Dollar General (DG 0.27%) is at the top of the dollar store market. First quarter earnings, although disappointing in comparison to analyst expectations, compared favorably to its main competitors. While Dollar General has successfully navigated the retail marketplace in the past year, two new variables loom large in this retailer's future.
Most notably, CEO Rick Dreiling announced his impending retirement only one week ago, which kicked off a search for a new chief executive . Meanwhile, billionaire Carl Icahn is pushing for a sale of Dollar General's main competitor Family Dollar (FDO +0.00%) . The replacement of Dreiling and the possible sale of Family Dollar both have interesting implications for Dollar General's future viability.
Dollar General and Family Dollar: two different stories
Two weeks ago, Dollar General's stock recorded a yearly high of $65.07, which could be a signal of increased optimism in the company after a successful first quarter. Specifically, store traffic positively increased and same-store sales improved 1.5% during the first quarter of 2014. Furthermore, quarterly diluted EPS grew about 7% in the first quarter of 2014, compared to the same quarter last year.
Dollar General's encouraging improvement describes a company on the upswing, which is further illustrated by the fact that its net sales rose almost 55% in the past 5 years. In contrast, its main competitor has not fared as well.
Family Dollar recently saw same-store sales drop 3.8% and diluted EPS dropped about 30% compared to the same quarter a year ago. In April, the company announced it would close 317 stores this year due to underwhelming earnings . Conversely, Dollar General opened 214 stores during the first quarter of 2014, and recent success spurred the company to look to open 700 more stores by the end of the year .
The success of Dollar General and underperformance of Family Dollar has led some analysts to believe a merger between the two could occur in the near future.
Dollar General as the buyer
Some analysts see distinct advantages in a possible purchase of Family Dollar by Dollar General. For one, a merger of the two largest dollar stores could create a dominant convenience-based retailer, according to investment firm Credit Suisse .
Furthermore, a merger could push Dollar General into its next business phase as internal opportunities continue to diminish. For example, Dollar General's expansion necessitates more real estate, and a purchase of Family Dollar's 7,600 stores would help fulfill that need.
But while these advantages appear to be beneficial, looking closer at what Dollar General would receive from a merger raises some red flags.
What Dollar General is actually getting in return
A combination of Dollar General and Family Dollar would indeed create a dominant convenience-based retailer, in comparison to the only other remaining dollar store, Dollar Tree. However, Dollar General sees Wal-Mart (WMT 0.71%) as its main competitor . With a $454 billion disparity in annual revenue, even a merger with Family Dollar would not do much to challenge retail's biggest player.
Consumers see dollar stores as "fill-in stores," which fall between supermarkets and large retailers like Wal-Mart . A merger with Family Dollar would do little to change this perception about Dollar General, unless the merger initiated a company-wide overhaul.
Additionally, real estate and inventory are two factors that would lead Dollar General to dismiss an opportunity to buy Family Dollar. Family Dollar and Dollar General stores usually appear in close vicinity to one another . If Dollar General was to utilize the real estate gained from a purchase of Family Dollar, then some store closures would be necessary. These closings would complicate the company's pre-existing plan of expansion.
Family Dollar's steady over-ordering of inventory is perhaps an even bigger issue pushing Dollar General away from a purchase Excess inventory could drag down profitability, especially with Dollar General's own decreasing margins .
Dollar General's shareholders should be wary of an attempted purchase of Family Dollar.
The silver lining in Dreiling's retirement
Of course Dollar General shareholders are concerned about losing Dreiling, as he has led the company to successful new heights. Fortunately for shareholders, Rick Dreiling's retirement announcement could nix a potential purchase of Family Dollar.
A period of transition is a dangerous time to make a landmark change such as a merger. A purchase of Family Dollar within the next year could severely complicate the process of initiating a new CEO. According to analysts from Sterne Agee, a purchase of Family Dollar is much less probable after Dreiling's retirement announcement .
Final Thoughts
Dollar General is succeeding in the current retail market. A merger with Family Dollar seems like a risky move as excess real estate and inventory could drag down Dollar General's profitability. As a result, shareholders could be dissatisfied as they see a once successful company lose its luster.
Although a CEO transition at a successful company isn't ideal, Dollar General shareholders should welcome Dreiling's retirement announcement for one reason: a merger with Family Dollar now seems like a longshot.
