Dollar stores are struggling. Blame Walmart

(CNN) — After years of prolific growth, US dollar stores have hit a downturn.

Dollar Tree shares plunged 20% Wednesday after the company cut its outlook for the rest of the year, citing “immense pressures” on its low- and middle-income customer base. Dollar Tree also owns the long-struggling Family Dollar chain.

The stock slump came on the heels of Dollar General slashing its full-year forecast, sending shares to their worst day on record last week.

Dollar General and Dollar Tree have been the fastest-growing retailers by new store openings in recent years, capitalizing on factors such as entrenched poverty in many areas of the country, a shrinking middle class and rival retailers’ store closures. Investors drove the companies’ stock up, assuming that dollar stores were protected from broader economic challenges because customers flock there to save money when times are tough.

But that theory is buckling.

While dollar stores once expanded to reach a growing number of financially strapped Americans, they underestimated just how financially strapped many Americans would become.

The companies have hit trouble as low-income customers struggle to afford basic necessities and dial back their spending, strategic mistakes haunt their business and competition from Walmart and other chains increases.

“The dollar store sector seems to be facing existential uncertainties,” UBS analyst Michael Lasser said in a note to clients last week.

Low-income customers struggling

Dollar General — which has more than 20,000 stores predominantly in rural towns — said last week that higher prices, a softer job market and higher borrowing costs have pressured low-income customers.

More than 60% of Dollar General’s sales come from households earning less than $35,000 annually.

“Inflation has continued to negatively impact these households, with more than 60% claiming they have had to sacrifice on purchasing basic necessities due to the higher cost of those items,” Dollar General CEO Todd Vasos said on an analyst call. Customers also are paying more for expenses such as rent, utilities and health care, he said.

Customers have been pulling back on essential items at Dollar General and struggling to stretch their budgets to the end of the month, Vasos said.

Dollar Tree, which has more than 8,000 stores primarily in suburban markets and caters to middle-income consumers, said that its customers were under strain as well.

“We started to see inflation, interest rates and other macro pressures have a more pronounced impact on the buying behavior” of customers, Dollar Tree chief operating officer Mike Creedon said Wednesday. Dollar Tree’s discretionary merchandise sales, such as party supplies and home decorations, have slumped.

Other companies have also recently pointed to low-income customers’ weakness, including McDonald’s.

Strategic mistakes

Economic challenges aren’t the only reasons the two chains are in turmoil. Both companies have made strategic missteps.

Historically, most of Dollar General’s sales have come from its “consumables” division: low-margin food, cleaning and household supplies and personal care products. In recent years, Dollar General has focused on growing the discretionary side of its business. The company has added assortments of pillows, candles, home decorations, gift bags and wrapping paper.

But this merchandise has sat on store shelves, forcing the company to mark down products to try to clear them away.

“They’re trying to dig out from a failed non-consumable strategy where they have lots of inventory,” David D’Arezzo, a former top executive at Dollar General and other retailers, told CNN. “They missed the fact in tough times the consumer would be looking for consumables.”

Meanwhile, Dollar Tree has been weighed down by its purchase of Family Dollar.

Dollar Tree bought its rival in 2015 for $8.5 billion, believing acquiring Family Dollar would help it compete against larger companies. But it misjudged the deal.

Earlier this year, Dollar Tree announced that Family Dollar will close more than 900 stores, and it subsequently said it will explore a sale or spinoff of Family Dollar. On Wednesday, executives said that process was ongoing.

“Dollar Tree has ensnared itself in a web of problems with Family Dollar and untangling itself from the mess will not be a simple process,” Neil Saunders, a retail analyst at GlobalData, said in a note to clients Wedensday.

The Walmart effect

Competition is also biting into dollar stores’ business.

Walmart, Target and other chains have lowered prices on some items in an effort to draw inflation-fatigued shoppers, taking a toll on trips to dollar stores.

Dollar General CEO Vasos acknowledged last week that Walmart has been “doing a pretty nice job” in appealing to shoppers from other chains who are looking for low prices.

In previous times of financial stress, Dollar General has seen middle-income and slightly more affluent households trade down into Dollar General to save money. That has not happened recently, however, as more affluent customers are increasing their spending at Walmart.

Walmart has grown recently with people making more than $100,000 a year and gained market share.

“I don’t believe that anybody in the world shares more customers than Dollar General and Walmart because of their close proximity to each other and the density of their locations in the southeast,” David D’Arezzo said. “When Walmart is doing well, Dollar General struggles.”