The final acquisition battle for Family Dollar (NYSE:FDO.DL) hasn't been fought yet. Although the two leading dollar store chains each made a case for why it should prevail, the deal only makes sense for one of them. Here's why investors should avoid the stock of Dollar Tree (NASDAQ:DLTR) if it wins the battle for Family Dollar.
Family Dollar is the second-largest dollar store chain behind Dollar General (NYSE:DG) in terms of locations and sales. It generated $10.5 billion in sales over the last 12 months from more than 8,000 stores in 46 states. Dollar General has more than 11,500 stores in 40 states, ringing up sales of more than $18.1 billion in the past year.
The third leg of the Big Three dollar store chains is Dollar Tree. It has about 5,300 stores in 48 states and made almost $8.4 billion in trailing revenues.
It was Dollar Tree that kicked off the bidding war for Family Dollar with an $8.5 billion offer to buy its ailing rival.
Rattling the cage for change
Activist billionaire investor Carl Icahn pushed for the deep discount chain to put itself on the market. He said Family Dollar lagged its peers across virtually all metrics and all time frames. While Dollar General was his preferred buyer, it was caught up in a CEO change that seemingly delayed its ability to make an offer. Dollar Tree stepped into the void with a bid that was quickly accepted by management and the board.
Even when Dollar General finally made an offer -- and even after it sweetened the pot -- Family Dollar has stuck by Dollar Tree's original plan.
No doubt part of that rationale is because Dollar Tree will keep the existing management on. Dollar General has made no such commitment.
With two competing offers to consider, investors in both bidders should hope Dollar Tree loses.
David vs. Goliath campaign
Despite being the smallest of the three, Dollar Tree is arguably the better-run outfit. For every one dollar in sales it makes, it generates over $0.12 in operating profits. Dollar General earns $0.09 for every sale, and, not surprisingly, Family Dollar barely makes a nickel.
The flat-pricing business model Dollar Tree perfected has served it well. Consumers can better budget their shopping trips because everything in its stores is priced at exactly $1. And the dollar store chain continues to add value to lure customers back.
Dollar Tree is rolling out refrigerators and freezers to almost all of its stores. Although there tend to be lower-margin items in the refrigerators and freezers, they also generate greater turnover, which increases store traffic. In the just-completed third quarter Dollar Tree recorded its best same-store sales performance in three years. Comps rose 5.9% from the same period last year.
Dollar Tree also continues to introduce more brand-name goods into its stores. Consumers associate quality with national brands. Making them available at the $1 price cements the idea that customers are getting great value.
As a result, Dollar Tree's stock has soared. Over the past one-, five- and 10-year periods Dollar Tree's stock has outperformed its rivals by a wide margin.
But it risks derailing all the hard work and gains it has won if it wins the Family Dollar bidding war.
There's no question Family Dollar is a broken brand. Where once it had been the leading deep discount chain it's now the industry laggard. That's what made it ripe for Carl Icahn to step in and shake things up. Of course he cashed in his chips after Family Dollar's stock jumped after the takeover offers were made and it was clear there was little further chance of additional gains.
There are four main risks to Dollar Tree's continued success if it wins the Family Dollar war.
- Dramatic changes to its business model.
- Higher costs and expenses.
- An unwieldy national footprint.
- Excessive operational risks.
Pay-one-price model threatened
As noted previously, Dollar Tree is the one-price-for-everything leader. In fact, it's the only major pure play in the space. Both Dollar General and Family Dollar offer customers a variety of price points and only about a quarter of the items they sell are priced at a dollar or less. Dollar Tree's Deal$stores also allow it to break the $1 price point. While it's regularly adding more stores to the concept, with just 200 stores right now they're a very small component of the business.
Family Dollar would drastically alter Dollar Tree's business. It would go from being a dollar store pure play to just another deep discounter. Successfully acquiring its rival would also bring with it a new level of competition.
Dollar General says if it wins Family Dollar it would be able to better compete against Wal-Mart for the very price-conscious consumer. It could be a fatal move for Dollar Tree to move up to that level of rivalry.
Competitive advantage put on ice
One of the keys to Dollar Tree's recent success has been the addition of freezers and coolers to its stores. It expects the vast majority of its existing stores to have them and almost all new Dollar Tree stores opened will feature them.
Consumables make up half of Dollar Tree's sales. Adding in refrigerated goods has increased the turnover in its inventory, increasing store traffic. Customers pick up additional items when they come in to restock the consumables.
Family Dollar also has refrigerated goods, but consumables make up a much larger percentage of its sales. Nearly three-quarters of its sales are consumable items. That would likely account for Family Dollar's lower margins. Dollar Tree would have to decide whether to bulk up its namesake store consumable goods, or reduce those offered at Family Dollar.
Big shoes to fill
Acquiring Family Dollar's 8,000 stores would nearly triple Dollar Tree's national footprint. It would catapult it ahead of Dollar General on most metrics.
Dollar Tree has less overlap with Family Dollar than does Dollar General. The latter says it would close up to 4,000 stores to win regulator approval of the deal. Dollar Tree thinks it would only have to close 500. But an acquisition of that size rarely goes smoothly. Meshing together two very different corporate cultures is not easy.
Dollar Tree and Family Dollar may be similar types of concepts, but the details show they are very different businesses.
Corporate culture clash
The differences make keeping Family Dollar's management team on board a big risk. They're the same ones that brought the dollar store chain to this low point. Keeping the team intact means the corporate culture at Family Dollar wouldn't change. At the least it would make it more difficult to change what's wrong.
The two stores also target different customers. Family Dollar targets lower-income consumers and Dollar Tree goes after middle-income customers.
There are certain economies of scale Dollar Tree would enjoy by successfully acquiring its rival. They're outweighed, though, by the risks it would face as a result.
Investors who benefited from Dollar Tree's many successes over the years should hope it is Dollar General that ultimately wins the bidding war for Family Dollar if they want to see those gains continue.