Dollar General's (NYSE:DG) attempt to derail Dollar Tree Stores' (NASDAQ:DLTR) acquisition of Family Dollar Stores (NYSE:FDO) shows that dollar store operators might be in an even more desperate situation than previously reported. It also calls the small-box operators' whole business model into question.
For those of you who haven't been paying attention, Dollar Tree Stores, a company with a market cap of $11.42 billion and a TTM revenue figure of $7.97 billion, has agreed to buy Family Dollar for $8.5 billion. Family Dollar has a market capitalization of $9.09 billion and last reported TTM revenues of $10.38 billion. Now Dollar General, which has a market cap of $19.32 billion and a latest TTM revenue figure of $17.79 billion, has offered $8.9 to 9.7 billion in cash for Family Dollar depending on which article you read.
News reports indicate that Family Dollar has rejected Dollar General's offer and is sticking with Dollar Tree. The same news reports indicate that Dollar General has made a number of moves to pressure Family Dollar to sell.
Do you see the problem here, folks? Dollar Tree and Dollar General seem to be trying to buy an ailing competitor with money they do not have. Dollar Tree's offer for Family Dollar already exceeds its TTM revenues. Dollar General's offer equals more than half the value of both its TTM revenue figure and its market capitalization.
Dollar Store Debt
Where is the money for the acquisition supposed to come from? My guess is that the answer to that question is debt, and a lot of it. Basically, Dollar Tree and Dollar General plan to borrow against future sales revenues at Family Dollar to finance their purchase of Family Dollar.
To me, that sounds like a recipe for disaster for a very simple reason. The dollar store operators have very low levels of free cash flow. On April 30, 2014, Dollar General reported a free cash flow figure of $167.37 million. On the same day, Dollar Tree reported a free cash flow of $126.30 million. Family Dollar's cash flow, which is supposed to be used to finance this deal, was $53.58 million on May 31, 2014.
Any serious drop in cash flow and the new dollar store giant will be drowning in debt. Such a situation could quickly develop because Family Dollar is already in pretty sorry shape. It is slashing its work force and closing 370 stores just to stay in operation. Part of the reason for the acquisition is that Family Dollar's management team essentially decided that they could no longer afford to stay in business as an independent operator.
All it would take to send the new dollar store behemoth into the kind of death spiral we've seen at chains like Radio Shack (NYSE:RSH) and Office Depot (NASDAQ:ODP) is a slight economic downturn or cuts to government benefits. Such a scenario is likely with the combination of lots of debt and low free cash flow levels.
Desperate Moat Building
Naturally, many of you are probably wondering why both Dollar Tree and Dollar General are willing to take such huge risks to acquire Family Dollar. The answer is a pretty simple one. They want to get bigger, and in the process, dig a deep moat around their operations.
As I've noted elsewhere, dollar stores' revenues and market capitalizations are extremely small when compared to some of their competitors. The numbers below tell the story better than I can.
Wal-Mart Stores Inc. (NYSE:WMT), which is often listed as dollar stores' direct competitor, reported a TTM revenue of $477.30 billion on April 30, 2014. Wal-Mart also had a market capitalization of $241.66 billion and a free cash flow of $3.78 billion.
Walgreens (WAG), which operates combination pharmacy/small-box stores in direct competition with dollar stores, reported a TTM revenue of $75.28 billion on May 31, 2014. Walgreens had a market capitalization of $59.38 billion and a free cash flow of $1.042 billion.
CVS Caremark (NYSE:CVS), which like Walgreens, operates combination pharmacy/small-box discount stores in direct competition with dollar stores, reported a TTM revenue figure of $132.04 billion on June 30, 2014. CVS Caremark had a market capitalization of $92.21 billion and a free cash flow of $394 million.
The combined annual sales at Dollar Tree, Family Dollar and Dollar General are just $35 billion a year, Yahoo reported. The smallest of the three direct competitors mentioned above; Walgreen, has a TTM revenue that's more than twice the size of that number.
Each of these direct competitors would still have several times the cash and resources of a combined Dollar Tree/Family Dollar or Family Dollar/Dollar General. A Family Dollar/Dollar General hybrid would have a TTM revenue figure of around $28 billion, while Family Tree & Family Dollar would have a TTM revenue figure of around $18 billion.
Note: these estimates don't include the possibility that Dollar General might be forced to close or sell off as many as 700 stores to comply with anti-trust laws if it merges with Family Dollar. If that event occurred, the Family Dollar/Dollar general combination would have even less revenue to pay that debt off with.
The dollar store operators are already having a hard coping with the drugstore operators even as Walmart plans an aggressive push into their area with its Walmart Express small box concept. The acquisition effort appears to be a desperate attempt to dig a moat around dollar stores before Walmart Express lands in the neighborhood.
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