Is Dollar Tree Ready to Take on Wal-Mart?

By Markets Fool.com

It's almost one big happy family as Dollar Tree's merger with Family Dollar draws to a close, but the challenges are just beginning.

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Dollar Tree's acquisition of Family Dollar is entering the final phase as the deep discount retailer said the Federal Trade Commission has substantially completed its review of the merger and identified some 340 stores that will need to be divested.

While that's more than the 300 stores the discount chains had been originally touting as the number they'd have to close if they joined together, it's also less than the 500 stores the regulatory agency had been scrutinizing. But it's not an unreasonable amount either, and it's certainly far less than the 4,000 stores Dollar General might have needed to divest had it been successful in courting Family Dollar's shareholders.

So all that's left is for Dollar Tree to begin integrating its peer's operations into its own, a process it believes will begin sometime next month when the FTC gives the acquisition deal the nod.

Now the real fun begins
That will be no small feat, however, and it may not even be the most difficult hurdle Dollar Tree faces. Competition in the deep discount market is intensifying and the one-time pure-play dollar store may not be ready for its biggest challenge: facing down Wal-Mart .

Dollar Tree sells virtually all goods in its stores for $1 or less. It has a much smaller operation in Deal$ that offers products above that pricing threshold, but with only a relative handful of Deal$ stores in operation -- just 219 at the end of January compared to over 5,100 of its namesake stores -- Dollar Tree was largely considered the one true dollar store.

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Both Family Dollar and Dollar General have broader product lines with just 20%-25% of their items priced at $1 or less. It's the primary reason why Dollar Tree has been the more profitable operation of the big three deep discounters, generating $0.12 in operating profit for each dollar of revenue compared to $0.09 at Dollar General and just $0.03 at Family Dollar.

But now that Dollar Tree is consuming Family Dollar and its 8,000-store network, the entire dynamic at the dollar store will change.

Cozier than Wal-Mart's supercenters, but offering more choices than a convenience store, Neighborhood Market is a direct threat to the dollar stores. Photo: Wal-Mart

Feeling bloated
The newly enlarged Dollar Tree will generate about $18 billion in annual revenue, more than half of which will come from the Family Dollar operation. Yes, Dollar Tree has some experience operating this mixed pricing platform, but the Deal$ contribution was mostly negligible so it's going to be a whole new way of doing business for the deep discounter.

Moreover, Family Dollar is an ailing business. Last week, it reported that Q2 GAAP earnings slid 18% as same store sales inched 0.5% higher while average transaction values fell.

Part of the rationale behind Family Dollar preferring to merge with Dollar Tree over Dollar General was that Dollar Tree agreed to keep Family Dollar's management on after the merger closes. Thus, Dollar Tree will keep in place those who've been the cause of Family Dollar's stagnation.

It's about to get real
Keeping the same management isn't a hopeful sign because competition in the deep discounting arena is only going to get more intense.

Wal-Mart is undertaking a major expansion into the space, bringing its hard-nose, win-at-all-costs attitude to bear on the niche. It has opened hundreds of small format Neighborhood Market stores that offer the same broad selection of goods, but without the depth of brand diversity its larger stores have, all in a 42,000 square foot space.

That's still about four times the size of an average Dollar Tree store and six times larger than Family Dollar's average store. But with a wider assortment of goods, including fresh produce, Wal-Mart has a distinct advantage.

Dollar General recognized that Wal-Mart -- not the other dollar stores -- is its main competitor. It wanted Family Dollar for itself to better go head-to-head against the retail king.

Dollar General had its ear to the ground sooner than others in recognizing the threat Wal-Mart posed to its business. These Dollar General Market stores are its answer. Photo:RustyClarkvia Flickr.

Let's get small
Dollar General leapt into the fray several years ago by opening more than 100 Dollar General Market stores, which are essentially full-service grocery stores but offering very low prices. In fact, Dollar General has been consistently able to beat Wal-Mart on price while not sacrificing profitability.

Others are going small too. Target has been opening more urban-oriented CityTargets, which are about two-thirds the size of a regular store, and it is experimenting with TargetExpress, a 20,000 square foot concept. Kroger operates the 7,000 sq. ft. Turkey Hill Marketplace and Aldi is a leading low-price grocer operating nearly 1,300 small-format stores in 32 states.

There's also competition from Trader Joe's, Publix, and other supermarkets that realize in order to grow they must go small. They might not offer the same bargain basement prices of the deep discounters, but when you start offering more selection it begins to change how consumers shop.

A coming case of indigestion
Dollar Tree isn't ready for that battle yet. It will need to integrate Family Dollar into the fold and then straighten out all that's wrong with the discount retailer.

Wars are lost fighting battles on two fronts and Dollar Tree has fights breaking out all around it. With the FTC review coming to a close and the nitty gritty details of integrating the merger only just beginning, investors would be wise to sit out this fight until Dollar Tree proves it has the ammunition to wage this war effectively.

The article Is Dollar Tree Ready to Take on Wal-Mart? 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.