Carl Icahn Admits to High Hurdles in Family Dollar Merger

On paper, the acquisition of Family Dollar (NYSE: FDO  ) by Dollar General (NYSE: DG  ) makes a lot of sense, but even billionaire investor Carl Icahn, who took a nearly 10% stake in the former company to agitate for its sale to the latter, is admitting that the recently announced retirement of Dollar General's CEO changes the calculus of the deal. Still, while it throws a hurdle in the merger's path, it's not one that Icahn views as insurmountable.

In June, the activist investor announced that he had taken a 9.4% stake in Family Dollar and fired off a letter to its CEO demanding the company put itself up for sale. He said management and the board were not up to the task of running the dollar-store chain -- that on virtually every metric it underperformed its peers and the S&P 500 over the past one- and three-year time periods.

"But perhaps more importantly, we believe that for a number of reasons we discussed last night it is imperative that Family Dollar be put up for sale immediately."
-- Letter from Carl Icahn to Family Dollar CEO Howard Levine. Emphasis in original.

Naturally, Family Dollar went into defensive mode, quickly adopting a poison-pill defense and saying that while willing to engage in constructive dialogue with any of its shareholders, it was already "undertaking an in-depth business review to identify opportunities to strengthen our value proposition, increase operational efficiencies, and improve financial performance."

FDO Chart

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It's already closed dozens of stores, with plans to close approximately 370 more in the second half of 2014, while slowing new store openings in the future. It's also moved around some of its top executives, appointing a new chief merchandising officer in January and promoting an executive to the senior VP for merchandise operations position to replace the person who quit in May.

But this past quarter, earnings were cut by a third even though sales rose 3.3% higher to $2.66 billion, actually beating Wall Street expectations of $2.61 billion, but perhaps underscoring Icahn's contention that management and the board need a major shakeup. In an interview with Reuters the other day, the activist investor said Family Dollar's CEO may be a nice guy, but "the leadership, to say the least, is questionable."

However, soon after Icahn made his move, Dollar General CEO Rick Dreiling announced that he will retire next year, an impediment to an immediate merger, but one that Icahn says wouldn't be detrimental over the long haul. 

He still believes the two dollar stores are a perfect match, one that would allow Dollar General to compete more effectively against Wal-Mart (NYSE: WMT  ) . While the dollar store itself views the discount retailer as its primary rival, the wide gulf between their sizes and the fact that consumers view them as fill-ins between their local supermarket and big-box mass retailers belies their nexus. 

Rather than being able to take on Wal-Mart on a more equal footing, the creation of Family Dollar General would better allow the deep discounter to cope with having its larger rival steal more of its customers. Even though this past quarter the General reported that revenues were 6.8% higher on comparable sales, rising 1.5%, margins continued to contract. Weather and a shift toward consumables may have played a part, but stiffer competition is eating into profits, too.

Certainly, Family Dollar could use the lift that a merger with Dollar General -- or anyone, for that matter -- would provide, and Dreiling's retirement complicates the situation. A sale could still be effected, though not likely to another dollar chain like Dollar Tree (NASDAQ: DLTR  ) or even Wal-Mart itself, which many have speculated might be in the market for an acquisition. If Dollar General is off the table for the moment, then a private-equity buyer might still be found, as hedge funds remain under pressure to generate returns in a low-interest-rate environment.

It seems likely, though, regardless of which way a buyout occurs, that we'll see Carl Icahn aggressively push for new management at Family Dollar. He's asked for three seats on the board and threatened to go directly to shareholders to get the change he seeks, and if the one path is closed to him, he'll fight harder on the other. 

Shares of the dollar-store chain have lost most of the gains made following Icahn's original announcement, but investors should probably expect that they won't be discounted for long.

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