Why Wal-Mart Should Buy Family Dollar

For the past several months, there has been a great deal of anecdotal evidence that retail king Wal-Mart Stores  (NYSE: WMT  )  is losing momentum. Extremely harsh winter weather, cuts to food stamps that hurt Wal-Mart's customer base, and an increasing public backlash against its employment practices were all theorized to be hurting the company.

After the company released full-year results, it's clear that the largest retailer in the world is indeed losing ground to its competitors... for all the reasons listed above. Wal-Mart can no longer rest on its laurels if it's going to restore sales growth. It needs to do something drastic to move the needle. Perhaps buying Family Dollar Stores  (NYSE: FDO  ) is the answer to what ails Wal-Mart.

Disturbing signs can no longer be ignored
Last year, Wal-Mart produced just 2% earnings growth along with flat U.S. comparable-store sales, which measure sales at locations open at least one year. And Wal-Mart expects little, if any, earnings growth in the current quarter as well.

Reflecting on its challenges, Wal-Mart announced just a 2.7% dividend increase. This represents its lowest dividend growth in years. Between 2008 and 2013, Wal-Mart increased its dividend by 15% compounded annually. The company's tepid performance and startlingly low dividend increase are clear signs that all is not well.

Family Dollar needs a knight in shining armor
It seems that dollar stores have all the momentum they need to succeed. Personal finances are still challenged for millions of Americans. In addition, Family Dollar holds an advantageous position in that a significant number of its stores are in large cities, a critical region that Wal-Mart has yet to successfully penetrate.

Add it all up and you'd think Family Dollar would have no trouble producing strong results. And yet, Family Dollar's comparable-store sales fell by 2.8% in the fiscal first quarter. Much of this is simply due to the fact that many Family Dollar retail locations are in disrepair and in need of renovations. Family Dollar allocated $112.5 million to capital expenditures in the first quarter, down 43% from the first quarter of fiscal 2013.

Family Dollar's results compare very poorly to the retailer's closest competitors, including Dollar General. Dollar General's most recent quarter set a company record for sales, operating profit, and net income. Its comparable-store sales jumped 4.4%, and earnings per share rose 19%. Dollar General is simply stealing market share from Family Dollar and didn't offer nearly as many margin-eroding promotions as Family Dollar did to keep sales afloat.

Not surprisingly, Family Dollar doesn't see much improvement in the near future. Second-quarter comparable-store sales are expected to decline again, and management warned that earnings per share could drop as much as 30% year over year.

Wal-Mart's decision: Go it alone
Wal-Mart buying Family Dollar makes a lot of sense, both strategically and financially. Wal-Mart needs to expand its small-store count and simultaneously increase its footprint in large cities and urban areas. Wal-Mart's long-held strategy of pursuing rural locations where it can obtain huge square footage for its superstores has run its course.

Plus, Family Dollar isn't exorbitantly expensive. Its most recent sales reports have disappointed the market, and as a result its stock sells at a discount to close peer Dollar Tree Stores. Family Dollar shares trade for 17 times trailing earnings, which is about on par with the market multiple. And Family Dollar trades for a price-to-sales ratio of just 0.7; for Dollar Tree, those figures clock in at 19 times earnings and approximately 1.4 times sales, respectively.

However, Wal-Mart will apparently pursue a self-help strategy. Its plan to boost small-store square footage within urban locations will be to branch out its own Neighborhood Markets and Walmart Express stores. Wal-Mart initially tested these locations in three markets, including Chicago. Apparently, these have done well enough for Wal-Mart to add as many as 300 small stores this year. That's double the original forecast it provided in October.

Bottom line: Wal-Mart's strategy may backfire
Buying Family Dollar could easily and quickly solve Wal-Mart's desire to expand its presence in big cities. Rather than trying to build on its existing small-store infrastructure, Wal-Mart has an inexpensive fix in the dollar retailer: Family Dollar's enterprise value of about $8 billion amounts to pocket change for Wal-Mart.

And the current issues affecting Family Dollar could conceivably be solved once Wal-Mart's management and distribution capabilities take over. Family Dollar is suffering a leadership crisis; its president and chief operating officer left the company immediately after releasing the latest financials.

However, that's not the strategy Wal-Mart will pursue. Instead, it's going it alone in the pursuit of small-store growth within big cities. Time will tell if its strategy pays off.

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