Family Dollar bidding war suggests 'peak dollar store' is here

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America is nearing “peak dollar store.”

A bidding war for Family Dollar Stores Inc. (FDO) burst into the open Monday, with Dollar General Corp. (DG) offering $9.7 billion in cash to best Dollar Tree Inc.’s (DLTR) $9.2 billion cash-and-stock offer.

Wall Street is exultant over the billions being slung among downmarket retailers, pushing Dollar General shares up by 10% and sending Family Dollar stock above the latest $78.50 offer price, with a session high so far of $80.90. First suitor Dollar Tree was down around 2% in afternoon trade.

The deal frenzy has plenty of room to carry on a bit further, for sure. The fact that Family Dollar shares have surpassed the Dollar General bid price means traders assign a pretty high probability that Dollar Tree will attempt to best it; or Dollar General will go higher in a negotiated deal; or perhaps another player such as Walmart Inc. (WMT) will become involved.

Yet the fevered activity to pay top dollar for companies struggling to grow on their own after years of rapid, profitable expansion is the kind of thing that tends to happen closer to the end of a sector’s heyday than to the heart of it. All this transactional buzz might be drowning out abundant signals that the great decade-long run for dollar stores is giving way to a tougher future:

- As noted here when the initial Family Dollar bid was announced, the Big Three dollar-store chains collectively last quarter had virtually flat same-store sales, revenues failing to keep pace with headline inflation.

- These chains are caught in a bit of a squeeze. Lower-income customers with few prospects for earning more have had their government benefits cut. Meantime, an improving job market and signs of some wage growth among the employed could be reversing the “trade-down” effect that sent so many people from mainline retailers to dollar stores in recent years.

- With 24,000 U.S. stores among them  one-third more than existed before the 2008-09 recession – dollar stores are showing signs of domestic saturation. Some 85% of Family Dollar Store locations are in overlapping towns or cities with a Dollar General store.

Convenience-store chains, the drugstore giants and big-box discounters such as Walmart and Target (TGT) are gunning for dollar-store traffic, the latter planning small-format stores to go toe-to-toe on Main Street.

- Dollar General was always the more logical acquirer of Family Dollar – it's larger, better run, and with greater borrowing and spending capacity to seal a deal. Yet even with these advantages, Dollar General is promising annual “synergies” – or cost and revenue improvements – from the merger of a relatively modest $550 million to $600 million in the third year after the closing of the deal. That’s only around 2% of likely combined sales, not to be attained until, say, the end of 2017.

This, as well as the sacrifice of Dollar General’s investment-grade credit rating due to the debt to pay for Family Dollar, helps explain why the proposed premium over the Dollar Tree offer is a relatively modest $4 per share.

Dollar General, then, is stretching to make this deal happen  mere months after declining to bid for Family Dollar at all. Does that sound like a company with great confidence in its own organic-growth prospects in the years to come?

- Carl Icahn, the activist investor who bought more than 9% of Family Dollar and then agitated for the company to be sold, unloaded the majority of his stake after the Dollar General deal sent Family Dollar shares up toward $75. If Icahn saw that as a full enough price, it hints that not too much long-term value remains now.

- Family Dollar and Dollar General shares are up between 150% and 200% in the past decade, compared to about 84% for the Standard & Poor’s 500 index and 44% for Walmart. This has been an impressive run for a sector that had previously been cheap and disrespected.

Now it is arguably an over-loved and expensive group, trading at substantially higher valuations than mainline retailers as investors extrapolate its extraordinary growth into the future.

One knock on the Dollar General bid versus the standing Dollar Tree one is that it offers no stock in the merged company, and therefore no participation in its long-term fortunes for Family Dollar shareholders.

Yet, all things considered, getting cashed out at a fat price by an aggressive competitive bid seems like a pretty good deal.

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