Family Dollar Stores (FDO) spiked on Tuesday on news that Dollar General (DG) may make a counter bid against Dollar Tree (DLTR)'s $8.5 billion bid for the discount retailer. According to Bloomberg, "Dollar General is working with an adviser to evaluate its options and knows that banks are willing to finance a counterbid, one of the people said, asking not to be identified discussing private information."
The market was encouraged by what such a bid could mean for Family Dollar. Shares rose to a 52-week high of $79.93 off an open of $75.37 before settling at just over $77 when trading for the day closed on Tuesday.
Dollar General is a better fit for Family Dollar. While there are some obstacles to such a merger, there is some support. In addition, Dollar General and Family Dollar would enjoy significant synergies - in fact, greater synergy than that between Family Dollar and Dollar Tree. A bidding war between Dollar General and Dollar Tree could push Family Dollar much higher going forward.
That's not to say a new entry in the bid for Family Dollar wouldn't meet some big obstacles - it would. "Family Dollar CEO Howard Levine and activist hedge fund Trian Management have agreed to vote their shares in favor of Dollar Tree's offer," according to TheStreet. "Combined, Levine and Trian own 16% of Family Dollar's outstanding shares."
In addition, "as part of their July 28 merger agreement, Family Dollar agreed to pay Dollar Tree $306 million were it to accept an outside bidder."
But that doesn't mean a deal with Dollar General won't happen.
Not all Family Dollar shareholders are excited about the Dollar Tree deal. Bloomberg reports that Family Dollar investor Shiva Stein filed suit to block the merger last week, alleging that "Dollar Tree's $74.50-a-share cash-and-stock offer for the 8,000-store chain undervalues" the company and that its directors failed to shop around for the highest price.
Then there is Carl Icahn. The famed investor was once Family Dollar's largest shareholder and had even threatened a proxy war if the company did not put itself up for sale. Icahn released the following statement on July 28, 2014:
"While we continue to believe there are a handful of potential buyers who could realize greater synergies through a combination with Family Dollar and are hopeful that one or more of them will surface as a result of today's announcement, we are extremely pleased with Dollar Tree's intention to acquire Family Dollar in a transaction that values the company at $74.50 per share. This is a big win for all shareholders of Family Dollar and yet another validation of the activist investment philosophy in general. An investor that had bought Family Dollar shares on June 6, 2014, the date our investment in the company was first made public, and held those shares through today (assuming the $74.50 deal price), would have paid $60.53 per share and realized a total return of 23.7% (as compared to a total return of only 1.5% for the S&P 500 Index over that same period). Over the period since we began purchasing the stock, the common shareholders of Family Dollar have enjoyed an aggregate gain in market value of almost $1.9 billion, an increase of over 28.5%."
According to Reuters on July 29, "Icahn said he was "determined" to dispose part of his stake rather than wait for the deal to close or for higher offers to emerge." Icahn cut his stake in Family Dollar from almost 10% to just 3.61% shortly after Dollar Tree's offer was announced, but Icahn is nothing if not persuasive. Even a 3.61% stake would give him a foothold to push for a Dollar General acquisition of Family Dollar.
WEIGHING IT OUT
Analysts are echoing Stein's concerns. TheStreet quoted Credit Suisse analysts as saying, "[W]e see the possibility of a competing bid from Dollar General, so Dollar Tree may have to pay more if it really wants the asset." Credit Suisse gives Family Dollar shares a price target of $80, which is higher than Dollar Tree's $74.50 per share offer - although it should be noted that that figure is the highest price target currently on record. Yahoo Finance reports 18 brokers put a mean price target of $63.86 on Family Dollar, with a range of $50 to $80.
In addition, there are the benefits of synergy to consider. Analysts at Bank of America Merrill Lynch project that if Family Dollar were to be acquired by Dollar General its synergies would exceed $500 million - far above the $300 million in synergies Dollar Tree expects to achieve by acquiring Family Dollar. And Bank of America Merrill Lynch estimates the benefit of those synergies could be seen almost immediately, boosting the company's earnings per share by as much as 50% in the first year.
And no wonder. Dollar General and Family Dollar have remarkably similar price points, product offerings, and customer demographics. Any visit to the discount retailers makes that point clear. They both favor yellow and black signage and branding, items on offer include everything from housewares to groceries, and price points range from snack cakes for less than a dollar to comforters and bedding sets for around $30. By combining their efforts, Dollar General and Family Dollar could benefit from economies of scale and would retain the same consumer base.
In comparison, Dollar Tree offers a similar range of products but keeps everything at $1. The company may share many customers with Family Dollar but they have very different product offerings and different strategies.
Dollar General would face significant hurdles in issuing a counterbid to Dollar Tree's offer for Family Dollar, but it isn't impossible. Family Dollar would be a more synergetic fit for Dollar General, and those synergies add value to the deal. Even if Dollar General does not ultimately succeed, its efforts could push Family Dollar's price much higher. It's not too late to buy in.
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.