Dollar General Corp. (NYSE:DG) has received an upgrade from analysts at Johnson Rice & Company in the wake of its bid to buy Family Dollar Stores, Inc. (NYSE:FDO). Analysts at Jefferies reiterated their Buy rating on Dollar General after the bid, saying they like the combination better than a merger with Dollar Tree, Inc. (NASDAQ:DLTR). However, they say a bidding war for Family Dollar is probably imminent.

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Dollar General upgraded to Overweight

In a report dated Aug. 18, 2014, Johnson Rice & Company analysts David Mann and Jill Caruthers Nelson upgraded Dollar General from Equal Weight to Overweight. They think a merger between Dollar General and Family Dollar is “transformative and makes a lot of sense,” noting that the two discount retail chains have business models that are similar and will see “significant” synergies from a merger.

On Monday, Dollar General revealed its $78.50 per share cash offer for Family Dollar. Mann and Nelson think this could increase but that Dollar General will probably prevail. The current offer values family Dollar at 11.6 times trailing TTM EBITDA or an enterprise value of $9.7 billion. This is significantly better than the $74.50 per share cash and stock offer from Dollar Tree—even though Dollar General will have to pay the $305 million breakup fee to Dollar Tree if it wins the bidding war.

Dollar General already has the financing in place for the merger and expects to offer a mix of revolver / term loans and senior notes to cover it. The analysts estimate that the financing rate will be between 5% and 5.5%.

Why Dollar General is a better match for Family Dollar

The Johnson Rice analysts say a merger between Dollar General and Family Dollar makes more sense because it would create the top small box retailer with 20,000 locations and $28 billion in pro forma revenues. They estimate between a $550 million to $600 million run rate in synergies in the three years after the deal closes. That’s twice the $300 million in synergies that Dollar Tree is estimating. Dollar General expects the synergies to come from management, margin gains through better purchasing and lower stem mileage and SGA savings.

Analysts at Jefferies also think Dollar General is a better match for Family Dollar. In their report also dated Aug. 18, 2014, Daniel Binder and his team offer a much higher synergy estimate, which they think will end up being closer to $1 billion. They reiterated their Buy rating and $75 per share price target on Dollar General.

Who will win a bidding war?

The Jefferies team also said they don’t think Dollar General’s bid will be the last one for Family Dollar. They think the significantly higher synergy will give the retail chain more flexibility so that it can win a bidding war, if it happens. They had set an acquisition price target at $79 per share for Family Dollar back when they believed Dollar General was the only company that would bid. However, they say the final acquisition price could be higher because of an expected bidding war with Dollar Tree.

They see a couple of possible scenarios. First, they say Dollar Tree could make a counterbid, which they think will have an increased stock component to pay for it. The other possibility is that Family Dollar keeps tracing the Dollar Tree offer and argues that the antitrust risk is lower. The result could be a sweetened offer from Dollar General, even if Dollar Tree doesn’t increase its bid.

However, they don’t think the Federal Trade Commission will have problems with a merger between Family Dollar and Dollar General. They also think Dollar General is ready to deal with the issue if it happens.