CHAPTER 18
Mergers and Acquisitions: Strategic Issues (The Dollar Stores)
In this and the next three chapters, we will use the acquisition of Family Dollar by Dollar Tree to evaluate a merger. Mergers are a type of investment and, as such, have the same three major elements as all investments have:
- Strategic
- Valuation
- Execution1
The primary difference between a merger and an internal investment (e.g., a plant the firm decides to build) lies in the execution. If a firm decides to build a plant, the plant can’t decide not to be built. In the case of a merger, the target firm often opposes the acquisition both in court and through a series of financial maneuvers.
As we’ve stated several times before, when doing an investment, the strategy piece should come first. However, as this is a finance book, in previous chapters we started with and focused on the valuation. Over the next four chapters, we will do the pieces in the proper order: first strategy, then valuation, and finally the execution (which is often the most interesting part). We will spend one chapter each on strategy and execution and two on valuation. All four chapters will deal with the particularly interesting, and at times contentious, recent acquisition of Family Dollar by Dollar Tree, both retailers of low-cost consumer products.
The Three Main Competitors
The concept of a “dollar store,” where everything in the store sells for $1.00,2 was created in 1955 by J.L. and Cal Turner (father and son). Their concept became Dollar General, which by the end of 2014 had 11,789 stores, sales of $18.9 billion, net profit of $1.1 billion, and a market capitalization of $23 billion. In 2014, Dollar General was the largest firm in its sector of the retail industry.
Dollar Tree competed against Dollar General, and its origins date back to 1954. At the end of 2014, Dollar Tree had 5,367 stores that totaled sales of $8.6 billion, net profit of $599.2 million, and a market capitalization of $16 billion. They were number two as measured by market capitalization or profit, but number three if measured by revenue or the number of stores.
Family Dollar was started in 1959. The founder’s son, Howard Levine, became CEO in 2003. At the end of 2014, Family Dollar operated 8,042 stores and had sales of $10.5 billion, net profit of $284.5 million, and a market capitalization of $9 billion. They were number two if measured by sales or the number of stores and number three if measured by market capitalization or profit.
Table 18.1 compares these three firms at their 2014 year-ends with a few relevant statistics.
Table 18.1 A Comparison of the Three Largest Dollar Store Retailers in 20143
| Firm | Dollar General | Dollar Tree | Family Dollar |
| Sales | $18.9 billion | $8.6 billion | $10.5 billion |
| Net profit | $1.1 billion | $599 million | $285 million |
| Number of stores | 11,789 | 5,367 | 8,042 |
| Sales per square foot | $230 | $185 | $180 |
| Market capitalization | $23 billion | $16 billion | $9 billion |
| Store locations | Rural & low income | Suburban | Small towns |
Despite the financial crisis of 2007–2008, or perhaps because of it, the three firms increased their aggregate number of stores from 18,430 in 2007 to 25,198 by the end of 2014, a compound growth rate of 4.6% a year.4
Recent History
In July 2007 KKR (which describes itself as “a leading global investment firm”) purchased Dollar General in an LBO paying $22.00 a share in a deal valued at $7.3 billion.5 KKR worked to improve Dollar General’s margins both by increasing its revenue per square foot and by reducing its costs. Just over two years later, in late July 2009, KKR announced it intended to do an IPO for Dollar General.6 The IPO, done on December 10, 2009, consisted of 34.1 million shares (Dollar General issued 22.7 million new shares, and KKR sold 11.4 million of its 295.2 million shares). The shares were sold at $21 per share for a total of $716.1 million.7 Immediately prior to the IPO, Dollar General paid a special dividend of $200 million to KKR. Immediately after the IPO, Dollar General had 317.9 million shares outstanding, giving the firm a market capitalization of $6.7 billion. Over the following five years, KKR sold all its remaining shares in Dollar General at prices of $30.50, $39.00, $45.25, and $60.71—the last sale of shares occurring on December 11, 2013.
Trian Partners (which describes itself as “a multibillion dollar alternative investment management firm”) is led by Nelson Peltz, Peter May, and Edward Garden (Nelson Peltz’s son-in-law). The firm noticed the success that KKR experienced with Dollar General and decided to purchase shares of Family Dollar. In late July 2010, Trian announced that it held 8.7 million of the retailer’s shares, or 6.6% (later increased to 8%). Peltz and Garden then began discussions with Family Dollar’s management to “enhance shareholder value by improving the company’s operational performance.”8
Around this time (the summer of 2010) Family Dollar engaged the investment bank Morgan Stanley to provide:
financial analyses of the company and advice about balance sheet matters … as an outgrowth of these reviews, Family Dollar announced an updated stand-alone strategic plan that included the incurrence of new debt, increased share buybacks, capital expenditures to remodel existing stores and the accelerated opening of new stores.9
On February 15, 2011, Trian made an offer to acquire all of Family Dollar for $55 to $60 per share in cash. The offer included allowing Mr. Levine (the founder’s son and CEO) to participate in the acquisition with Trian.10
At the Family Dollar board meeting on March 3, 2011, “Mr. Levine informed the board that he was not interested in accepting Trian’s invitation that he participate as an investor alongside Trian in connection with its proposal and confirmed that he had not had any discussions with Trian that indicated an intention to participate as such an investor.”
The board then rejected the offer as “inadequate,” stating “the continued implementation of the stand-alone strategic plan would be in the best interests of Family Dollar stockholders.”11
On May 25, 2011, Pershing Square Capital Management (an employee-owned hedge fund founded and led by William Ackman12)12 announced it had taken a 6.9% ownership percentage in Family Dollar’s outstanding common shares, rising to 8.9% by June 9, 2011.13
On November 13, Paulson and Co., announced it held 9.9% of Family Dollar’s outstanding shares and advocated for the firm to sell itself.
At this point, with three hedge funds taking major positions in Family Dollar (Trian with about 8.0%, Pershing Square with 8.9%, and Paulson and Co. with 9.9%), it appeared that Family Dollar was “in play” as an acquisition target.
To deal with the Trian bid, Family Dollar entered into a two-year standstill agreement (set to expire in July 2013). What is a standstill agreement? It is an agreement in which everyone agrees not to purchase more shares—in other words, they agree to “stand still.” Family Dollar agreed to increase its number of board members from 10 to 11 and appoint Trian’s Edward Garden to its board. In return, Trian agreed to withdraw its proposal to acquire Family Dollar and agreed to limit its ownership of Family Dollar’s outstanding common shares to not more than 9.9%.14
As can be seen in Table 18.2, from fiscal 2010 (just prior to Trian’s announcement of its investment in Family Dollar) to fiscal 2013, operations at Family Dollar were mixed. The number of Family Dollar stores increased 16.7% (from 6,785 to 7,916), sales increased 32.9% (from $7.9 billion to $10.5 billion), and net income rose 22.7% (from $358.1 million to $439.3 million). However, EBIT in 2012 and 2013 was essentially flat and fell dramatically in 2014. Importantly, Family Dollar’s sales per square foot were only $180, or 21.7% below the $230 sales per square foot at Dollar General.
Table 18.2 Family Dollar Income Statements, 2010–2014
| ($000’s) | 8/28/2010 | 8/27/2011 | 8/25/2012 | 8/31/2013 | 8/30/2014 |
| Sales | 7,866,971 | 8,547,835 | 9,331,005 | 10,391,457 | 10,489,330 |
| Operating costs/other | 7,291,373 | 7,909,763 | 8,642,904 | 9,675,295 | 10,036,728 |
| EBIT | 575,598 | 638,072 | 688,101 | 716,163 | 452,602 |
| Interest income | 1,597 | 1,532 | 927 | 422 | 190 |
| Interest expense | 13,337 | 22,446 | 25,090 | 25,888 | 30,038 |
| Income before tax | 563,858 | 617,158 | 663,938 | 690,697 | 422,754 |
| Income tax | 205,723 | 228,713 | 241,698 | 247,122 | 138,251 |
| Net income | 358,135 | 388,445 | 422,240 | 443,575 | 284,503 |
| EPS | 2.64 | 3.12 | 3.58 | 3.83 | 2.49 |
| Dividend/share | 0.60 | 0.695 | 0.60 | 0.94 | 1.14 |
| Number of stores | 6,785 | 7,023 | 7,442 | 7,916 | 8,042 |
| Sales growth | 6.3% | 8.7% | 9.2% | 11.4% | 0.9% |
| Net margin | 4.6% | 4.5% | 4.5% | 4.2% | 2.7% |
| ROA | 13.0% | 14.1% | 13.0% | 7.7% | |
| ROE | 27.3% | 38.8% | 33.9% | 17.8% |
Table 18.3 provides Family Dollar’s Balance Sheets over this period. The stock market responded to Family Dollar’s financials by increasing its stock price in line with the increase in the Dow Jones Industrial Average: Family Dollar’s stock price rose 33.7%, slightly above the 30.6% increase in the Dow Jones Industrial Average over the same period.
Table 18.3 Family Dollar Balance Sheets, 2010–2014
| ($000’s) | 8/28/2010 | 8/27/2011 | 8/25/2012 | 8/31/2013 | 8/30/2014 |
| Cash and investment | 503,079 | 237,411 | 224,885 | 180,442 | 180,020 |
| Inventory | 1,028,022 | 1,154,660 | 1,426,163 | 1,467,016 | 1,609,932 |
| Other | 129,107 | 141,773 | 117,122 | 209,547 | 312,094 |
| Current assets | 1,660,208 | 1,533,844 | 1,768,170 | 1,857,005 | 2,102,046 |
| PP&E | 1,111,966 | 1,280,589 | 1,496,360 | 1,732,544 | 1,688,213 |
| Other | 209,883 | 181,772 | 108,535 | 120,312 | 67,036 |
| Total assets | 2,982,057 | 2,996,205 | 3,373,065 | 3,709,861 | 3,857,295 |
| Short-term debt | — | 16,200 | 31,200 | 16,200 | 16,200 |
| Accounts payable | 676,975 | 685,063 | 674,202 | 723,200 | 773,021 |
| Other | 377,512 | 315,792 | 360,255 | 340,822 | 339,809 |
| Current liabilities | 1,054,487 | 1,017,055 | 1,065,657 | 1,080,222 | 1,129,030 |
| Long-term debt | 250,000 | 532,370 | 516,320 | 500,275 | 484,226 |
| Other | 256,016 | 359,706 | 493,461 | 530,309 | 578,314 |
| Total liabilities | 1,560,503 | 1,909,131 | 2,075,438 | 2,110,806 | 2,191,570 |
| Contributed capital | (244,092) | (882,675) | 63,243 | 29,430 | (58,316) |
| Retained earnings | 1,665,646 | 1,969,749 | 1,234,384 | 1,569,625 | 1,724,041 |
| Total equity | 1,421,554 | 1,087,074 | 1,297,627 | 1,599,055 | 1,665,725 |
| Total liabilities and equity | 2,982,057 | 2,996,205 | 3,373,065 | 3,709,861 | 3,857,295 |
Family Dollar’s inability to improve operations further and achieve results comparable to Dollar General led its board to consider moving away from its strategic plan to stand alone. However, rather than selling to Trian, Family Dollar began to consider partnering with another firm to enhance shareholder value.
Shopping a Firm/Finding a Buyer
Partnering with another firm can take one of two possible paths: Family Dollar could acquire another firm and have its current management run the combined firm. Alternatively, Family Dollar could be acquired by another firm. In the latter case, it is likely that Family Dollar’s current management would be replaced.15
So let’s now turn to the question: Was Family Dollar worth more with or without its existing management? That is, would a combination of Family Dollar and another firm be more valuable if Family Dollar’s management stayed in charge, or would it be more valuable if another firm’s management took over?
The economic rationale behind a merger is that the combined firm is worth more than the sum of the parts (2 + 2 = 5). This occurs for a number of reasons. The catch-all phrase to justify a merger is “synergy,” which can be real or imaginary. Real synergies involve the combined firm obtaining greater revenues and/or lower costs. This can happen because of economies of scale, increased monopoly power, and better management (including better financial and product market policies).
If the combination is due solely to economies of scale or increased monopoly power, it does not matter whose management runs the combined firm. However, if the increased value is due to better management, it obviously does. The fact that Family Dollar’s sales per square foot were the lowest of the three main competitors, all of which followed the same product market model, suggests that bringing new management to Family Dollar might be synergistic.
Statements to the financial press supported the argument that better management was sought: “The management is not doing a good job,” “I think they’re going to be forced to bring in a new manager,” “They haven’t executed it right. . . it’s a management problem.”16
At the same time, synergies created through increased monopoly power usually generate scrutiny from the Federal Trade Commission (FTC). If Family Dollar merged with either Dollar General or Dollar Tree, the combination of two of the largest three firms in an industry would obviously greatly consolidate the industry. This meant that any such deal was likely to be complicated by the necessity of FTC approval.17
What did Family Dollar’s board do? They turned to their investment banker, Morgan Stanley, for advice. Morgan Stanley recommended selling Family Dollar to either Dollar General or Dollar Tree. The bankers and the board agreed that Family Dollar would be worth more to a competitor in a merger than it was as a stand-alone firm. Essentially, Family Dollar looked around and decided that Dollar General or Dollar Tree were the leading potential buyers, so they invited them (one at a time) “out to dinner.”
Strategic Rationale for Dollar General to Purchase Family Dollar
Looking at the merger from Dollar General’s point of view: Would it make economic sense for the number one firm in an industry to buy the number two firm in an industry? Yes. First, based on the sales per square foot ($230 for Dollar General versus $180 for Family Dollar), it appeared there was substantial room for Dollar General to improve Family Dollar’s operations. Second, the purchase would enhance Dollar General’s market power (both in buying and pricing). However, it was not clear that the FTC would approve the deal. And, as always, there was the question of: At what price? Remember, there is usually a price at which an investment has a positive NPV, and there is always a price at which it has a negative NPV.
As we will discuss in Chapter 21, Dollar General, at least initially, decided to play hard to get.
Strategic Rationale for Dollar Tree to Purchase Family Dollar
Does it make sense for the number three firm in an industry to buy the number two firm in an industry? Yes. As with Dollar General, Dollar Tree could also potentially improve Family Dollar’s operations. Second, the purchase would vault Dollar Tree to number one in the industry, with the possibility of increased market power (both in buying and pricing). Additionally, Dollar Tree had less of a geographic overlap of stores with Family Dollar compared to Dollar General’s. The FTC might therefore be less onerous in its approval process.
In a press release on July 28, 2014, Dollar Tree discussed the merger and provided the following list as the “compelling strategic rationale” for its acquisition of Family Dollar:
- Creates a leading discount retailer in North America. The transaction will create a leading discount retailer in North America based on number of store locations, operating more than 13,000 stores in 48 states and five Canadian provinces, with sales exceeding $18 billion and over 145,000 associates.
- Complementary business model across fixed– and multi–price point. Dollar Tree is the nation’s leading operator of fixed–price point stores, selling everything for $1 or less, and Family Dollar is a leading national operator of multi–price point stores providing value-conscious consumers with a selection of competitively priced merchandise in convenient neighborhood stores. Dollar Tree intends to retain and to grow each of its brands and the Family Dollar brand going forward and will optimize the combined real estate portfolio.
- Targets broader range of customers and geographies. Dollar Tree targets customers within a broad range of Middle America with stores located primarily in suburban areas, and Family Dollar targets low- and lower-middle-income households through its urban and rural locations. The transaction will enable Dollar Tree to serve a broader range of customers and deliver even greater value to them.
- Leverages complementary merchandise expertise. Dollar Tree’s assortment consists of a balance between consumable merchandise and variety/seasonal merchandise. Family Dollar’s assortment consists primarily of consumable merchandise and home products. The complementary assortments will enable the Dollar Tree and Family Dollar brands to expand category offerings and to deliver a broader, more compelling assortment to all customers.
- Generates significant synergy opportunities. Dollar Tree expects to generate significant efficiencies in sourcing and procurement, SG&A, leverage, distribution and logistics efficiency, and through format optimization. Dollar Tree anticipates that the transaction will result in an estimated $300 million of annual … synergies to be fully realized by the end of the third year post-closing.
- Enhanced financial performance and improved growth prospects. The transaction is estimated to be accretive to cash EPS within the first year post-closing, excluding one-time costs to achieve synergies. Dollar Tree will be better positioned to invest in existing and new markets and channels and to grow its store base across multiple brands. The combined company expects to generate significant free cash flow, enabling it to pay down debt rapidly.
Press reports aside, there did seem to be a strategic fit between the dollar stores. The potential synergies included economies of scale in purchasing and greater market power. Another potential synergy was better management, as evidenced by the fact that both Dollar General and Dollar Tree had higher sales per square foot and better cost control than Family Dollar. As Trian’s Mr. Gardner noted:
Family Dollar was collecting just $180 in sales per square foot annually in its stores, compared with $230 at Dollar General. . . . Dollar General could pay a big price, because their great management could bring their metrics to Family Dollar.18
Elsewhere the financial press seemed to have the same opinion. For example:
Family Dollar will be able to procure goods from Dollar Tree’s vendors at better prices. Also, both of them can use the same distribution centers and delivery trucks that can help them reduce costs. Overall, this can help Family Dollar offer products at competitive prices.19
Summary
This chapter has explained the strategic reasoning behind the purchase of Family Dollar by either Dollar General or Dollar Tree.
Now, imagine you are at a meeting where you are a director of either Dollar General or Dollar Tree voting on the Family Dollar acquisition. You have been told by your management that this makes strategic sense. You have been told by your investment banker that the price being discussed is fair. Furthermore, you know another firm is also interested, and you must consider a potentially higher competing offer for Family Dollar. The board meeting only lasts for a few hours. The motion is moved and seconded. It is time for your vote. How do you vote? Ah, perhaps before you answer, you’d like to know more about the valuation and execution.
Coming Attractions
Eventually, a bidding war between Dollar General and Dollar Tree took place, the details of which will be discussed in Chapter 21. However, first we will value Family Dollar in Chapters 19 and 20.