Dollar General Corp (DG) Q2 2021 Earnings Call Transcript

Good morning. My name is Robert, and I will be your conference operator today. At this time, I'd like to welcome everyone to the Dollar General Second Quarter 2021 Earnings Call. Today is Thursday, August 26, 2021. This call is being recorded. Instructions for listening to the replay of the call are available in the company's earnings press release issued this morning. Now I'd like to turn the conference over to your host, Mr. Donny Lau, Vice President of Investor Relations and Corporate Strategy. Mr. Lau, you may begin your conference.

Thank you, and good morning, everyone. On the call with me today are Todd Vasos, our CEO; Jeff Owen, our COO; and John Garratt, our CFO. Our earnings release issued today can be found on our website at investor.dollargeneral.com under News and Events. Let me caution you that today's comments include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995, such as statements about our strategy, plans, initiatives, goals, priorities, opportunities, investments, guidance, expectations or beliefs about future matters and other statements that are not limited to historical fact. These statements are subject to risks and uncertainties that could cause actual results to differ materially from our expectations and projections. These factors include, but are not limited to, those identified in our earnings release issued this morning under Risk Factors in our 2020 Form 10-K filed on March 19, 2021, and in the comments that are made on this call. You should not unduly rely on forward-looking statements, which speak only as of today's date. Dollar General disclaims any obligations to update or revise any information discussed in this call unless required by law. We also will reference certain non-GAAP financial measures. Reconciliations to the most comparable GAAP measures are included in this morning's earnings release, which, as I mentioned, is posted on investor.dollargeneral.com under News and Events. At the end of our prepared remarks, we will open the call up for your questions.

Thank you, Donny, and welcome to everyone joining our call. We are pleased with our second quarter results and continue to be grateful to our associates for their dedication to fulfilling our mission of serving others. Despite what remains a challenging operating environment, including additional uncertainties brought on by the Delta variant and pressures on the global supply chain, our teams continue to successfully adapt and deliver for our customers. Because of their efforts, during the quarter, we saw an improvement in customer traffic as compared to Q1 and once again, increased our market share in highly consumable product sales as measured by syndicated data. Looking ahead, we remain focused on controlling the things we can control and believe we are well positioned to navigate the current inflationary environment and global supply chain challenges. As always, the health and safety of our employees and customers is our primary focus, while meeting the needs of the communities we serve. And with more than 17,500 stores located within 5 miles of about 75% of the U.S. population, we believe we are well positioned to continue supporting our customers through our unique combination of value and convenience. To that end, we recently hired our first Chief Medical Officer. Going forward, our plans include further expansion of our health offering, with the goal of increasing access to affordable health care products and services, particularly in rural America. Overall, we remain focused on our operating priorities and strategic initiatives, as we continue to meet the evolving needs of our customers and further position Dollar General for long-term sustainable growth. Turning now to our second quarter performance. As we continue to lap difficult quarterly sales comparisons from the prior year, net sales decreased 0.4% to $8.7 billion, followed by a 24.4% increase in Q2 of 2020. Comp sales declined 4.7% compared to the prior year period, which translates into a robust 14.1% increase on a 2-year stack basis. Our Q2 sales results include a year-over-year decline in customer traffic, which was partially offset by the growth in average basket size. From a monthly cadence perspective, comp sales were lowest in May, with July being our strongest month of performance. And I'm pleased to report that Q3 is off to a great start. Importantly, we continue to be very pleased with the retention rates of new customers acquired in 2020, underscoring the broadened appeal of our value and convenience proposition. We believe we will ultimately exit the pandemic with a larger, broader and more engaged customer base than when we entered it, resulting in an even stronger foundation from which to grow. Overall, our second quarter results reflect strong execution across many fronts as we continue to strengthen our position while further differentiating and distancing Dollar General from the rest of the discount retail landscape. We operate in one of the most attractive sectors in retail and we believe our unique store footprint, further enhanced through our multi-year initiatives, provides a distinct competitive advantage and positions us well for continued success. As a mature retailer in growth mode, we are also laying the groundwork for future initiatives, which we believe will unlock significant growth opportunities as we move forward. In short, I feel very good about the underlying strength of the business, and we're confident we are pursuing the right strategies to enable balanced and sustainable growth by creating meaningful long-term shareholder value. With that, I'll now turn the call over to John.

Thank you, Todd, and good morning, everyone. Now that Todd has taken you through a few highlights of the quarter, let me take you through some of its important financial details. Unless we specifically note otherwise, all comparisons are year-over-year, all references to EPS refer to diluted earnings per share, and all years noted refer to the corresponding fiscal year. As Todd already discussed sales, I will start with gross profit. As a reminder, gross profit in Q2 2020 was positively impacted by a significant increase in sales, including net sales growth of 41% in our combined non-consumables categories. For Q2 2021, gross profit as a percentage of sales was 31.6%, a decrease of 80 basis points, but an increase of 87 basis points compared to Q2 2019. The decrease compared to Q2 2020 was primarily attributable to: increased transportation costs, a higher LIFO provision, a greater proportion of sales coming from the consumable categories and an increase in inventory damages. These factors were partially offset by higher inventory markups and a reduction in shrink as a percentage of sales. SG&A as a percentage of sales was 21.8%, an increase of 138 basis points. This increase was driven by expenses that were greater as a percentage of sales, the most significant of which were retail labor and store occupancy costs. Moving down the income statement, operating profit for the second quarter decreased 18.5% to $849.6 million. As a percentage of sales, operating profit was 9.8%, a decrease of 219 basis points. And while the unusual and difficult prior year comparison created pressure on our operating margin rate, we're very pleased with the improvement in our profitability on a 2-year basis. Our effective tax rate for the quarter was 21.4% and compares to 21.5% in the second quarter last year. Finally, EPS for the second quarter decreased 13.8% to $2.69, which reflects a compound annual growth rate of 27.7% or 24.3% compared to Q2 2019 adjusted EPS over a 2-year period. Turning now to our balance sheet and cash flow, which remains strong and provides us the financial flexibility to continue investing for the long term while delivering significant returns to shareholders. Merchandise inventories were $5.3 billion at the end of the second quarter, an increase of 20% overall and 13.7% on a per store basis as we continue to cycle unusually low levels of inventory in Q2 2020, which were driven by extremely strong sales volumes in that quarter. Similar to Q1, we strategically pulled forward certain inventory purchases during the quarter, particularly in select non-consumable categories in anticipation of longer lead times. As a result, we were pleased with our strong inventory position for the back-to-school shopping season, and our teams continue to work closely with suppliers to ensure delivery of seasonal and other goods in the remaining back half of the year. Year-to-date through Q2, we generated significant cash flow from operations totaling $1.3 billion. Total capital expenditures for the quarter were $518 million and included our planned investments in new stores, remodels and relocations, distribution and transportation projects, and spending related to our strategic initiatives. During the quarter, we repurchased 3.3 million shares of our common stock for $700 million and paid a quarterly dividend of $0.42 per common share outstanding at a total cost of $98 million. At the end of Q2, the remaining share repurchase authorization was $979 million. Our capital allocation priorities continue to serve us well and remain unchanged. Our first priority is investing in high-return growth opportunities, including new store expansion and our strategic initiatives. We also remain committed to returning excess cash to shareholders through anticipated share repurchases and quarterly dividend payments, all while maintaining our current investment-grade credit rating and managing to a leverage ratio of about 3x adjusted debt to EBITDAR. Moving to an update on our financial outlook for fiscal 2021, we continue to operate in a time of uncertainty regarding the severity and duration of the COVID-19 pandemic, including its impact on the economic recovery, global supply chain, consumer behavior, and our business. Despite continued uncertainty, including additional pressure throughout the supply chain and cost inflation, we are updating our full year sales and EPS guidance, which reflects our strong first half performance. For 2021, we now expect the following: net sales growth of 0.5 point to 1.5 points; a same-store sales decline of 3.5% to 2.5%, which reflects growth of approximately 13% to 14% on a 2-year stack basis; and EPS in the range of $9.60 to $10.20, which reflects a compound annual growth rate in the range of 20% to 24% or approximately 19% to 23% compared to 2019 adjusted EPS over a 2-year period. Our EPS guidance assumes an effective tax rate in the range of 22% to 22.5%. Our expectations for real estate projects remain unchanged from what we stated in our earnings release on May 27, 2021. With regards to share repurchases, we now expect to repurchase approximately $2.4 billion of our common stock this year compared to our previous expectation of about $2.2 billion. Finally, we are increasing our expectations for capital spending in 2021 to a range of $1.1 billion to $1.2 billion to reflect higher equipment costs for store projects and the pull forward of select supply chain investments.

Thank you, Todd. Let me take the next few minutes to update you on our operating priorities and strategic initiatives. Our first operating priority is driving profitable sales growth. The team continues to drive strong execution against a robust portfolio of growth initiatives. Let me take you through some of our more recent highlights. Starting with our non-consumables initiative or NCI. The NCI offering was available in more than 8,800 stores at the end of Q2, and we continue to be very pleased with the strong sales and margin performance we are seeing across our NCI store base. In fact, this performance is contributing to an incremental 1% to 2.5% total comp sales increase in NCI stores and a meaningful improvement in gross margin rate as compared to stores without the NCI offering. Overall, we remain on track to expand this offering to a total of more than 11,000 stores by year-end, including over 2,100 stores in our light version, with the goal of completing the rollout of NCI across nearly the entire chain by year-end 2022. Moving to our newer store concept, pOpshelf, which further builds on our success and learnings with NCI. pOpshelf aims to engage customers by offering a fun, affordable and differentiated treasure hunt experience delivered through continually refreshed merchandise, a differentiated in-store experience, and exceptional value with the vast majority of our items priced at $5 or less. During the quarter, we opened 8 new pOpshelf locations, bringing the total number of stores to 16, including 4 conversions of a traditional Dollar General store into our pOpshelf concept. And while still early, we remain extremely pleased with our results, which continue to exceed our expectations for both sales and gross margin. We also recently opened our first 2 store-within-a-store concepts, which incorporates a smaller footprint pOpshelf shop into one of our larger Dollar General market stores, and we're encouraged by the initial results, including positive reaction from customers. For 2021, we remain on track to have a total of up to 50 pOpshelf locations by year-end as well as up to an additional 25 store-within-a-store concepts as we continue to lay the foundation for future growth. Overall, we remain very excited about the significant and incremental growth opportunities we see available for this unique and differentiated concept. Turning now to DG Fresh, which is a strategic, multi-phase shift to self-distribution of frozen and refrigerated goods. I'm very pleased to report that during the quarter, we completed the initial rollout of DG Fresh across the entire chain and are now delivering to more than 17,500 stores from 12 facilities. This important milestone is a direct reflection of the hard work and dedication of the team, and I want to thank them for their incredible execution over the past 2.5 years. Notably, the rollout was completed about 6 months ahead of our initial rollout schedule. As a reminder, the primary objective of DG Fresh is to reduce product cost on our frozen and refrigerated items, and we continue to be very pleased with the savings we are seeing. In fact, DG Fresh continues to be the largest contributor to the gross margin benefit we are realizing from higher inventory markups, and we expect additional benefits going forward as we continue to optimize our network and further leverage our scale. Another important goal of DG Fresh is to increase sales in these categories, and we are pleased with the success we are seeing on this front, driven by higher overall in-stock levels and the introduction of additional products, including both national and private brands. For example, we recently introduced about 25 new and exclusive items under the Armour brand as we continue to optimize our assortment while further differentiating our product offering from others. And while produce was not included in our initial rollout plans, we believe DG Fresh provides a potential path to accelerating our produce offering in up to 10,000 stores over time as we look to further capitalize on our extensive self-distribution capabilities. Moving to our cooler expansion program, which continues to be our most impactful merchandising initiative. During the first half, we added more than 34,000 cooler doors across our store base and remain on track to install approximately 65,000 cooler doors this year. Notably, the majority of these doors will be in high-capacity coolers, creating additional opportunities to drive higher on-shelf availability and deliver an even wider product selection, all enabled by DG Fresh. In addition to the gross margin benefits associated with NCI and DG Fresh, we continue to pursue other gross margin-enhancing opportunities, including improvements in private brand sales, global sourcing, supply chain efficiencies and shrink.

Our second priority is capturing growth opportunities. Our proven high-return, low-risk real estate model continues to be a core strength of our business. In the second quarter, we completed a total of 772 real estate projects, including 270 new stores, 477 remodels and 25 relocations. For the full year, we remain on track to open 1,050 new stores, remodel 1,750 stores, and relocate 100 stores. In addition, we now have produce in more than 1,500 stores, with plans to expand this offering to a total of more than 2,000 stores by year-end. As a reminder, we recently made key changes to our development strategy, including establishing our larger 8,500 square foot format as our base prototype for nearly all new stores going forward. We're especially pleased with the sales productivity of this larger format as average sales per square foot continue to trend well above an average traditional store. In total, we expect to have nearly 2,000 stores in this format by the end of the year as we look to further enhance our value and convenience proposition, particularly in rural America.

Next, our digital initiative, which is an important complement to our brick-and-mortar footprint as we continue to deploy and leverage technology to further enhance convenience and access for customers. Our efforts remain centered around building engagement across our digital properties, including our mobile app, which continues to grow in popularity. In fact, we ended Q2 with nearly 4 million monthly active users on the app, a 28% increase over the prior year. Importantly, as we continue to drive higher levels of digital engagement, our DG Media Network, which we launched in 2018, has become an increasingly more relevant platform for connecting our brand partners with our customers. Of note, during the first half, the number of campaigns on our platform increased 65% compared to the prior year period, and we are very excited about the growth potential of this business as we look to further enhance the value proposition for both our customers and brand partners. Overall, our strategy consists of building a digital ecosystem specifically tailored to provide our customers with an even more convenient, frictionless and personalized shopping experience. And we are pleased with the growing engagement we are seeing across our digital properties.

Our third operating priority is to leverage and reinforce our position as a low-cost operator. We have a clear and defined process to control spending, which continues to govern our disciplined approach to spending decisions. This zero-based budgeting approach, internally branded as Save to Serve, keeps the customer at the center of all we do, while reinforcing our cost control mindset. Our Fast Track initiative is a great example of this approach, where our goals include increasing labor productivity in our stores, enhancing customer convenience and further improving on-shelf availability. The first phase of Fast Track consisted of optimizing our rolltainers and case pack sizes, resulting in more efficient stocking of our stores. The second component of Fast Track is self-checkout, which provides customers with another flexible and convenient checkout solution, while also driving greater efficiencies for our store associates. Self-checkout was available in approximately 4,300 stores at the end of Q2, and we continue to be pleased with our results, including customer adoption rates and higher overall satisfaction scores in stores that include this offering. Our plans consist of a broader rollout this year, and we remain focused on introducing self-checkout into the vast majority of our stores by the end of 2022, as we look to further extend our position as an innovative leader in small box discount retail. Our underlying principles are to keep the business simple, but move quickly to capture growth opportunities, while controlling expenses and always seeking to be a low-cost operator.

Our fourth operating priority is investing in our diverse teams through development, empowerment and inclusion. As a growing retailer, we continue to create new jobs in the communities we serve. As evidence, we recently launched a national hiring event with the goal of hiring up to an additional 50,000 employees by Labor Day, and I am pleased to note that we are on track to meet our goal. We believe the opportunity to start and develop a career with a growing and purpose-driven company is a unique competitive advantage and remains our greatest currency in attracting and retaining talent. And because over 75% of our store associates at or above the lead sales associate position were internally placed, employees who joined Dollar General know they have an opportunity to grow their career with us. We also continue to innovate on the development opportunities we can offer our teams, including continued expansion of our private fleet and those associated with DG Fresh as well as pOpshelf. Importantly, we believe these efforts continue to yield positive results across our store base, as evidenced by a robust internal promotion pipeline and staffing above traditional levels. We also held our annual leadership meeting earlier this month, resulting in a rich and virtual development experience for more than 1,500 leaders of our company. This is one of my favorite events every year, and I was once again inspired by the incredible talent and dedication of our people.

In closing, I am proud of our team's performance as we continue to advance our operating priorities and strategic initiatives. Overall, we are very pleased with our position as we head into the back half of the year, and I'm excited about the significant growth opportunities ahead. I want to offer my sincere thanks to each of our more than 159,000 employees across the company for their unwavering commitment to fulfilling our mission of serving others. With that, operator, we would now like to open the lines for questions.

Our first question comes from Rupesh Parikh with Oppenheimer.

So Todd, I wanted to revisit one of your comments from the script. You mentioned that Q3 has had a good start, or a great start, as you said. Can you provide any additional insight into what you are observing?

Yes. Rupesh, we are happy with the way Q3 started out. Back-to-school is doing very well for us. We got all of our products that we anticipated getting from overseas as well as domestically. And the consumer has a little extra money in their pocket. So as evidenced by our guidance in the back half, we feel pretty good about our sales line as we go forward.

Okay. Great. And then maybe just one follow-up just on the gross margin line for John. Any more color you can provide in terms of the puts and takes to think about on the gross margin line in the back half of the year? And then if you look at the distribution of freight pressures, would you expect them to persist into next year?

Yes. So in terms of gross margin, and I'll start by saying we're very pleased with the performance, up 62 basis points year-to-date. While down 80 basis points in Q2, we’re up 87 basis points over Q2 2019 as we continue to see initiatives like DG Fresh, NCI and others really contributing. But like with our Q2 results, we do expect some continued pressure on gross margin in the second half due primarily to inflation, which we believe to be transitory, but related to higher transportation costs, higher than previously expected. Of course, we're seeing elevated demand with great sales, and that's resulting in some transportation and supply capacity challenges with our third-party carriers. And then on top of that, we did mention a higher LIFO provision as a result of product cost increases. Some others have seen similar inflation and pass some of that along. And then, of course, we have a very challenging lap as we talked about with the year-over-year mix. In Q2, we lapped 40% non-consumable sales. And so while non-consumable business is still doing fabulously, it's a very difficult lap in the back half. And certainly, you have a very favorable last year mix profile with that mix. And then you also had unusually low clearance activity associated with non-consumables on that high sell-through. So while we expect to continue to do well, it provides a challenging lap. So near-term inflationary pressures, which, again, we believe to be transitory. But as you look ahead, we believe still, that with the growing benefit from initiatives, with all the levers at our disposal between private brands, foreign sourcing, shrink, supply chain efficiencies as we get through the near-term pressures and of course, category management and of course, our scale, we believe we're in a great position to continue to expand margins over the long term and believe we're in a great spot right now in terms of price too and don't see the need to invest there. So near-term pressure for sure, but the fundamentals of the business, I would say, are stronger than ever, and we feel very good about the future. In terms of how long this persists, we said that we expect this to be elevated through the end of the year, at least through Chinese New Year. It's hard to say how long beyond that. This is really a supply and a demand issue. We would expect this to start to normalize, but it's hard to say, hopefully, as we push through next year, but hard to say exactly when that will happen.

Our next question comes from Matthew Boss with JPMorgan.

So Todd, maybe could you speak to new customer acquisition that you're seeing today coming out of this crisis? Maybe if we compared it to customer acquisition or customers that shop Dollar General for the first time coming out of the financial crisis. And with that, if you think about the behavior that you're seeing near term, how would you map out traffic versus basket moving forward, just again, given the current customer behavior that you're seeing today?

Yes, Matt, that's a great question. We are very pleased with what we're seeing from our consumers, especially the new ones. We launched our retention program last summer and intensified our efforts throughout the latter half of last year, maintaining that momentum. I’m happy to report that by the second quarter, we are achieving double our expected retention rate for new consumers, which is significantly higher than what we experienced in 2008 during the financial crisis. I believe this success is largely due to the relevance of our current offerings. While we made notable improvements after the '08-'09 period, our product lineup is now much more applicable to a wider range of consumers, which is helping us retain these customers. Additionally, as John mentioned, we're seeing positive results in our non-consumable, or discretionary, segments, which have improved compared to 2008. Both our consumable and non-consumable businesses are performing exceedingly well. Looking at our unit sales, they have increased by 11.5% on a two-year basis, which is very strong. This is a clear indication of our ability to engage both our new and existing consumers effectively. Our long-term aim remains to boost our traffic numbers. However, our core consumer tends to behave differently when they have some extra money. Historically, when our consumers have disposable income, they shop less frequently but spend more during each visit. We've observed this trend in our data. Our two-year stacked traffic figures are showing a 25% increase, which is robust. As we anticipate a return to normalcy and a possible reduction in government stimulus, we expect that consumers may visit more often but spend less per trip, reverting to typical shopping behaviors.

That's great color. Maybe just as a follow-up, Todd, or maybe even Jeff, I guess by category, where do you see the most low-hanging fruit remaining on the market share front as we think about where you're focusing your initiative efforts coming out of the pandemic from here?

Thank you, Matt. This is Jeff. I'm really proud of the team's ability to really, as you know, they do such a great job of knowing what the customer wants, talking to our customers, but also our category management skills, and our supply chain and our operators give us a lot of flexibility to be able to serve that customer the way she wants to be served. And so very pleased with our DG Fresh rollout and the ability that gives us to continue to broaden that assortment in that very important category for that customer. So very pleased at the gains that we're seeing there. Of course, also very pleased that our ability to continue to grow our health and beauty business. And I'm very pleased at the share we've seen there as well. And quite frankly, as you think about it, very pleased overall at our ability to grow share in the quarter. And when you look at it on a 2-year basis as well, very pleased and strong results. So I would say, as we look forward, our goal is always to make this box the most relevant it can be and to serve the customer the way she wants to be served, and quite frankly, our teams do that better than anybody.

Our next question comes from Simeon Gutman with Morgan Stanley.

I wanted to ask about the algorithm for 2022. I understand it's early and we're not discussing guidance, but could you share some insights on the factors that might impact the top line? Comparisons should start to ease next year, but we will also be facing the effects of all the stimulus. Additionally, some margin pressures could persist into next year. I'm curious about how these factors relate to the long-term algorithm for this business.

I feel very positive about our fundamentals and the performance of our algorithm. While I cannot provide specific guidance for 2022 at this time, given the ongoing nature of the pandemic and inflationary pressures, we believe these challenges are temporary. Our team is effectively addressing these issues, which we anticipate will create a favorable environment as conditions normalize and as we achieve more typical product mix levels. This year, we are faced with the challenge of high non-consumable sales from last year and low clearance activity. However, we previously saw ourselves at the high end of our growth expectations, and we are pleased with the retention of new customers, surpassing our expectations, as well as maintaining larger purchase sizes. The relevance of our brand has never been stronger, which we believe will support our sales momentum as our initiatives align to benefit both our bottom line and top line. Our efforts to retain new customers and increased basket sizes through our enhanced shopping experience are crucial. Regarding gross margin, we anticipate ongoing benefits from our strategic initiatives and have many resources available to us, which we believe will provide further opportunities as we navigate through these temporary challenges. We expect to maintain our gross margin expansion and capitalize on our ability to manage operating expenses effectively, while also generating significant cash flow to enable share buybacks. Overall, we are optimistic about our business outlook and confident that our growth strategy remains on track. Additionally, our real estate strategy, aiming for 17,000 potential units, looks promising. We are seeing strong economics at the unit level and are continuing to innovate with new formats that will allow for ongoing growth. We feel very optimistic about the algorithm and will address our 2022 specifics as the year progresses.

Okay. And then the follow-up is regarding the second half, the SNAP and child care tax credits, how much, if any, is factored into your second half top line guide?

Yes. What I would say is we've considered all of that. And I would say there's a lot of moving pieces here that seemingly are directionally offsetting. You do have the roll-off of the enhanced unemployment benefits, which is a bit of a headwind, but then you have the child tax credit, which is a bit of a tailwind. And then when you look at SNAP, there's puts and takes there that are directionally offsetting. The 15% benefit expires on October 1. But then with the USDA's action with the Thrifty Food Plan, that puts back some enhanced benefits. And then they did extend the emergency supplemental benefits, which allows waivers that allows folks to get maximum benefits regardless of income. So as you look at all the pieces, it's hard to say exactly what the net impact would be, but right now, it looks directionally offsetting, and that's contemplated in the guidance. And we feel very good about the guidance based on what we know now.

Our next question comes from Karen Short with Barclays.

I want to discuss the guidance and the implied expectations for the second half. You've raised the full-year top line guidance, but there doesn't seem to be a corresponding increase for the second half. However, when we examine the guidance for the EBIT margin in the second half, it appears to have decreased despite the higher sales. I understand you mentioned a couple of factors, but I still struggle to see how they fully explain the change in the implied EBIT margin guidance for the second half. A bit more clarity on that would be appreciated. Additionally, I have another big-picture question.

Sure, that's a great question, Karen. I want to say that we are pleased with the updated guidance stemming from our strong performance in the first half. As you noted, we have increased our sales outlook and raised the lower end of our EPS expectations while keeping the upper end unchanged. It's also important to consider the two-year comparison, showcasing a compound annual growth rate of 20% to 24%, which reflects impressive performance relative to our projections. However, we are experiencing some pressure from freight costs, which is a limiting factor in our ability to increase further. Like others in the industry, we’ve noted elevated transportation costs, and our LIFO provision indicates that higher product costs are primarily due to these increased transportation expenses. Despite these challenges, we remain confident in our business fundamentals, which are stronger than ever, and we will monitor how situations develop moving forward. We see these pressures as temporary, and we are very satisfied with the expected performance according to the guidance, which suggests significant improvements for both revenue and profits compared to our standard expectations.

Okay. That's helpful. And then I guess there's kind of this view that in general, that the lower-end consumer will really struggle next year as all these benefits lap. And I think there's some perspective that, that will negatively impact you disproportionately. I'm not sure I agree with that. But how do you think about the puts and takes to DG, if that is true in general, in terms of your core customer feeling much more challenged?

Yes. Karen, this is Todd. I'll take that one. And I would tell you, we feel very good about this core customer. And also remember, the customer that we've retained during this pandemic and continue to retain, we feel very good about keeping her well engaged into next year as well. You couple that with all the initiatives that we have in front of us, both in play and as you heard from Jeff, some newer ones like health care that will, in fact, start to play out as we go into next year, but even longer term than that. But when you start to think about who we are, right, and who we serve, we're an all-weather brand and always have been. And it's even more pronounced now, I believe, than ever before, right? So when times are good, we do pretty well. And when times aren't so good, that consumer needs us more. And now we've got that new trading customer that we've gotten, that seemingly will have a little bit more money even when times turn a little negative for our core customers. So once again, we feel good about it. We're not prepared to give guidance yet for '22. But we are here always control what we can control. And we feel good about that algorithm over time growing the comps at 2% to 4% over the long term. And that is still our vision, and we work toward that each and every day.

Our next question comes from Michael Lasser with UBS.

Todd, do you feel like you've worked off some of the excess that a lot of the consumable retailers experienced during the heart of the pandemic? And another way to look at it is your guidance for the back half of the year implies a 2-year compound annual sales growth rate of 9% to 10%, which is largely consistent with what you were doing in 2019 prior to the pandemic. So as other consumable retailers are experiencing a drag from a further return to normalcy and less new occasions at home, perhaps you'll face less of a drag because your workers have been working at a work site the whole time. You've got new customers, and you've got your initiatives such that you've entered into a sustainable sales rhythm from here?

We consider all these factors, and I want to emphasize that we feel optimistic about where the consumer stands and how she is positioned for the future. However, our primary focus is on managing what we can influence. The comp rate you mentioned, whether we achieve the 4% to 5% target or not, aligns well with our projections. We are confident about this, but I don’t want to overstate expectations for even better performance. Nonetheless, the initiatives we’ve implemented and the retention rates we’re seeing from new customers give us the assurance to increase our sales guidance for the latter half of this year and will drive us into 2022.

Okay. My follow-up question is on the gross margin. The 87 basis point increase over 2019, is it fair for us to assume half of that was due to your initiatives like DG Fresh and NCI, and the other half is from still a favorable environment where promotions have not returned to the level of 2019? And can you quantify this for simplicity's sake, John, how much gross margin pressure you are expecting because of these elevated freight costs?

Yes. When we exclude the impact of freight costs, the underlying drivers remain the same, and we continue to experience significant benefits from initiatives like DG Fresh and NCI. We've been highlighting three main contributors for several quarters: lower product costs related to DG Fresh, reduced markdowns, and a favorable product mix, largely driven by NCI. We are still seeing these benefits grow, which remain the primary factors enhancing our gross margin. However, we are facing a tougher comparison due to the 40% non-consumable growth that we are now lapping this quarter, along with increased pressures from freight and, to a lesser extent, product costs. The fundamental drivers are consistent, but we did not provide a specific figure for freight costs. Nevertheless, we identified it as the top headwind. Looking into the latter half of the year, similar to Q2, we anticipate that this will continue to be a growing challenge compared to our earlier expectations, although we believe it is a temporary issue in the long term.

Our next question comes from John Heinbockel with Guggenheim Partners.

Todd, I have two questions, but I want to start with your thoughts on health care, considering you've mentioned that drug stores are your biggest share donors. Specifically, when you think about services and products, do you see an opportunity to partner with independent pharmacists? How do you assess the sources and potential size of that opportunity? Do you believe it could be significant enough to be comparable to a NCI type of opportunity?

Yes, John, that's a great question, and I appreciate you bringing it up because we're quite excited about the potential of this health care initiative. However, I want to remind everyone that this will be a long journey. Our focus will be on providing services that rural America, especially, currently lacks access to. We often discuss grocery deserts, and there are equally concerning health care deserts across the country, and we're present in those communities. With my background in health, I see a significant opportunity for these services. This includes eye care, telemedicine, and prescription delivery—not just pharmacies within our stores but also build-to-order services and possibly in-store pickup and mail orders. A partnership could be beneficial, and we will explore this in the coming quarters. This could potentially be a larger opportunity than NCI, and while I don't want to be overly optimistic, it has the potential to greatly impact Dollar General's financial performance and make our stores even more valuable to consumers in rural America who currently have to travel long distances for basic health services. We genuinely believe there's a significant opportunity here, and you can probably sense my enthusiasm about it, although it's just the beginning of our journey.

And maybe just as a follow-up to that, right? When you think about doing the store-within-a-store right in the DG Markets. And I know I ask this all the time, but the box is getting bigger. Does the small version of DG Market eventually come on the radar screen again as another format, where you'd rather use the 8,500 to accomplish that?

No, John, we already have a smaller version of the DG Market, and we're continuing to expand that. This originated from the Walmart Express stores we acquired a few years back. We have developed those 44 stores we purchased and have grown that format as well. We don't discuss it often because we believe it could become a significant part of our rural strategy over time, especially regarding the combination you mentioned. We already have stores within a 5-mile radius of 75% of the population, and if we could offer even more options, including healthcare and pOpshelf in a smaller space, I think it could be very effective. I know Jeff shares this belief, and we will be working towards that in the coming years.

Our next question comes from Kelly Bania with BMO Capital.

Just in terms of freight, just to be clear, how much of that is domestic versus ocean freight? And how much are you passing along or not passing along in the current environment?

Yes. I would tell you that the majority of the headwind is coming from the import side of that equation. We have seen some tightness in the domestic market, but pretty manageable overall there. It really is the import side that we feel is the headwind here. And then as far as passing along, what we do here at Dollar General, probably better than most is negotiate with our vendors, with our size and scale. We've been doing that for many years. It's second nature to us, if you will. But I would tell you that we've been able to offset some of these inflationary pressures that you've seen out there. But yet, we have taken price in some instances. But what I'm happy to say is that our price positioning is as good as it's ever been. As you may remember over the last few quarters, I've been very bullish on our positioning, and it's just as good as ever. So I would tell you, we've been very thoughtful on passing along price because we know that our core consumer can ill afford very many price increases. But we have the ability with just 10,000 to 12,000 SKUs to also pick and choose the SKUs that we offer our consumer. And if we have some price increases that we don't believe we should pass on to her, we'll drop the SKU and move on to something else that, in fact, she'll need also. And we've done that a lot in the last quarter to 2 quarters.

Great. That's very helpful. And just also wanted to follow up on a comment you made. You talked about some of the puts and takes in terms of the macro in the back half, including the end of the extended unemployment benefits. I was just curious what you are seeing in some of those states, both from impact on the top line when those states ended the benefits and also just in the wage and employee environment.

Yes. What we have seen is when you look at the employee environment, I'll start with that. What we initially saw as those states rolled off the enhanced unemployment benefits. What we did see was an initial nice pickup in applicant flow and staffing. The good news now is we're seeing that across the system. And so it's hard to discern that impact now because everything is up. And so that's been helpful. We did see a little bit, not a huge impact, but we did see a little bit of a negative impact in states when the enhanced unemployment benefits rolled off. But then as I mentioned, then you have the benefit of the child tax credit. And that's why we said as we look at all the puts and takes, the way we see it now, we think it's directionally offsetting.

Our last question comes from Michael Montani with Evercore ISI.

Just had two things to ask on. One was just a little bit surprised on some of the discretionary headwind, given the strength that we've seen from some other retailers in that area. So I was just hoping you could help explain a little bit more why that would be a headwind? And then what's the timing for that to kind of roll off? And then the follow-up was on traffic.

Yes. I would tell you, Michael, I think the discretionary headwind that we talk about really stems from the robust number we had last year. Last year, other retailers were either shut down still, limited hours, one-way aisles. I think you remember all of that. We were pretty much in full swing last year, helping out all the communities that we serve. So it was really on a 2-year stack basis, we couldn't be more happier or proud of our discretionary business. As a matter of fact, feel very robust about it going into the back half of the year and in years to come because of our NCI initiatives, because of our pOpshelf initiatives and many other things that we're working on. So yes, I wouldn't characterize it any other way other than on a year-over-year basis is really the headwind. I would tell you that starts to subside as we move into '22, right? And so watch out for that as we move into '22. But right now, we feel good about where we are on a discretionary platform basis.

Okay. Great. And then just wanted to clarify on the 2-year traffic stack for 2Q and 1Q. Was 2Q a high single-digit decline on traffic, if you do a 2-year stack? Just trying to see how that's been trending.

Yes. I would tell you, we really haven't said what those numbers were, but as I mentioned earlier, we just have to remember, on the traffic side, you've got 2 things that are in play here. Number one, you still have a consumer that is contracting her shopping patterns due to COVID, right? You still have some of that dynamic going on, not as much as we saw last year, obviously, and we're starting to see those traffic numbers come back, and I'll explain that in a second. What we're starting to see now is as stimulus starts to wane, COVID in many states starting to wane, I know it's flaring in certain states and a little less than others. The consumer is getting out more, and we're seeing our traffic numbers start to rebound. And what normally happens with our core consumer as that dynamic takes place, especially around her income levels, what we'll start to see is smaller basket sizes and more traffic. And that's exactly what we're starting to see occur over the last couple of months, and we anticipate that to continue as we move through the back half of the year. Well, thank you very much for all the questions and thanks for your interest in Dollar General. I want to start by saying how proud I am of this team, which continues to execute at a high level, resulting in another great quarter. As you heard today, we have a number of exciting initiatives in place, and we believe we are well positioned to grow same-store sales, new stores, operating profit margins, and market share over time, while providing a strong employee proposition. So overall, I'm proud of the year-to-date results, feel very good about the underlying business and very optimistic about the future. Thank you for listening. And I hope you have a great day. Thank you.

This concludes today's conference. You may disconnect your lines at this time, and we thank you for your participation.