The surprise $8.5 billion acquisition by Dollar Tree Inc. (DLTR) of Family Dollar Stores Inc. (FDO) – and the live prospect that industry leader Dollar General Inc (DG) might storm in with a competing bid – has kicked up plenty of excitement in the deep-discount retail business. Yet beyond the deal-making headlines and related trading machinations, the sober reality is that the best days for the dollar-store industry may have passed.
There are too many store locations, which will only get worse given expansion plans by the big players and new competitors. Sales growth has slowed dramatically across the industry. And the economic sweet spot for the limited-selection, low-priced neighborhood shopping game is receding.
Despite these challenges, shares of the leading dollar-store chains are significantly more expensive than other mainline retailers, suggesting that, once this flurry of mergers is through, the stocks will have a hard time delivering good long-term returns. Following the announcement Monday morning, Dollar Tree shares are up 3.5% to $56.13 in afternoon trade; Family Dollar is surging almost 25% to $75.64. The deal was done for $74.50 a share in cash and stock, 23% above Family Dollar's closing price Friday.
Dollar Tree’s agreement to buy Family Dollar – which has been a chronic underperformer and was prodded toward a deal by activist investor Carl Icahn – would create a chain of 13,000 stores. With Dollar General operating 11,000 locations, there are 24,000 dollar stores owned by what would be a Big Two, with expansion plans on paper to get toward 30,000 in several years. By comparison, the current dollar-store count is 17% more than the three largest, ubiquitous-seeming drugstore chains – Walgreen Co. (WAG), CVS Caremark Corp. (CVS) and Rite Aid Corp. (RAD) – have.
A played-out game?
Over the past decade – and especially since the onset of the recession half a dozen years ago – dollar stores spread rapidly, catering to cash-strapped consumers with rock-bottom prices on food and other necessities, while also stocking an assortment of convenience and impulse-buy items.
Yet the recent sales record suggests this game is largely played out. In their most recent quarter, same-store sales growth for the top three dollar-store chains was between a 2% increase (Dollar Tree) and a 3.8% decline (Family Dollar), so as a group the top line failed to keep pace with inflation.
Credit Suisse analyst Edward Kelly greeted news of the Family Dollar purchase by downgrading Dollar Tree shares to Neutral, contending the deal is a risky shift in strategy and saying he's “not convinced this is the best move for Dollar Tree shareholders.”
Dollar Tree operates a true “dollar store” format, with nearly all goods at that price or less, while Family Dollar is a “multi-price” concept with products up to around $10. The companies indicated they will continue running both chains, with the long-lagging Family Dollar management in place. When big companies pay aggressive prices using lots of new debt on an untested strategy, it often means their outlook for organic growth has become clouded.
Kelly added he believes Dollar General should, and possibly will, move to buy Family Dollar instead, given that they follow similar merchandising strategies and could wring out more efficiencies in a merger.
This would simply push the price for Family Dollar even higher than the current rich valuation of 11-times the past year’s cash flow. That’s pricier than most every major mainline and off-price retailer – higher even than the multiple of Michael’s Inc. (MIK), the crafts chain taken public recently by private-equity backers at a pricey cash-flow multiple. (Shares of Michael's are now trading below the $17 offer price.)
Dollar Tree and Dollar General shares are up 252% and 144%, respectively, over the past five years, compared to 100% for the Standard & Poor’s 500 index, 52% for Walmart Inc. (WMT) and 38% for Target Corp. (TGT). It’s not easy to see how much more the dollar store names can offer Wall Street from here.
An investor buying dollar-store stocks at such lofty multiples needs to overlook several challenges. Aside from slowing sales, Walmart and Target are both exploring smaller-format stores to compete for the dollar-store customer. This will only add to the crowding in the retail segment offering everyday necessities in convenient locations. CVS and Walgreen, top-notch merchants themselves, had same-store sales last quarter of 1.4% and 2.2%, respectively, in their non-prescription merchandise sales, which accentuates how tough the competition is here.
While no one would, or should, suggest that a wave of prosperity is about to wash over lower-income consumers, the economy is on the verge of producing more than 200,000 jobs for a fifth straight month, and average hourly wages have been rising since the winter. At the margin, this loosens dollar stores’ grip on subsistence consumers.
One up-and-coming group of retail chains now beginning to get the Street’s attention is convenience stores, especially those carved out of petroleum-company parents. Murphy USA Inc. (MUSA), spun off from Murphy Oil Corp. (MUR) in September, and CST Brands Inc. (CST), separated from Valero Energy Corp. (VLO) just over a year ago, both have good sales momentum, lower valuations than the dollar stores, and significant opportunities to expand their retail offerings and create more shareholder value as newly public companies.
In this case, investors might want to turn toward a couple of low-frills retailers that have split away from bigger companies, rather than the ones now hustling to merge as their growth prospects dim.