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Summary

  • Dollar Tree buying Family Dollar does make strategic sense.
  • Industry consolidation was likely, given immense competition.
  • Still, Dollar Tree paid a handsome price for a struggling and vulnerable rival.

There was another high-profile merger to analyze, this time in the world of discount retail. This deal involves two of the nation's major deep discount chains joining forces. Dollar Tree, Inc. (NASDAQ:DLTR) announced it would buy struggling competitor Family Dollar Stores Inc. (NYSE:FDO) for $8.5 billion in cash and stock, or approximately $74.50 per share. The buyout will instantly create a deep-discount juggernaut in the United States.

But while the deal presents some strategic benefits for Dollar Tree, and Family Dollar investors are obvious winners, Dollar Tree investors have reason to be skeptical. That's because of the hefty price tag involved. There's no doubt Dollar Tree will benefit from synergies and instant growth from snatching up Family Dollar, but it paid a hefty premium considering Family Dollar's operational deficiencies in the months leading up to the deal.

That might explain why shares of Dollar Tree jumped initially early in the day, but steadily drifted lower throughout the day and closed only modestly higher. Buying Family Dollar makes a lot of sense, but not for the price paid.

Family Dollar's woes are forgiven
Dollar Tree is paying a 22% premium over Family Dollar's previous close. This is a high price, especially considering Family Dollar is performing very poorly. Same-store sales, which measure sales at locations open at least one year, fell 1.8% last quarter. Through the first nine months of the year, earnings per share collapsed 26%.

Family Dollar is spending a lot of money to try to lure customers back into its stores. Its plan also included closing 370 under-performing stores by the end of the year.

Complicating things is that Family Dollar didn't see a recovery happening this year. Management forecasts called for a low-single digit decline in same-store sales, and earnings per share to clock in at just $3.12 at the midpoint of its guidance. That would represent an 18% drop from the previous year.

The picture looks even bleaker considering the large restructuring charges Family Dollar will take this year. Management expects restructuring to shave off another $0.51 per share from this year's earnings. Including this, earnings per share will likely fall 31%.

With all this in mind, you'd think Dollar Tree would be able to snatch up Family Dollar for a bargain. But this didn't stop Dollar Tree from forking over a big premium for Family Dollar. At $74.50 per share, Dollar Tree has valued Family Dollar at 28 times 2014 earnings per share estimates.

By contrast, Dollar Tree trades for just 18 times its 2014 earnings guidance, and Dollar Tree is in a vastly better financial condition than Family Dollar. Dollar Tree's earnings per share grew 13% last quarter.

Are strategic benefits enough?
To be sure, the rationale for acquiring Family Dollar is clear. Family Dollar holds hundreds of small stores located in urban areas and big cities that are very attractive to Dollar Tree. That's because Dollar Tree employs the same strategy, and will now have one less major competitor to deal with. Not surprisingly, this should result in considerable synergies.

To that end, Dollar Tree won't have to undergo the time-intensive and costly effort of finding suitable locations and building its own stores to fuel expansion. The company opened 94 new stores last quarter alone. It instantly accomplishes growth of square footage by buying Family Dollar.

Moreover, the combined company will be able to cut duplicative costs, since they're in the exact same business. That's why total cost reductions are expected to reach $300 million three years after closing. And, the deal is expected to be accretive to earnings in the first year after closing.

Some final thoughts
Dollar Tree's pursuit of a vulnerable competitor was a great idea. Buying Family Dollar instantly removes one of its biggest competitors, and the acquisition presents huge cost synergies. In addition, the deal creates a true dollar store giant, with more than 13,000 stores and annual sales that exceed $18 billion.

But the bigger point is that Dollar Tree missed an opportunity to swallow a struggling rival at an advantageous price. It's valuing its takeover target as though Family Dollar is a high-growth company and not the vulnerable prey that it was. Family Dollar investors should be thrilled about the premium they will receive for their shares, given how badly the company has performed over the past year. On the other hand, Dollar Tree does not look very savvy for paying such a premium.

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.

Source: Dollar Tree Overpaid For Family Dollar