Does a Dollar Store Merger Make Sense?

Dollar General Corp. (NYSE: DG  ) and Family Dollar Stores  (NYSE: FDO  ) shares soared last Friday in after-hours after Carl Icahn disclosed a 9.4% stake in the latter on Twitter. The billionaire investor is now the largest single shareholder of Family Dollar and plans to push for a merger of dollar stores -- without excluding the possibility of including Dollar Tree  (NASDAQ: DLTR  ) -- according to Fox Business News. Yet is this a good idea for shareholders?

Why merge?
With activist investors Carl Icahn, Nelson Peltz, and John Paulson now owning nearly a quarter of Family Dollar, talks of a merger with Dollar General are undoubtedly about to get serious. Family Dollar has been at the epicenter of these talks before, but for whatever reason, such discussions have always fallen apart.

However, the business landscape has changed for discount retailers. Specifically, it's no longer a growth market. Rather, it's one well-positioned for increased efficiencies, with room for margin growth, and a Dollar Store plus Family Dollar could achieve this feat with ease.

Company

Gross Profit Margin

Operating Margin

Dollar General

30.5%

9.72%

Family Dollar

34.5%

5.83%

Dollar Tree

35%

12.3%

Just look at the above chart, and in particular just how efficient Dollar Tree is as a company. Unlike its peers, Dollar Tree sells everything in its stores for only $1, which means it finds and acquires goods, processes, ships, sells, and keeps the lights on by using this business model.

All the while, it has managed to produce higher margins than either of its peers, which sell goods at various prices, and this is a true testament to just how efficient Dollar Tree's model has been. In fact, Dollar Tree might be the most efficient retailer in the world, as no company churns out more profits with a better value model.

As a result, there may be little upside margin potential in a Dollar Tree merger, although management at other companies could definitely learn from its approach. However, Dollar Tree's efficiencies might signal the opportunity for significant improvements through a Dollar General and Family Dollar merger, as both companies operate with far too many unprofitable and inefficient stores that could be consolidated to maximize shareholder value.

For example, Family Dollar's operating margin is lower than that of Dollar General, but its gross margin implies the potential for higher profits. Also, it's worth noting that Family Dollar pays a dividend yield of 2% while Dollar General does not, which will also help squeeze margins higher once it is gone.

Same business, different strategy
Aside from the obvious supply chain, workforce reduction, and inventory synergies that could be created through a Dollar General and Family Dollar merger, investors should note that between them, these two companies have nearly 20,000 stores. Moreover, many of these stores are built nearly side-by-side in small towns for the sake of competition. But if these companies combined, we'd likely see many of these stores close.

With that said, these are two companies that have been operating seemingly different strategies in recent years. For one thing, Family Dollar is planning to close 370 underperforming stores this year, which should boost margins or lead to a better capital return program for shareholders. Meanwhile, Dollar General is planning to open 700 new stores while relocating or remodeling another 500 stores.

These two separate strategies have led to greater growth for Dollar General but less risk on Family Dollar's balance sheet. For example, Family Dollar's debt-to-assets ratio sits at 19.8% versus 29.3% for Dollar General. Also, because of Family Dollar's thriftiness, it has less than $800 million in total debt on its balance sheet, which means that financing options are available to fund a merger.

Foolish thoughts
With all things considered, this is a merger that could create great shareholder value. While Family Dollar appears to be the obvious beneficiary, Dollar General has long-term value to gain. Clearly, the synergies are present, but the merger would also create considerable growth. With Family Dollar trading at 0.66 times sales, Dollar General can acquire revenue inexpensively, as it trades at nearly 1.0 times sales. Icahn's investment looks like a well-placed bet, and while mergers and acquisitions are speculative, this is one that makes sense from all possible angles.

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