No Victory For Dollar Tree

Jul.30.14 | About: Dollar Tree, (DLTR)

Summary

Dollar Tree recently announced its plan to acquire Family Dollar for approximately $8.5 billion.

The acquisition will be financed entirely through debt.

Trends in the dollar discount sector are against Dollar Tree.

Dollar Tree (NASDAQ: DLTR) recently announced its plan to acquire Family Dollar (NYSE: FDO) for approximately $8.5 billion. Shares of Dollar Tree opened at $54.87 on Monday. Dollar Tree has a one-year low of $49.59 and a one-year high of $60.19. The company has a market cap of $11.348 billion and a P/E ratio of 19.33. Although there is optimism about the acquisition, investment in the dollar store sector seems to be risky at the current time, for the following reasons:

1. Competitor Reaction

We have already begun to see the start of competitor reaction to the increased presence of dollar discount retailers. Both Wal-Mart (NYSE: WMT) and Target (NYSE: TGT) have entered the market with smaller footprint stores. Wal-Mart has launched two new formats: Wal-Mart Express and Wal-Mart Neighborhood Market. Wal-Mart has doubled the number of smaller stores it operates to 407 over the past two years. Analysts believe this number could reach 2,000 smaller stores in the coming years. These new express stores directly compete with the core competencies of the dollar stores - speed at a low price. With its enormous buying power, Wal-Mart will be a force to reckon with, if it continues to successfully expand in the express market. Wal-Mart's infrastructure and relationship with suppliers gives it an opportunity to come in at an even lower price point. There are even speculations that Wal-Mart will purchase the top player in the dollar store segment, Dollar General (NYSE: DG), to speed up the transition into this segment.

Target also entered the market last week by opening its first TargetExpress, with four more Express stores planned for 2015.

2. Too Much Debt

Dollar Tree will finance the acquisition through a financing commitment from Chase Bank (NYSE: JPM) - no additional shares will be issued. Management expects to relieve the heavy debt burden using the anticipated increase in cash flow from the combination of the two businesses. This is a risky assumption, especially due to the larger decrease in net income that Family Dollar saw in Q3.

3. Movement to More Consumables

The retail industry is currently seeing a trend to increase consumable product offering. The logic behind this makes sense - consumables need to be replenished more often, increasing store foot traffic. Ideally, the low margins from the consumables are compensated by the purchase of other products while in store. Wal-Mart and Target have seen success with this concept, because they have expertly incorporated grocery with other departments. However, I have not seen the same with dollar stores. Consumables are separated, and passing through other departments to prompt impulse buys does not occur. Therefore, they are being hit hard by the poor margins.

Family Dollar put heavy investment into increasing its consumables category. Now, approximately 72% of Family Dollar's products are consumables. There has been a 1.5% increase in net sales of consumables in the past year. However, if you look at net sales by category from Family Dollar's Q3 financial results, you will notice a drop in sales in all of the other (higher-margin) categories:

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4. Over-Expansion

A big concern with the dollar store sector is over-expansion. Together, the two companies will have more than 13,000 stores, plus there are an additional 11,000 stores from Dollar General. This is 24,000 stores, without even considering other players, such as Five Below (NASDAQ: FIVE), The Dollar Store, and so on. It seems like I can't go anywhere these days without passing a Starbucks (NASDAQ: SBUX), yet there are under 13,000 of the coffee chain stores in the United States. Looking at the numbers and expansion plans of the dollar sector, there is a strong threat of oversaturating the market.

While it is exciting to see the second- and third-largest players in the dollar store segment team up, the odds are against them. Analysts are currently downgrading shares of Dollar Tree to acknowledge the risk as well. Bank of America (NYSE: BAC) downgraded from a "buy" rating to a "neutral" rating in light of the news on Monday. Dollar Tree must compete with larger players with more buying power, risk associated with such a large amount of debt, the expansion of a product line with razor-thin margins, and overexpansion of the dollar store sector as a whole.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.