Icahn's Got It Wrong -- Here's The Dollar Store To Own

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Dollar stores have been on a tear since the financial crisis. Consumers flocked to the low-price stores in an effort to pinch pennies.

But even as the economy has rebounded, many of these companies have continued to perform fairly well. It appears they have integrated themselves into the lives of shoppers to the point that dollar stores are becoming one-stop shops.

This comes as they have expanded into tobacco and consumer staples. Dollar stores are also typically much smaller and easier to navigate than the likes of big-box merchants like Wal-Mart (NYSE: WMT ) or Target (NYSE: TGT ) , which makes them ideal for consumers who are short on both time and money.

But not all dollar stores have continued to perform well throughout the strengthening economy. One of the biggest players in the market, Family Dollar (NYSE: FDO ) , has come under fire from billionaire activist Carl Icahn.

Family Dollar's net income has grown at an annualized 7.4% over the past three years, which is impressive on a stand-alone basis. But when stacked up against industry leader Dollar General (NYSE: DG ) , which has seen annualized growth of 17.7% over the same period, it appears Family Dollar is in need of a makeover.

Icahn owns nearly 10% of Family Dollar, and he is pushing the company to sell itself. He joins activist Nelson Peltz of Trian Partners, who owns 7.3% of the company. On a performance basis, shares of Family Dollar have underperformed both Dollar General and the S&P 500 over the past three years.

There's speculation that Icahn will either push Family Dollar and Dollar General to merge or get Wal-Mart to buy the struggling retailer. There's also the potential for a private equity buyout.

Different Business Models
Wal-Mart and Family Dollar are very different, catering to different customers. It seems unreasonable that Wal-Mart would want to get in the discount business, especially since it's starting to roll out its own small-format stores.

Meanwhile, why would Dollar General buy up an underperforming retailer when it can open up new stores of its own to accelerate growth? Dollar General's stores are bringing in close to $159 million per store, compared with Family Dollar's $128 million.

Dollar General has plenty of room to continue increasing its market share. It has a 11,000-plus store base and plans to add another 700 this year. Compare that to Family Dollar's 8,100 stores and Wal-Mart's 5,000.

The key for Dollar General, compared to Wal-Mart and Target, is that its smaller stores are ideal for small towns. Its discount-pricing model is well-received in rural areas, giving Dollar General a large addressable market.

Hedge Fund Interest
While Family Dollar does have a major activist that owns nearly 10% of the company, Dollar General has a "who's who" among hedge fund owners. A couple of the largest shareholders are "Tiger Cubs" Stephen Mandel of Lone Pine Capital and Chase Coleman's Tiger Global. Fellow billionaires Leon Cooperman and John Paulson are just a couple of the newest owners of Dollar General as of last quarter.

The hedge fund interest is definitely more robust in Dollar General. This comes as the company is a consistent performer: Last year marked the twenty-fourth straight quarter that Dollar General saw growth in comparable-store sales.

While Dollar General doesn't offer a dividend yield (compared to Family Dollar's 1.8% yield), it is active on the buyback front. Over the past three years, Dollar General has reduced its shares outstanding by 11.2%, compared with Family Dollar's 3%.

Family Dollar appears to have set a stock price floor, having bounced from the $50 to $55 range a number of times through the years. This comes as buyout speculation has circulated since 2011, when the retailer successfully fended off the buyout attempt by Trian Partners.

Shares of Family Dollar are trading at a forward price-to-earnings (P/E) ratio of 20 based on next year's earnings estimates. Meanwhile, Dollar General trades at a forward P/E of 15. But Family Dollar's net profit margin over the past 12 months is a full 2 percentage points below Dollar General, coming in at 3.8%.

Risks to Consider: Dollar General managed to perform well during the tough economic environment, but as the economy rebounds, consumers may eventually start moving back to upmarket retailers. The other issue is Dollar General's aggressive store growth, where it could hit saturation and start to see a decrease in per-store revenues.

Action to Take --> My price target on Dollar General is $80. That's upside of 30% and is based on the assumption that Dollar General should be trading more in line with the industry average as well as its five-year average P/E multiple.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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