Should You Follow Carl Icahn Into Family Dollar?

Billionaire investor Carl Icahn has recently announced a big position in discount retailer Family Dollar (NYSE: FDO  ) . Icahn believes the stock is materially undervalued at current levels, and initiatives such as a potential merger with Dollar General (NYSE: DG  ) are some of the possibilities to unlock value and generate gains for shareholders. Should you follow Icahn into Family Dollar?

Shopping for bargains
Carl Icahn is well-known for his extraordinary success over the years, which has led him to become one the most famous activist investors in the world. Icahn usually takes big positions in companies he believes to be undervalued, and he then pushes management to make strategic changes to improve the business and maximize returns for shareholders.

Icahn announced on Friday the ownership of approximately 10.7 million shares in Family Dollar, representing nearly 9.4% of the company. According to reports from Fox News, Icahn may try to take control of the company, and he could also explore the possibility of a merger with bigger competitor Dollar General.

Both Family Dollar and Dollar General have been facing considerable headwinds lately, so Icahn seems to believe that investors are overreacting to disappointing financial performance in the short term, while missing the long-term opportunities for gains.

Industry headwinds
Family Dollar reported a 6.1% decline in sales during the quarter ended on March 31, to $2.7 billion, versus $2.9 billion in the same period during 2013. Management estimates that the extra week in 2013 accounted for approximately $189 million in sales, so revenues would have increased by 0.4% if it weren't for calendar differences. Comparable-store sales fell 3.8% versus the prior year.

Gross profit margin declined from 33.4% of sales to 33.2% of revenues during the period, and net income fell from $140.1 million to $90.9 million. Excluding the impact of the extra week in 2013, Family Dollar estimates that net income in the second quarter of fiscal 2013 would have been $132 million.

Management said in the earnings press release that Family Dollar was affected by external factors such as an intensely promotional competitive environment, a financially strained consumer, and the unusually cold winter.

But Family Dollar is also taking responsibility for its disappointing financial performance, and the company launched a series of strategic actions to strengthen its value proposition, increase operational efficiencies, and improve financial performance.

The future
Family Dollar is lowering its price on nearly 1,000 basic items to reinforce its competitive position, reducing corporate overhead to improve efficiency, and closing approximately 370 underperforming stores. The company plans to open 350 to 400 new stores in fiscal 2015, down from approximately 525 new stores in fiscal 2014.

Cutting costs and restructuring the store base is no magical solution to slowing sales growth, but it sounds like a step in the right direction when it comes to increasing profitability per store and improving return on invested capital.

Importantly, these are the kinds of initiatives an activist investor such as Carl Icahn would usually propose, so Icahn and the company's management team seem to be on the same page when it comes to the need to make strategic changes.

As for the possibility of a merger with Dollar General, it's important to note that Dollar General is materially bigger than Family Dollar, so any kind of deal with Dollar General would mean a big transformation, and a risk, for both companies, especially for Family Dollar.

Dollar General delivered lower than expected sales and earnings during the last quarter, too, but the company seems to be doing better than Family Dollar. Sales during the quarter ended on May 2 increased by 6.8% to $4.52 billion, while same-store sales grew 1.5% versus the same period in the prior year.

Industry consolidation can be a big positive for investors, as it would reduce overall supply and competition. Besides, a merger between Family Dollar and Dollar General could create a huge industry player, and scale is a big advantage in discount retail, as it allows for increased negotiating power with suppliers and cost efficiencies in several areas.

Foolish takeaway
Carl Icahn's investment in Family Dollar looks like a smart move considering that management seems to be willing to make the necessary strategic changes in order to protect the company's profitability under challenging conditions for the industry. It's far too early to tell if a merger with Dollar General has any chances of going through in the medium term, but the idea makes sense from a competitive and operational point of view. It looks like Icahn could be on his way to another successful investment with Family Dollar.

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