Dollar Tree Should Forget About Family Dollar and Focus on Five Below

The reasons for Dollar Tree's (NASDAQ: DLTR  ) attempt to acquire Family Dollar (NYSE: FDO  ) are evident: Dollar Tree is nearing its peak for both margins and store expansion, and Family Dollar is a turnaround project with profit upside. Moreover, Dollar Tree management has proven itself to be one of the most efficient in retail -- perhaps ever -- but investors might be much better served if Dollar Tree would abandon its bid for Family Dollar and instead look to a different low-cost retailer for growth.

A dollar store merger
Dollar Tree's bid to acquire Family Dollar for $8.5 billion is not the highest offer, by far -- Dollar General (NYSE: DG  ) made a bid valued at $9.1 billion  -- but it is reportedly the offer that Family Dollar believes is best. While less in upfront cash, one can't deny that there is something special about how Dollar Tree does business, creating a $0.12 profit on every item sold, each of which cost consumers just $1.

In other words, Dollar Tree must find goods, ship them, sell them, pay staff, and manage all other expenses on $1 items! Not to mention, it must stock shelves with items that consumers actually want that cost $1. And it does this better than its competitors that sell items for $1 and more, offering items such as seasonal decor, brooms, cleaning supplies, and a wide array of discretionary and consumable items for $1. And most importantly, it manages this feat while boasting the highest operating margin -- 12.3% -- within the entire industry, more than double that of Family Dollar.

Therefore, when Dollar Tree says its acquisition of Family Dollar would create $300 million in cost synergies by 2018, it's most likely implying it would improve Family Dollar's distribution channels, improve the product mix, and cross-sell products at both stores while not having the $1 cap at Family Dollar stores. Hence, if Dollar Tree can find laundry detergent, party supplies, and cookware to sell for less than a buck, just think of what it can do with items it can sell for $5, $10, or $20!

A better investment for the future
The only problem is that Dollar Tree is dealing with a tarnished brand. There's a reason Family Dollar is being forced to close 370 underperforming locations. Family Dollar is a company whose comparable-store sales are falling, 2% in its last quarter, with inventories that continue to rise.

Maybe Dollar Tree could reignite the Family Dollar brand, but unfortunately, it is hard to correct negatives such as bad store placement and bad public perception. Investors have suggested for years that Dollar Tree should start a new chain of sorts, one without the $1 limit. Because after all, costs in all industries continue to rise, and the fact is, a dollar doesn't buy as much anymore.

Not to mention, $8.5 billion is a lot of money for Dollar Tree, a company that has just $467 million in cash. At the end of 2013, Dollar Tree reported that its retained earnings were just less than $1.2 billion. So, Dollar Tree will have to raise significant cash via debt or dilute its stock significantly in order to complete its acquisition of Family Dollar. With that said, Dollar Tree might be best-suited focusing its efforts on recreating a new Dollar Tree, or a similar concept like Five Below (NASDAQ: FIVE  ) , a retailer that's popular with teens that sells everything for $5 or less.

Like Dollar Tree, Five Below sells name-brand products like Bic and Coppertone, but because of the $5 cap, it can also sell iPhone covers, chargers, and clothing, including popular brands like Hello Kitty. Lastly, Five Below also has its own manufacturing, or designers it works with exclusively, allowing it to keep costs in check, much like Dollar Tree.

As a result, the concepts of Dollar Tree and Five Below are more aligned, and despite Five Below being a growth company that's aggressively expanding, its operating margin of nearly 10% is second to only Dollar Tree among dollar stores. However, once it becomes a mature company, no longer investing a high percentage of its working capital on expansion, Five Below will likely be the most profitable of the dollar stores.

Five Below the next Dollar Tree?
Not to mention, Five Below's growth trajectory is tracking very much like Dollar Tree's back when it was of similar size, in 1997, as seen below. Based on this fact, one might conclude that Five Below could ultimately grow to become the next Dollar Tree over the next two decades.

 

Dollar Tree Full-Year 1997 

Five Below 2014 Expectations

Revenue

$635 million

$680 million

Revenue Growth YOY 

29%

27%

Comparable Sales Growth YOY 

7.8%

4%

Number of Stores

887

366 *

Revenue Per Store

$715,896

$1.85 million

*Number of stores expected at year-end 2014; current store count is 323.

Five Below may look like a pricey retailer with a market cap over $2 billion, but by giving Dollar Tree the possibility, or opportunity, to create the next $8 billion a year concept, which is the amount of revenue that Dollar Tree currently creates, Five Below might be too good an opportunity to pass up.

Foolish final thoughts
While Dollar Tree does seem to be in the lead to acquire Family Dollar, Dollar General's bid is higher, with estimated savings of $550 million to $600 million annually. Therefore, Family Dollar CEO Howard Levine might not want to merge with Dollar General, but shareholders might not give him a choice.

At that point, the bidding for Family Dollar could get too expensive for Dollar Tree, which could be a blessing in disguise. After all, it would give Dollar Tree the opportunity to pursue Five Below, which, long term, could be the best deal for a company that loves value.

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Related Tickers

9/30/2014 3:59 PM
DLTR $56.07 Up +0.01 +0.02%
Dollar Tree Stores CAPS Rating: ****
DG $61.11 Down -0.22 -0.36%
Dollar General CAPS Rating: ***
FDO $77.24 Down -0.26 -0.34%
Family Dollar Stor… CAPS Rating: **
FIVE $39.61 Down -1.43 -3.48%
Five Below CAPS Rating: **

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