Family Dollar Stores' Earnings Just Cratered. Why Does Dollar Tree Want to Buy This Company?

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Family Dollar investors will likely get a pretty penny from competing merger offers. Photo: Mike Mozart via Flickr

The dollar store operator at the center of a takeover bidding battle between two rival chains on Thursday reported fiscal 2015 first quarter earnings that were nearly cut in half as new pricing policies took effect. As Family Dollar continues struggling to turn around its operations, the subpar performance raises a legitimate question: Just what do Dollar Tree and Dollar General continue see in the chain that makes them think it's so valuable?

Price is what you pay
Family Dollar said transitioning away from a promotional pricing strategy to one featuring everyday low prices caused GAAP net income to plunge 47% to $41 million from the year-ago period. Adjusted for the costs associated with the pending merger offers, they were down only 35%.

The dollar-store chain enjoyed strong growth in consumables in the quarter, which now comprise more than three-quarters of its net sales, but those goods are typically food and tobacco, and they tend to be lower-margin items. They couldn't make up for the decline in the number of customer transactions or their value, so same-store sales fell 0.4%, continuing a trend of lower comparable sales that began in earnest in late 2013.

Value is what you get
Yet the chain has long lagged behind the profitability of its suitors. Dollar Tree turns more than $0.10 of every dollar of revenue generated into operating profit; Dollar General pockets $0.08 in operating profit from every dollar of revenue. In comparison, Family Dollar's take is less than $0.03 per dollar, down sharply from the nickel it earned a year ago.

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Dollar General says it's willing to pay $9.1 billion to add Family Dollar's 8,000 stores to its own fleet of 11,700 stores to better combat Wal-Mart, which is marching forward with plans to open greater numbers of deep discount Neighborhood Markets stores that will eat into the dollar chain's business.

There's some sense to that argument because both Dollar General and Family Dollar sell goods that despite their respective stores' names are largely priced at more than $1.00. Their multiple price-point policies find just 25% of Dollar General's items selling for a dollar or less while 22% of Family Dollar's products are at that price level.

In contrast, all of Dollar Tree's merchandise is priced at exactly $1.

Which is why it's pursuit of Family Dollar is such a head-scratcher. As I've pointed out elsewhere, there are four main risks to Dollar Tree's continued success if its $8.5 billion offer wins the bidding war:

  • Its business model will dramatically change.
  • It will have an unwieldy national footprint.
  • It will incur higher costs and expenses.
  • It will encounter substantial operational risks.

The switch from a flat-pricing policy to a multiprice-point one will significantly change Dollar Tree's business, and dilute the appeal it has with consumers. While Dollar Tree does offer the Deals stores, which offer different prices, there are only 200 or so of them, a rather insignificant number in relation to the 5,300 namesake stores it runs. But adding in Family Dollar's stores would nearly triple its size and tilt the business toward higher-priced goods.

As noted above, consumables make up over 75% of Family Dollar's sales, but they make up just half of Dollar Tree's. Absorbing them into its operations would negate the profit advantage Dollar Tree holds over Dollar General.

And Dollar Tree plans on keeping Family Dollar's management team around. The same folks that got the dollar-store chain into its predicament and are struggling to turn it around now, will be the same ones tasked with fixing it afterward, all the while during an integration process that is sure to have more than a few speed bumps.

Which is why Family Dollar's latest quarterly earnings report ought to have Dollar Tree investors seriously questioning what it is their management team continues to see in its rival.

The article Family Dollar Stores' Earnings Just Cratered. Why Does Dollar Tree Want to Buy This Company? originally appeared on Fool.com.

Rich Duprey has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.