Family Dollar (UNKNOWN:FDO.DL) is the second-largest of the three major U.S. discount chains, but it is decidedly last when it comes to operating efficiency. The company has a similar gross margin compared to its rivals, but has a much lower operating margin. Dollar Tree (NASDAQ:DLTR) and Dollar General (NYSE:DG) are battling it out to acquire Family Dollar in the hope that its cost base can be streamlined. The company's poor performance and the takeover efforts make it more important than ever for investors to analyze management's comments. Let's take a look at what Family Dollar's executives have to say about the company's future.
Favors Dollar Tree over Dollar General
Family Dollar came out in favor of Dollar Tree's July 28 offer to acquire the company for $74.50 per share. The board continues to endorse the Dollar Tree bid despite two higher bids made by Dollar General. After being rebuffed twice, Dollar General commenced a hostile tender offer for Family Dollar at $80 per share, subject to the merger being approved by the target's board.
However, Family Dollar remains committed to accepting Dollar Tree's bid for $74.50 per share. The board is concerned that regulators would use antitrust provisions to block a merger with Dollar General, which could ultimately cost shareholders. CEO Howard Levine said, "Our Board of Directors, with the assistance of outside advisors and consultants, reviewed all aspects of Dollar General's revised proposal and unanimously concluded that it is not reasonably likely to be completed on the terms proposed."
The board's stance is important for shareholders because Family Dollar's stock price is higher than Dollar Tree's offering price. As a result, shareholders will lose money unless the board changes its stance, Dollar Tree raises its bid price, or Dollar General wins a proxy contest.
Low-income consumers are struggling
Family Dollar got a huge boost in 2009 when millions more Americans joined the ranks of the lower class. However, prolonged stagnation at the poorer end of the economy is starting to become a problem for discount chains. Family Dollar says its customers' budgets are shrinking as a result of high unemployment and cuts to government benefits – trends that are making it difficult to drive customers to stores. Levine explained:
The low end consumer has not benefited in this recovery at all, in fact I think have slipped further back. Unemployment trends remain high. The government cutbacks continue, there is quite a bit of health care uncertainty coming from this unbelievably cold winter, heating prices, heating oil and gas prices are moving upwards ... As expected, the environment remains very competitive as retailers look for ways to drive traffic as customers consolidate their shopping trips.
Stocking lower-priced items
Family Dollar is responding to the poor economic environment by making "margin investments" – a euphemism for lower prices. Unfortunately, management says it is making "long-term investments" in pricing, meaning its latest round of discounting is likely to be permanent.
In the third quarter, Dollar General's total gross profit grew by 2.2%, but gross profit as a percent of sales declined by 4 basis points compared to the same period in 2013. As long as lower prices continue to drive higher volume – and thus gross profit continues to increase – this is a good outcome. Keep an eye on gross profit to make sure that it keeps growing. Management is already encouraged about the new pricing program:
Overall the skews that we reduced price are showing nice unit lifts, our customers are responding more quickly than we actually thought. We tried to enhance that with some of our investments on the marketing side with some great end store assignments to let them know what we're doing. And they're delighted with it. So again very positive most of the price adjustments were in the consumable areas not as much in the discretionary side which is most visible to them given the turn on those categories but again some good traction there. We're creating some energy and some excitement in our stores. We think that as we said earlier this is a long-term investment that will continue to grow over the next year or so.
Overall, Family Dollar is starting to stabilize after a few rough quarters. Comparable store sales decreased 1.8% in the third quarter, but that was better than the first and second quarters when comparables declined 2.8% and 3.8%, respectively. Management is enthusiastic about the change in momentum:
Comparable store sales results in the third quarter in all four merchandise categories improved relative to our second quarter results. And the momentum carried into June finishing with the strong July fourth weekend.
Doing more of what works
The company has identified a new product segment – beer and wine – that could boost comparable store sales in the coming years. Shoppers who check out with alcohol have an average checkout price that is 2-3 times the average. Only a limited number of Family Dollar stores sell beer and wine, but the company plans to rapidly expand the number in the coming quarters. This could have a profound impact on the average checkout price, thus increasing sales without having to increase foot traffic.
From our research, we know that customers spend about $6 million on an annualized basis on adult beverages and our test has shown that our average beer and wine basket is two to three times larger than our average basket. We will have a limited number of stores selling beer and wine by the end of 2014 and plans to accelerate the roll out in fiscal 2015.
The tepid economic recovery is pressuring Family Dollar's results, but the company's price initiative and product expansion is pulling it out of a dive. Management's opinions on the various takeover bids are the most important things for investors to pay attention to in the coming weeks and months; keep an eye on Family Dollar's press releases to stay up to date on the board's thoughts.
Ted Cooper has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.