3 Reasons Family Dollar's Stock Could Rise

Family Dollar (NYSE: FDO  ) shareholders may have been reconsidering their investment before Dollar Tree (NASDAQ: DLTR  ) announced its intention to acquire the rival discount chain. Family Dollar's stock was down nearly 15% in the 12 months prior to the merger announcement. Shares are now up 10% over the last year -- and could go higher. There are three compelling reasons investors who hang on to their Family Dollar shares could reap further gains.

Synergies in merger
In all likelihood, Family Dollar shareholders will be Dollar Tree shareholders come early 2015. If the merger goes through, Family Dollar shareholders will receive $59.60 per share in cash -- about 80% of the deal's value -- and will collectively own between 12.7% and 15.1% of the combined company. Since 20% of Family Dollar shareholders' compensation comes in the form of Dollar Tree stock, the performance of the combined company will be a meaningful part of shareholders' returns if they decide to hang on.

Source: Dollar Tree investor relations.

There is reason to believe the combined company will perform much better than each company has on its own. The merger will create the largest discount retailer in North America, with more than 13,000 stores in the U.S. and Canada and over $18 billion in sales. The two companies will have greater purchasing power for consumable merchandise and can realize savings by eliminating redundant marketing and administrative expenses.

All told, Dollar Tree anticipates that $300 million in annual savings will flow through to the bottom line after three years as a combined company. That would result in a 6% reduction in sales, general, and administrative expenses and boost operating earnings by 18%. If these savings materialize, Family Dollar shareholders will reap gains on their Dollar Tree stock.

Bidding war
Dollar Tree expects to close on the acquisition in early 2015, leaving a narrow window of opportunity for another retailer to make a competing bid. Dollar General (NYSE: DG  ) was long thought to be the most likely acquirer, but the departure of its CEO makes a deal less likely to occur.

Now, Wal-Mart (NYSE: WMT  ) is the most likely candidate to make a higher bid for Family Dollar. Wal-Mart is accelerating store openings for its Neighborhood Market concept to recapture consumers who have left Wal-Mart's everyday low prices for even deeper discounts at dollar stores. Still, there were just 407 Neighborhood Market stores at the end of Wal-Mart's fiscal 2014, while Family Dollar sports over 8,200 discount stores. Acquiring Family Dollar would give Wal-Mart a much larger presence in the discount segment and prevent the creation of the mega-discount chain that would result from the merger with Dollar Tree.

Family Dollar investors should not hold on to their shares simply because Wal-Mart could make a higher offer, but a potential deal gives investors upside that could boost their returns in the months ahead.

Store expansion
Expansion can offset a lot of problems a company is having with same-store growth -- and goodness knows Family Dollar has struggled to grow comparable sales. In a letter sent to CEO Howard Levine, activist investor Carl Icahn noted that Family Dollar has "consistently underperformed its peers on most, if not all, operating metrics," including same-store sales, sales per square foot, and operating margins.

Fortunately, the company's long runway for growth buys time to fix its current problems. The company is in the process of closing 370 underperforming stores while opening over 110 stores per quarter. If it continues at this pace, it will increase its store count by more than 5% per year, excluding the stores already marked for closure. At that rate, it should be able to grow revenue even while experiencing low-single-digit comparable-store sales declines.

Moreover, earnings could appreciate further if Family Dollar realizes synergies from a merger with Dollar Tree or Wal-Mart. However, the company eventually needs to strengthen its existing store base so it doesn't need store growth just to maintain earnings.

Foolish takeaway
It is telling that two of the three most compelling arguments for holding on to Family Dollar involve the company being acquired. Family Dollar has underperformed its peers for many years and faces an uphill battle on its own. None of the aforementioned catalysts for stock price appreciation is guaranteed to occur; they are simply the most likely sources of higher returns. However, with solid execution and a bit of luck, Family Dollar shareholders may be rewarded for hanging on.

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