Here's Why Family Dollar Has Come Under Pressure

So far, there hasn't been much good news coming out of the retail sector this earnings season. In fact, much of the news has been down right troubling. Discretionary spending has been under pressure as consumers remain strapped for cash, and the weather is no longer providing a default excuse for under-performing retailers. Family Dollar's (NYSE: FDO  ) most recent earnings report showed a significant drop in net income, which increased the likelihood of a merger with Dollar General (NYSE: DG  ) as suggested by major stakeholder and activist investor Carl Icahn.

Feeling the pinch
Family Dollar's third-quarter report was nothing to write home about, although the market didn't seem particularly concerned as the results led to increased speculation about a possible deal with Dollar General.

Its earnings per share of $0.71 tanked more than a third from $1.05 in the year-ago period. Excluding items, its EPS of $0.85 missed the $0.89 analyst consensus. Revenue on the other hand rose 3.3% to $2.66 billion to beat calls for $2.62 billion. Comp-store sales declined by 1.8% for the period. Looking ahead to the fourth quarter, EPS estimates are roughly in line with analyst projections, with flat comp-store sales expected .

Reversing its previous expansion plans, Family Dollar now expects to close 370 stores by the end of the fiscal year and has cut the number of stores it plans to open from 525 to between 350 and 400 new locations. According to management, the results reflect the continuing economic hardships faced by a large portion of American consumers, as well as increased competition in many of its core product categories .

Part of the company's problem is the fact that it's more expensive than some of its competitors, and it has invested some $50 million in lowering prices on around 1,000 items. By product category, consumables continued to lead the way with a 4.4% increase in net sales, with tobacco products doing particularly well. The worst performer was home products where net sales dipped 1.6 %.

Pressure is mounting
Last month, it was reported that activist investor Carl Icahn had acquired a 9.4% stake in Family Dollar and that he was pushing for a merger with rival Dollar General. In response, the company adopted a "poison pill" that would limit the impact of individual investors and halt a hostile takeover. However, industry watchers believe that the quarter's poor results will put extra pressure on Family Dollar to consider a merger with Dollar General .

According to Icahn, a tie-up with Family Dollar's larger rival would be naturally beneficial for both companies, and allow them to more effectively compete with big-box retailers such as Wal-Mart (NYSE: WMT  ) which are increasingly encroaching on their territory .

Meanwhile, Wal-Mart is having some growth troubles of its own, as it recently reported its lowest sales growth figures in five years. For the period ending April 30th, its traffic dropped by 1.4% while comp-store sales in the US fell by 0.1 for the fifth straight quarterly decline. The company guided for EPS of $1.15-$1.25 per share for the current quarter, which came in below analyst projections of around $1.28 per share. As a result of these growth issues, the company is focusing on its smaller locations as well as its online business .

The bottom line
In yet another blow for the retail sector, discounter Family Dollar came out with a miss in its most recent earnings report, with profit falling by roughly a third while comp-store sales sagged. However, investors didn't react too badly to the news, as the weak results led to increased speculation on a possible merger with larger rival Dollar General as advocated by activist investor Carl Icahn. If a merger is indeed in the cards, Family Dollar investors may be well rewarded, but until this is to some degree confirmed it remains speculation, and one should probably wait for growth to return before considering a new long position. 

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