Dollar stores face hard times

April 11, 2014, 1:00 PM UTC
A Family Dollar store in Mansfield, Texas

FORTUNE — It’s a rough retail environment out there, even for the least expensive of goods.

On Tuesday, Family Dollar (FDO) announced that its profits had declined 35% in the second quarter as comparable store sales fell 3.8%. Its profit of $90.9 million, or 80 cents a share, missed analyst estimates of 90 cents. In connection with the disappointing earnings, the company announced the closing of 370 of its underperforming stores and an effort to lower its prices.

The most recent earnings for rivals Dollar General (DG) and Dollar Tree (DLTR) were healthier than Family Dollar’s, but they also missed Wall Street’s estimates.

Growth in the discount-store sector “really started to slow in the last six to nine months,” says Nick Mitchell, a senior vice president at Northcoast Research.

That’s an about-face from the huge success the sector saw during the recession and in its wake. As the downturn squeezed the pocketbooks of the middle class, sales growth in the variety store sector — which includes dollar stores — surged. Sales grew 6.4% in 2008, then 7.9%, and 9.6% in the following two years, respectively, according to Euromonitor. Growth has been stuck at 7.6% for the past two years, and Euromonitor projects that sector sales will increase by 3% in 2013, and by 3.7% this year.

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There are a multitude of factors causing sales to slow. Some of it is due to the fact that penny-pinched customers who downgraded to discount stores during the recession are now reverting back to their preferred retailers. “The middle- to upper-class consumer, making $75,000 to $80,000 a year traded down in 2009, 2010, [and] 2011 because maybe one family member lost their job. Those households are trading back up; they’re giving more money to grocery stores and a little to the Targets and Costcos of the world,” says Mitchell.

Luckily for dollar stores, the recovery hasn’t hit all shoppers equally. Those making $40,000 or less still feel the need to shop at discount stores, Mitchell says. That would be good news for dollar stores it it weren’t for the $8.6 billion cut to food stamps that Congress passed as part of the farm bill in February and the long-term unemployment benefits that the House of Representatives has failed to extend. Those benefit reductions are hitting the dollar stores especially hard, since an estimated 40% of their customers receive some sort of government assistance.

During a Thursday morning earnings call, an analyst asked Family Dollar CEO Howard Levine how the food stamp cuts impacted Family Dollar’s sales. “We certainly think there is some impact from the reduction,” he said in response. “[It’s] difficult to quantify, but [I] would certainly tell you that it’s not positive for our customers.”

Increased competition is also dragging down dollar store sales. Grocery and drug stores lost market share to the dollar stores during the recession, and they’ve fought to gain it back. In particular, Walgreens (WAG) and CVS (CVS) have made aggressive plays to reduce prices and increase deals on their front-end items — products that aren’t behind the pharmacy counter and appear at the front of the store. “They lowered their prices on key, trip-generating items,” says Mitchell. “No one shops the drugstore channel because they think they’re getting a low price. [Walgreens and CVS] are trying to change that image.”

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And then there’s the simple fact that it’s hard to keep increasing sales every year. “If you’re up 6% one year and 6% again the next, it’s hard to do 6% again,” says Joseph Feldman, a senior managing director at Telsey Advisory Group. That’s especially the case when shoppers are only buying the basics. At Dollar General, for instance, sales of consumables jumped 8.5% in its most recent quarter, and home products sales increased 6.6%. Sales of apparel, meanwhile, fell 0.6%.

“When you look at the employment landscape,” Feldman says, “that [dollar store] customer remains under the most pressure.”