Family Dollar Stores (NYSE:FDO) is in the news after Carl Icahn disclosed a 9% position in the company after hours on June 6. Factoring in Trian Management and Paulson & Co.’s existing stakes, activist investors now own 23% of the company.
Icahn has not publicly announced his intentions for FDO, but it has been reported that he plans to push for a merger with Dollar General or some other partner. Others have suggested that Icahn may be interested in taking the company private. FDO has responded to that possibility by introducing a poison-pill plan with a 10% ownership threshold.
A Positive Development
Whatever course Icahn pursues, shakeups in management looks like a positive development for the company. FDO has struggled in recent years, and its return on invested capital (ROIC) has fallen from 15% in 2011 to 11% in 2013. More recently, same store sales dropped 4% in 2Q14 and FDO announced it would be closing 370 stores.
FDO’s financial performance compares poorly to the results of a competitor such as Dollar Tree, which has maintained a steady 15% ROIC for the past three years. DLTR also increased same store sales by 2% in the most recent quarter. DG has a lower ROIC than FDO but has managed to maintain same store sales growth.
Likely Scenatio
The question is not whether a shakeup is needed at FDO, but whether Icahn will be able to make a positive impact. The most likely plan seems to be a merger with DG, but there are several issues that could derail this plan. Most notably:
- It might not make sense for DG. The most DG could pay for FDO and still earn an ROIC above its weighted average cost of capital (WACC) is $10.3 billion. I base this number off of FDO’s $550 million after-tax profit (NOPAT) and DG’s WACC of 5.3%. After the post-Icahn announcement surge, FDO has an enterprise value of ~$11.2 billion. Unless DG expects significant synergies, a merger does not make economic sense at current valuations.
- It doesn’t address core issues. One of the biggest problems for FDO recently has been the increasing percentage of its sales made up by low-margin consumables, while higher margin categories suffer. Consumables have increased from 67% of sales to 72% of sales in the past two years. Unfortunately, this problem is even worse at DG, where consumables now make up 75% of sales. Both companies have seen gross margins decline by roughly one percentage point over the past few years.
- Scale only helps so much. The biggest competitor for both FDO and DG is Wal-Mart (NYSE:WMT). A combined FDO and DG would have $28 billion in annual revenue compared to $475 billion for WMT. A merger might produce some economies of scale, but it wouldn’t put them at any less of a disadvantage to the retail giant.
Taking the company private involves some of the same issues. FDO was reasonably cheap at ~$60/share before Icahn disclosed his stake, but management’s hostility to an activist buyout, as evidenced by the poison pill plan, means a significant premium would likely be required.
Going Private
More importantly, taking FDO private doesn’t inherently solve any of its problems. The experiences of Bill Ackman at JC Penney (NYSE:JCP) and Eddie Lampert at Sears (NASDAQ:SHLD) show that a good activist investor is not always so good at running a retail business.
Icahn bought into FDO because he believes that the stock is cheap due to poor management. On that point I agree with him. However, I’m less convinced that he will be able to fix the company’s woes. Icahn might be able to engineer a sale to DG or someone else that will earn himself and other shareholders a quick profit, but unlocking long-term value will be a much more difficult task.
Sam McBride contributed to this report.
Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, or theme.