How Will Merger Change Family Dollar, Dollar Tree Stores?

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Now that Family Dollar (FDO) shareholders have voted to merge with Dollar Tree (DLTR) over rival suitor Dollar General (DG), what kind of makeover should shoppers -- and investors -- expect to see in the combined company's stores?

The answer lies in how the battle between dollar store giants was finally resolved last week. Family Dollar shareholders chose to merge with Dollar Tree over much larger competitor Dollar General in part due to antitrust fears. Family Dollar had estimated regulators would force 3,500 to 4,000 store closings under a Dollar General merger, versus the 500 closings that Dollar Tree now projects as it moves to close the deal.

So leaving stores mostly status quo for now will keep regulators happy. But there's also a business reason to avoid rushing in with dramatic changes to either format: The two companies operate under very different models.

At Dollar Tree, most items actually retail for $1. The company imports a substantial amount of merchandise from China, and it specializes in buying closeouts and promotional merchandise to pass on to patrons, so its product line is ever-changing. The company describes the Dollar Tree shopping experience as "fun, fast, and friendly, with surprising products engendering a thrill-of-the-hunt atmosphere."

Family Dollar, however, can be thought of as a dollar store in name only. Its price points range from $1 to $20 and beyond. Its inventory doesn't change with the same frequency as Dollar Tree's, because Family Dollar customers expect to see the same products from week to week. Being the friendly neighborhood discount store with a predictable selection worked well decades ago, but today it means that Family Dollar must compete with big-box titans like Walmart (WMT), only with less purchasing power, and this formula has hurt the company's results in recent years.

Where Change Is Likely

Shoppers may find the first notable differences on the food shelves of Family Dollar. These days, dollar stores are increasingly acting like grocers, since food and other consumables (beauty aids, household cleaning goods, etc.) pull shoppers through the door. Once you're in, dollar stores try to convince you to drop more nonconsumables into your shopping cart before checking out. Unfortunately for retailers, consumables carry slimmer margins than other products.

Dollar Tree has proven to be savvy at this game, increasing both sales and net income as it has added more food shelves and freezers to its stores. The grocery trend hasn't been as kind to Family Dollar, which has continually blamed the lower margins associated with food and other consumables for its shrinking profits.

Walk through a Dollar Tree's food aisle or scan its freezer section, and you'll find a sea of private-label $1 food items, evidence of the company's skill in purchasing from both food giants such as ConAgra (CAG) and multiple independent distributors.

Family Dollar's consumables, on the other hand, skew toward well-known brands. During fiscal 2014, nationally advertised brands from the likes of Procter & Gamble (PG), Nestle (NSRGY), and Colgate-Palmolive (CL) accounted for roughly 71 percent of Family Dollar's sales.

Dollar Tree's consumption credentials may help stretch the family's dollar. As the two companies combine their purchasing power and streamline distribution, consumers may see more private-label $1 food and other consumable items in Family Dollar Stores. Inserting as many of these products as possible among the labels loyalists expect to see could help revive Family Dollar's lagging profits.

Family Dollar Will Help Dollar Tree "Deal"

Family Dollar will extend some efficiencies to Dollar Tree as well. Roughly 200 out of 5,000 Dollar Tree stores operate under the brand name "Deals." Deals stores are closer in format to Family Dollar locations, with the average item price extending well past $1. Family Dollar's purchasing strength with global manufacturers means that Deals customers may soon see more attractive brand names in their local stores. If offering more sought-after products lifts sales, the Deals store base could expand more quickly than previously anticipated.

Dollar Tree may also benefit from Family Dollar's foray into the "sinful" side of consumption. Family Dollar began experimenting with wine and beer sales last year. Initial results have been promising, and the company will accelerate these sales from 500 stores to 2,000 by the end of the current fiscal year. While wine and beer can't be profitably sold at the magic $1 price point in Dollar Tree locations, they may be a great fit for Deals stores. And as with food, the two chains can combine their financial strength when buying from distributors to increase profits.

Dollar Tree is aiming to close the transaction this March, subject to satisfying the FTC and various state attorneys general. After that, there may be just enough change in the combined stores' selections to keep both shoppers and investors happy.

Motley Fool contributor Asit Sharma has no position in any stocks mentioned. The Motley Fool recommends Procter & Gamble. Try any of our Foolish newsletter services free for 30 days. Check out our free report on one great stock to buy for 2015 and beyond.
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