Last week Carl Icahn announced his newly acquired 9.4% stake in Family Dollar (UNKNOWN:FDO.DL). According to the Schedule 13D filing, Icahn intends to initiate talks with Family Dollar about strategies to enhance shareholder value, which may include exploring strategic alternatives like a merger. Despite growth in the industry, Family Dollar has not been as successful as rivals with shares up a modest 30% in the past three years compared to 85% for Dollar General (NYSE:DG) and 72% for Dollar Tree (NASDAQ:DLTR).
A hypothetical merger between Family Dollar and Dollar General was tossed around by analysts, and had investors celebrating as shares of both shot up. But here at the Fool we like to look past short-term market movement. There has to be real value for such a deal to occur. So what value might be unlocked for investors?
Enhancing shareholder value
Jefferies analyst Daniel Binder believes that there could be up to $1.2 billion in synergies. In any merger one can expect there to be cost savings from elimination of redundancies in a combined entity. In this case there would likely be a dip in administrative expenses on top of margin relief from closing underperforming stores in overlapping areas. But I like looking for opportunities where value can be enhanced through growing and not just trimming down. That's not to say efficiency is unappreciated--I just prefer it to be coupled with something more.
As per their most recent quarterly reports we can see on the chart below that even though Family Dollar benefits from higher gross margins, it suffers from lower operating margins.
The result of this for Family Dollar is a mere $392 million net income in 12 months ending March 1, 2014, on $10.3 billion in revenue, compared to Dollar General's $1.03 billion net income on $17.5 billion revenue in 12 months ending Jan. 31, 2014.
This discrepancy hints at how Dollar General could benefit from Family Dollar's supply chains, and Family Dollar from Dollar General's business infrastructure.
Supply chain improvements
Family Dollar operates about 8,000 stores in 46 states, and these stores are supplied by 11 distribution centers across the United States. Meanwhile, Dollar General operates over 11,000 stores in 40 states that are supplied by 12 distribution centers . A combination of the distribution centers would significantly reduce average stem miles between distribution centers and stores. What this means is that many stores will be able to better manage inventory with faster restocking.
The best example of where this would be felt is in the two states where the two companies combine for over 2,600 stores. Right now Dollar General supplies its 1,500 stores in Texas and Oklahoma from a massive 1,310,000 square-foot distribution center in Ardmore, Oklahoma, located just 40 miles north of Texas' northern border. In a merged company this facility would supply Family Dollar stores as well; while Family Dollar's two 900,000 square-foot distribution centers in Odessa, Texas, and Duncan, Oklahoma, would help supply Dollar General Stores.
Growth in frozen and refrigerated food
Family Dollar also offers an advantage in the fastest-growing and largest merchandise group. In 2013 Family Dollar signed a six-year, exclusive deal with McLane Company, a supply chain-services company, to expand Family Dollar's assortment of refrigerated and frozen foods among other things. This has helped lead to one of the few bright spots for them last year as the lower-margin consumables sales increased 16.9% to 72.4% of total sales. It could also lead Dollar General to an even better year in consumables, which represented 75% of its total sales and 89% of its total sales increase from fiscal 2012 to 2013.
This is something one of their competitors, Dollar Tree, recognizes and has taken steps to work on. While Dollar Tree only makes up 49% of its net sales from consumables, it added 610 stores with freezers and coolers in 2013 to a total of 3,160 stores out of its 5,000. Frozen and refrigerated food is the next big organic growth opportunity in the market and serves as a means of driving traffic to the store more frequently.
Now there are significant risks and challenges facing any deal, the least of which is whether either company would even bite. Dollar General has been spending its cash on a share repurchase program that has totaled $2 billion since 2012 and has not expressed any interest. Family Dollar has as recently as 2011 rejected a takeover bid from Nelson Peltz's Trian Fund Management.
Beyond that there is no guarantee that Family Dollar will be able to improve its margins merely by merging with Dollar General. It may face the same challenges in its operating expenses as it faced before with its focus more in urban areas than Dollar General. The supply chains might not merge efficiently and estimated synergies may never be realized.
My Foolish Takeaway
Even if this deal does not work out the underlying strengths and opportunities are still there for both companies. But I also believe both companies have enough incentives to want to move forward as a more capable combined entity. As of now it is to be seen what proposals are set forth by Icahn and how Family Dollar will act.