Family Dollar Stores, Inc. (FDO), Dollar General Corp. (DG): Would These Two Companies Benefit From a Merger?

An improving economy is good for most stores, but not dollar stores. The deep-discount chains reaped enormous profits during the financial crisis and ensuing recession because of falling incomes and high unemployment. However, as the economy improves — and as competition from Wal-Mart Stores, Inc. (NYSE:WMT) and other stores emerges — profits will be harder to come by for this recession-resistant group.

Given the tougher road ahead, now is a good time for dollar-store giants Family Dollar Stores, Inc. (NYSE:FDO) and Dollar General Corp. (NYSE:DG) to combine strengths in a merger of equals. But, even if this game-changing combination does not take place, both companies have a bright future.

Family Dollar Stores, Inc. (NYSE:FDO)

A natural fit

The two businesses are a natural fit. Family Dollar Stores, Inc. (NYSE:FDO) is concentrated in urban areas, while Dollar General Corp. (NYSE:DG) has more locations in rural areas — meaning a combination would not require a massive closure of competing stores.

In addition, the combined company would become the largest dollar-store concept in the United States; it would have over 18,000 locations — far more than Wal-Mart Stores, Inc. (NYSE:WMT)’s 286 Neighborhood Market stores. The combined purchasing power and cost synergies would widen margins and allow the stores to compete for a larger share of low-income consumers’ spending — even competing with Wal-Mart Supercenters.

Although the combination would eliminate redundant costs, the real value in a merger would come from lower competition in the companies’ westward expansion. Both companies are expanding westward at a feverish pace, with each planning to open more than 500 stores in 2013 (Family Dollar has 7,700 locations, and Dollar General has 10,500). A merger would slow the pace of expansion to a more cautious rate, as it will no longer be necessary to reach a market before a major competitor locates there.

Meanwhile, both companies are changing their merchandising strategy to include more traditional grocery offerings, including lower-margin products like produce, meat, and cigarettes. Although this change is squeezing margins, it’s also enabling the companies to capture a larger portion of their target customers’ spending. According to a recent investor presentation, Family Dollar Stores, Inc. (NYSE:FDO) increased the amount each customer spends at its stores by over 30% from 2007 to 2012.

An enticing merger

Family Dollar Stores, Inc. (NYSE:FDO) and Dollar General Corp. (NYSE:DG) are pursuing similar strategies that also compliment one another. The only major external threat to their continued success — aside from a booming economy — is competition from drugstores (such as Walgreen and CVS) and traditional retailers (such as Wal-Mart).

If the two companies merge, they could slow down expansion, conserve cash, and focus on increasing same-store foot traffic to take a greater share of consumer spending from companies like Wal-Mart.