Thursday, June 12, 2014

What is Carl Icahn Thinking in Taking an Interest in Family Dollar?

Last week, the financial world learned that Carl Icahn had taken a 9.4% interest in Family Dollar.  The question for this move is, why?  Let's start by looking at the industrial sector, which the FINVIZ website classifies as "discount variety stores."  The top three players here are Wal-Mart, Target and Costco, which no one is going to target for a hostile takeover, simply based on the sheer size of the companies. 

However, the next group of companies -- Dollar Tree, Dollar General and Family Dollar -- are smaller and therefore far more attractive.  From a purely tactical perspective, Family Dollar has the smallest market cap at 7.56 billion, meaning this company is simply easier to attack.  And, to make this possibility more attractive, family dollar stock has under-performed competitors over the last three years by a wide margin:

When a stock underperforms at this level its for one (or a combination of) of three reasons: the sector is in a downturn, management is not performing well or the market is simply over-looking a bargain.  Icahn clearly believes the latter is the case.  And, I agree with him.

FDO is clearly the "red-headed stepchild" of the group.  And, it's not for lack of revenue performance:

As the chart shows, the year over year revenue growth of FDO, DLTR and DG are all solid (FDO is in orange and has not reported its final 2014 numbers yet).

What Icahn is thinking is this company can be merged with one of its competitors to achieve better financial efficiencies.  Consider a comparison of the three companies' net margins:

Dollar tree is clearly the winner of the three in financial efficiency, with a net margin between 2%-4% higher than FDOs.   

And it's not just in the net margins.  The company's cash/investment ratio has been positive for the last three years, indicating they can self-finance expansion through existing sales.  An expand they have, increasing their store count from 6655 in 2009 to 7916 in 2013.   They have also moved to better manage their own internal infrastructure:

At the end of fiscal 2013, each distribution center served an average of 720 stores, compared to 744 stores in fiscal 2012. Our tenth distribution center in Ashley, Indiana, began operations in June 2012, and our eleventh distribution center in St. George, Utah, began operations in July 2013. The opening of the eleventh distribution center reduced the average stem miles between our distribution centers and our stores by approximately 7% at the end fiscal 2013, as compared to the end of fiscal 2012.
The bottom line is pretty clear: this is a good company that could easily be merged into one of its larger rivals, thereby achieving better efficiencies.  What Icahn has done is to purchase a solid percentage of shares in a small (as expressed in market cap) company that will make a good partner for one of its two larger rivals.