Dollar General Corp missed Wall Street profit expectations after taking markdowns to clear slow-selling apparel out of its stores, sending shares down about 5 percent.

Gross margins in the company's fiscal first quarter were lower than expected due to the need to cut prices on clothes, said ThinkEquity analyst Mark Mandel.

They've been working on trying to improve that space for quite some time and have not found the right formula, he said. Clearing out the wrong product is a step in the right direction. The question is will they be able to find the right thing to put in its place.

Dollar General prices most of its merchandise below $10 and is updating its stores to entice shoppers with better layouts, more food and a wider variety of apparel.

The company said on Wednesday it earned $157 million, or 45 cents per share, in the fiscal first quarter, compared with a profit of $136 million, or 39 cents per share, a year earlier.

Excluding litigation settlements and the repurchase of senior notes, the company earned 48 cents per share, missing Wall Street's expectations of 50 cents per share.

The company stood by its outlook for the year, saying that 2011 earnings, including an extra week, would be in the range of $2.20 to $2.30 per share.

Analysts, who generally excluded the 53rd week, expect it to earn $2.26 per share.

Sales rose 10.9 percent to $3.45 billion. Sales at stores open at least a year, or same-store sales, rose 5.4 percent.

The company had both more traffic and higher purchases per store visit, wrote RBC Capital Markets analyst Scot Ciccarelli in a research note.

The company and rivals like Family Dollar Stores Inc Inc and 99 Cents Only Stores have benefited from the weak economy as lower-income shoppers come to its stores looking for low-priced food and other basic goods.

Some of the largest stock-picking hedge funds have jumped into the sector as a string of reports suggested low-priced retailers were ripe for takeover deals.

Products such as food and cleaning products were the fastest-growing segment for the company, with sales up 13 percent, while apparel sales rose only 3 percent.

Dollar General is majority-owned by private equity firm Kohlberg Kravis Roberts & Co LP , which brought the company back to the public market in November 2009.

The Goodlettsville, Tennessee-based company has stores in 35 U.S. states. It plans to enter Connecticut, Nevada and New Hampshire this year and break into California in 2012.

Dollar General's shares were down 5.3 percent at $33.22 during premarket trading.

(Additional reporting by Jessica Wohl in chicago; Editing by Derek Caney, Maureen Bavdek, Dave Zimmerman)

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