sales rose just 0.5% for the quarter ended Aug. 2, while operating profits nosedived 21% year over year.
Dollar General's problems with profitability are unfortunately nothing new as its already thin margins have been under pressure for years.
Data by YCharts.
A core issue is Dollar General's constant pursuit of expansion. Earlier this year, the chain opened its 20,000th store, but the more locations it opens, the greater the potential for new stores to cannibalize sales from nearby locations, making it more difficult for those same-store sales numbers to stay positive. Overexpansion can do more harm than good in some cases, and to manage those extra stores, the company has to add staff and incur greater overhead, which puts pressure on the bottom line.
How cheap is Dollar General stock?
Dollar General has fallen to multiyear lows, but with its profit margins shrinking, it may make sense the stock is settling into a lower valuation. It's trading at 13 times trailing earnings as of this writing, well below its five-year average of nearly 21.
Data by YCharts.
According to analyst price targets, which factor in where analysts believe the stock will trade in the next 12 to 18 months, Dollar General could rise about 30% from where it trades today.
Despite its recent struggles, there is a case to be made that the stock is trading at too steep a discount, making it an attractive choice for value investors.
Why to avoid Dollar General stock, even with the discount
Dollar General stock does have the potential to rebound and generate strong returns for shareholders given its low price point, but investors must be bullish on management's ability to turn things around. The biggest concern is the company's continued expansion in the face of its worsening financial picture. Management should be prioritizing cost reductions and efficiencies because if the company is struggling now, it will suffer far more if economic conditions worsen.
As tempting as it may be to buy a stock that looks deeply discounted, the danger is in assuming Dollar General stock has bottomed out. There's room for it to fall even further, especially if its profits continue to shrink.
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David Jagielski has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
