Dollar Tree

Source: Dollar Tree.

Deep-discount retailer Dollar Tree (NASDAQ:DLTR) caused a major shake-up in the dollar-store industry when it acquired close rival Family Dollar Stores (NYSE:FDO) and its 8,200 stores last year. The huge $8.5 billion takeover instantly vaulted Dollar Tree into the No. 1 spot among dollar stores by annual revenue, passing competitor Dollar General.

However, the Family Dollar acquisition looks worse and worse with each passing quarter. What was once hailed as a great growth strategy has turned into a nightmare of rising costs and sagging sales. Looking back, it appears there wasn't much of a good reason for Dollar Tree to acquire Family Dollar.

Here's why Dollar Tree might be regretting its massive takeover of Family Dollar.

Buyer's remorse?
Dollar Tree's stock fell 9% after the company reported its second-quarter earnings results on Sept. 1. Sales grew 48% year over year, to $3.01 billion in total sales, which looks outstanding. However, Dollar Tree's quarterly revenue missed analyst estimates, which called for $3.04 billion, according to forecasts compiled by Thomson Reuters.

The reason Dollar Tree's huge sales growth failed to impress investors is that $811 million of that revenue was due to the integration of Family Dollar, which swung to a $98 million loss last quarter, completely reversing a $151 million profit from the same quarter last year.

One reason for such a deterioration in profitability is that Dollar Tree's margins are declining substantially with Family Dollar in tow. Last quarter, Dollar Tree's gross margin fell to 28.4% year over year, a nearly 6-percentage-point year-over-year contraction.

It seems that Dollar Tree assumed it could simply rebanner existing Family Dollar stores under the new name and bring customers back to the stores. But that hasn't happened.

If it isn't broken, don't fix it
At this point, it's clear that the integration of Family Dollar isn't as simple as replacing the banners at the front of the stores. Things are simply not going as smoothly as the company anticipated when it made the deal. Dollar Tree is spending much more on renovating stores and improving merchandise than it originally expected to, and the effects are likely to be felt for some time. Dollar Tree expects third-quarter sales to more than double, to a range of $4.78 billion-$4.87 billion. But again, this figure also missed analyst estimates, which call for $4.91 billion.

Part of the rationale for Dollar Tree's buying Family Dollar was the significant synergies that are typically associated with such large takeovers. But here as well, the reality is proving to be a much different story. Dollar Tree expects to deliver $300 million in annual run-rate synergies by the end of the third year after the acquisition, but that represents a fairly small amount in comparison with how much Dollar Tree spent on Family Dollar.

Dollar Tree management attempted to reassure investors by pointing to the company's performance excluding the Family Dollar acquisition. Indeed, it's true that isolating Dollar Tree paints a different picture. Dollar Tree by itself grew same-store sales by 2.7% last quarter, representing the 30th consecutive quarter of positive same-store sales growth. And the Dollar Tree segment in isolation produced a $218 million operating profit last quarter.

But drawing this comparison leads one to wonder why Dollar Tree bought Family Dollar at all. If things were so good at Dollar Tree, moving to buy out a deeply distressed competitor at such significant cost makes little sense.

Bob Ciura 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.