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Source: Family Dollar

It was reported earlier this month that famed activist investor Carl Ichan took a 9% interest in dollar store operator Family Dollar (NYSE:FDO). In an interview with FOX Business, Ichan mentioned that he would potentially push for a merger with peer Dollar General (NYSE:DG). Notwithstanding the probability of this happening, the key issue is if there are any potential benefits associated with such a marriage.

The strongest competitive threat to dollar store operators comes from retail giant Wal-Mart (NYSE:WMT), which is aggressively expanding with its small store format. It's worth exploring if a larger combined entity would be in a better position to compete with Wal-Mart.

Why Family Dollar needs a new partner
Family Dollar's recent performance has been nothing short of disappointing. It saw its revenues and earnings decline by 6% and 35%, respectively, in the second quarter of fiscal 2014.

Family Dollar also registered a negative comparable-store sales growth of 3.8%, in line with the decline in the number of shopper visits per year from 184 trips in early 2012 to 173 trips in at the end of 2013. Its gross margins also dropped from 35.4% in the second quarter of 2010 to 33.2% in the second quarter of 2014 as it engaged in higher markdowns.

Family Dollar isn't standing still. It planned to shut down 370 underperforming stores and engage in cost rationalization and price reduction on key basic items. The store closures suggest that management expanded too aggressively in the past, while the inability to keep costs (and therefore prices) low reflects the fact that Family Dollar isn't sufficiently large enough to benefit from economies of scale.

Family Dollar's woes also go beyond the numbers. This month, it agreed to pay up to $1.15 million to settle a proposed class action lawsuit in New Jersey federal court. More than 500 of Family Dollar's current and former store managers alleged in the lawsuit that Family Dollar didn't pay them overtime wages. Notwithstanding the authenticity of such claims, this will unavoidably affect Family Dollar's staff morale. 

With all these issues mentioned above, it doesn't hurt to have a new pair of hands in the form of Dollar General.

Why Dollar General would be interested in becoming bigger
In contrast with Family Dollar, Dollar General has been a star performer. It has expanded its top line and bottom line by three-year CAGRs of 10.3% and 17.8%, respectively. Dollar General also achieved same-store sales growth and an average ticket increase for the 25th straight quarter in the first quarter of 2014.

Also, while Family Dollar is closing stores, Dollar General plans to expand its presence to 43 states by adding stores in Maine, Rhode Island, and Oregon in 2014 and 2015.

Dollar General faces its own set of problems, though. Its gross margin fell by 57 basis points year-over-year to 30% in the first quarter of 2014 as a result of a larger proportion of consumables sales. In a sense, this is a catch-22 situation for Dollar General.

The addition of tobacco products and a wider range of perishable food items have helped to increase customer footfall and drive greater visit frequency. This comes at a price, though, as these consumables carry lower margins. If Dollar General doesn't cross-sell enough of its other high-margin products, its overall margins will suffer.

This is where a marriage with Family Dollar will be beneficial. With revenues close to 60% of Dollar General, a merger with Family Dollar would increase Dollar General's purchasing power with suppliers and improve distribution efficiency (possibly by consolidating distribution centers.) The cost savings derived will enable Dollar General to continue pricing its products competitively.

Does the combined entity have what it takes to fight the world's largest retailer, though?

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Source: Wal-Mart

Wal-Mart's small store format a potential game changer
Historically, dollar stores have successfully competed with big box retailers by grabbing a bigger chunk of regular fill-in trips by convenience-seeking consumers. This is set to change with Wal-Mart's new plans to accelerate its small-store format expansion, however.

It aims to increase the number of Wal-Mart Express stores six-fold from 20 in fiscal 2014 to 120 in fiscal 2015, while Neighborhood Market stores will grow from 346 to 500 within a year. Overall, this represents a 320% growth in Wal-Mart's "smaller stores" between fiscal 2011 and 2015, a clear signal of its intentions to expand in this space.

Recent results validate Wal-Mart's investments in small store formats, given that its Neighborhood Market stores have achieved decent comparable sales growth of 4% in fiscal 2014. More importantly, its new store format will combine the winning elements of convenience, low prices, and wide product assortment.

The average store size for Wal-Mart's Neighborhood Markets and Wal-Mart Express stores are 43,000 and 12,000 square feet, respectively. This makes them small enough to be housed in convenient locations and yet sufficiently large to provide a wider range of products than their dollar store counterparts.

Wal-Mart's revenues are also approximately 27 times as large as that of Dollar General, giving it an unassailable advantage with respect to purchasing power and cost efficiency. Dollar store operators have traditionally benefited from the illusion of lower overall product prices (with smaller packaging), but this apparent advantage will disappear with Wal-Mart offering more products in different packet sizes at its smaller stores.

Foolish final thoughts
A Family Dollar-Dollar General merger, even if happens, isn't going to matter. Wal-Mart's entry into the small store space is the real story. In my opinion, both Family Dollar and Dollar General, be it separate or combined, will find Wal-Mart too tough to handle.

Mark Lin has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.