Walking past a deep discount store where most items sell for $5 or less, you might not realize that you are walking past a gold mine, with the discount sector handily beating department stores in everything from sales growth to profit margins to returns on equity.
Discount retailers are so hot right now that they are fighting amongst themselves to consolidate and acquire more of a great thing.
Dollar General (NYSE: DG), the nation’s largest deep discount retailer, has been attempting to purchase the third largest chain Family Dollar (NYSE: FDO) for $9 billion when it was worth some $7 billion – before the markets drove FDO’s market cap up to the current $9 billion in anticipation of a successful take-over.
But the take-over isn’t happening, with Family Dollar rejecting Dollar General’s offer. It appears Family Dollar is being courted by another discount retailer, the nation’s second largest chain Dollar Tree (NYSE: DLTR), which Family Dollar has expressed its preference for.
With two suitors fighting over it, Family Dollar is obviously going to marry the one offering the largest dowry. Right? Wrong. Dollar Tree is offering Family Dollar only $8.5 billion.
This has left many scratching their heads. What is Family Dollar thinking? Is it purely business, or is it personal?
Many are wondering just that, and they are getting none too friendly about it.
Investors might want to pay attention as this plays out, for the discount retail gold mine still has a great deal of profit potential to be tapped.
The Accusations
So what is Family Dollar’s reason for rejecting Dollar General’s larger offer? “…A transaction with Dollar General … has a high likelihood of not closing due to antitrust considerations,” explained Ed Garden, an independent director on Family Dollar’s board.
Family Dollar believes that the combining of its 8,100 stores with Dollar General’s 11,000 stores would not be approved, as the merged entity would control too much of the deep discount market share.
Others, though, including Dollar General itself, are not so sure anti-trust issues are the real reason for the rejection. Dollar General’s CEO Rick Dreiling assured that Dollar General had performed “extensive antitrust analysis using experienced advisers, the results of which confirm that the transaction as proposed is capable of being completed”. Dreiling then “questioned whether his counterpart at Family Dollar, Howard Levine, was serving his own interests,” reported Reuters.
Some on-lookers agree with Dreiling. “It is not clear to us why the antitrust concerns could not be resolved via methods such as store divestitures,” expressed S&P Capital IQ analyst Efraim Levy, alluding to Dollar General’s willingness to close a number of stores to shrink its combined market share and quell anti-trust concerns. “It might be that antitrust was not the full reason,” Levy concluded.
So what is Family Dollar CEO Levine’s suspected “full reason” for rejecting Dollar General’s bid in “serving his own interests”? Reuters answers, “Were Dollar General to buy Family Dollar, Levine is expected to lose his job, although this has not been confirmed.”
So the accusation is that Family Dollar’s Levine rejected Dollar General’s larger bid because he doesn’t want to lose his job as Family Dollar’s CEO. The offer made by Dollar Tree, on the other hand, is purely a cash-and-stock bid, and would not result in such a complete integration as a merger with Dollar General would. If Dollar Tree buys the chain, Family Dollar would still be at least partly autonomous.
But other observers feel this is an unfair characterization of Family Dollar’s Levine’s motives. Diana Moss, vice president of the pro-competition American Antitrust Institute, for one, does see some red flags in a merger between the number one and number three chains. “That’s going to raise some eyebrows,” she opined. “I can see this will get some heavy scrutiny.”
Where combining number one General with number three Family would produce a behemoth controlling more than 20,000 stores generating more than $28 billion in annual revenues, a marriage between number two Tree with number three Family would produce a smaller giant of just 13,000 stores generating $18 billion in sales – making it the new number one, but only slightly larger than General’s 11,000 stores, while only equalling General’s $18 billion in revenues.
But there are more figures pointing to Dollar Tree as a better partner for Family Dollar. For a moment, let’s call a ceasefire on the mud slinging and let’s look at the numbers like good little businessmen.
Who’s the Better Partner?
It’s no surprise that consumers’ shopping habits were changed dramatically by the financial crisis of 2008-09, which saw the erosion of 33% of residential property values, the disappearance of more than 8 million jobs, and the evaporation of some 50% of corporate stock value.
Over the past five years since then, the department store sector has been split into two groups of winners and losers, with deep discount chains rubbing shoulders with the best of them, as noted in the graph below. The nation’s top three discounters showcased above are outperforming even the biggest retailer of them all – Wal Mart.
Source: BigCharts.com
At the present time, department stores as a whole are still trailing the deep discounters. Where the department store sector is currently delivering a return on equity of 15.2% with profit margins of 2.5%, the deep discount and variety sector is giving shareholders a 20.6% return on equity with 3.3% net profit margins.
Getting back to our love triangle amongst the top three deep discounters, when we look into the companies’ figures we find that Family Dollar would probably be better off marrying the number two Dollar Tree despite the lower bid.
Second largest Dollar Tree has been generating better returns for its shareholders than the larger Dollar General has, with better profit margins and quarterly growth as well. Tree’s returns on assets and equity of 21.36% and 39.35% are better than General’s 10.25% and 20.53%; Tree’s profit and operating margins of 7.54% and 12.37% are better than General’s 5.77% and 9.72%; and Tree’s quarterly year-over-year revenue and earnings growth of 7.20% and 3.60% are better than General’s 6.80% and 1.10%.
Comparing the two suitors on a broader set of performance figures we find at least 19 metrics in which the number two Dollar Tree surpasses the number one Dollar General, whereas General beats Tree in only 5 metrics, as noted in the table below.
Source: Own
As any lady at a dance would opt for the man with the smoothest moves, when comparing present performance and future prospects, Dollar Tree clearly stands out as the most graceful partner for Family Dollar.
Riding on Their Coattails
Investors might pay close attention to the retail shuffle playing out on the consumer dance floor.
Although the economy is improving slowly, the overall hard economic times we’re in will likely continue for several years more, as GDP is still sluggish, wages are still stagnant, and jobs have only just reclaimed the 8.5 million that were lost since the crisis began – though not keeping up with the population growth since then.
Deep discount retailers like the three noted above will likely continue to outperform the majority of the department stores, including the king of retail Wal Mart – whose profit and operating margins of 3.30% and 5.53% are lower than Dollar General’s and Dollar Tree’s, while matching Family Dollar’s. Worse still, Wal Mart’s returns on assets and equity of 8.21% and 20.27% are below those of all three of the discounters showcased here.
So the next time you walk by a deep discount or thrift store, don’t belittle the single digit sale signs. There’s a great deal of money being made there. While they’re making money one their stores’ stock, we could be making money on their companies’ stock.
Joseph Cafariello
