Description

Dillard’s (DDS) operates retail department stores located primarily in the southwest, southeast and midwest. They have 342 department stores in 29 states all under the “Dillard’s” name, and own 75% of these stores. Dillard's is the third-largest fashion apparel and home furnishing retailer, with $8.6 billion in sales, behind Federated’s $18 billion, and May Dept Stores’ $14.5 billion. Private label program accounts for 15% of sales. Private label increases the company's control over the buying cycle--ability to amend existing orders closer to delivery date as opposed to buying poor products a year and half ahead of delivery and not being able to cancel it. Management is trying to make the company more of a product-driven retailer and one that is less reliant on key vendors, such as Tommy Hilfiger which has performed poorly.

DDS management has been faulted recently for being poor merchandisers. Their recent inability to be read market trends resulted in a company with bloated inventories and a store offering that has seemed out-of-step. The department store business is highly competitive, and such missteps can have dire consequences. In this case, the consequence is a rapid decline in like-for-like sales from the mid single-digits of the early-to-mid 1990s to the current negative figures being posted in 2001. It is important to note that DDS has not always been like this, though. In fact, it was a highly respected retailer throughout the 1990s, growing sales at a compound 11% rate and like-for-likes between 1% and 8% per year. The company has prime locations and in many cases it is THE anchor store in a mall.

Management is taking steps to turn the operations around, and even though my investment case does not rest on management’s turnaround capabilities, I will discuss a few of these steps. For one, they are paying more attention to private-label business, which has a much greater margin. The success that they’ve had over the past few years with the private-label business has encouraged them to promote them more aggressively. Second, the company has changed its markdown and buying policies to bring them into alignment with competitors. This will help ensure pricing is competitive on a seasonal basis, and should eliminate the volatility in sales relative to its competitors. They only introduced this new policy in calendar Q4 of 2000 so, until then, like-for-likes will likely remain weak. However, by Xmas ’01, the company should begin showing positive like-for-like growth (my opinion).

Interestingly, even with the supposed weakness of operations, Dillard’s does seem to have a strong financial condition. Last year, DDS generated almost $600mn of free-cash-flow (net of capex), nearly 36% of market cap, even as they posted a loss of $6mn. They spent $380 to pay off debt and $182 to buy back stock. In fact, share count has been reduced by 25% in 4 years. Last year caps off three straight, solid, cash-flow-generating years where they have generated an accumulated $1.4bn of free cash flow, which is 88% of today’s market cap. This fact alone indicates to me that the critics are too harsh with this company and it’s management.

Asset Value
An unusual aspect to this story is that DDS owns 75% of its stores. This contrasts with the 10-20% usually owned by most competitors. The stores are located in prime malls and are usually one of two anchor department stores. The other anchor tends to be either a May or Federated Store. I have a list of transactions which (if I knew how to cut and paste from Excel to VIC they would be below) are from 1994 to the present and encompasses 11 transactions involving May, Saks, Profitt’s, JC Penney, Nordstrom, and Federated with values of between $150mn to $4.1bn. The median value per store was roughly $26.7mn and $143,000 per square foot. This implies a value for DDS’ owned stores of $6.8bn (i.e. 342*75%*$26.7), vs. PPE book value of $3.6bn. I take a 25% discount to this to arrive at a store value of $5.2bn. I then add the value of excess inventory, which I arrive at by comparing DDS with May (best in class) which is roughly $600mn. I also add my estimate of the value of credit card receivables, at a 15% discount, of $900mn. I then subtract net debt of $2.3bn and also an adjustment called store-closing expenses. I assume an acquirer would have to close down 25% of DDS’ stores due to overlap and under-performance, etc. At 10x rental expenses, this would be equate to a further reduction of $730mn-$770mn. The net value to equity holders, then, is about $3.4bn, or $40-$42 per share. At the current price, DDS trades for less than half of intrinsic value. The takeaway, here, is that DDS policy of store ownership has created significant unrealized value in its store portfolio that is reflected neither in its books nor its income statement.

Potential acquirers include May and Federated, both of whom have expressed interest in the past. Without commenting on the likelihood of an acquisition, I would just state that the asset value provides a significant safety cushion while management turns the company around. Prior to the current problems, DDS earnings were regularly in excess of $2, implying a “normalized” P/E of less than 8x. After restating assets on a market value basis, the stock trades at less than half of net tangible assets as well.

As far as conventional financial figures, interest expense is offset by service charges on its credit cards, so the debt is not an issue. I would quote an EV/EBIT figure, but they tend to be skewed for department stores due to the service charges and credit card portfolios. I therefore prefer to look at P/E, P/B, and P/NTA.

Risks
Obviously execution is a risk. Insular, family-dominated management may also be a long-term risk. At this price, macro considerations do not pose a risk.

For bond investors, DDS bonds yield 9%.

Management: owns 7.3% of Class A shares outstanding and 99.4% of Class B shares. Class B shares are empowered to elect two thirds of the Directors of the company. The company is family operated with William Dillard and Director and CEO and his three sons holding posts of President, Executive Vice President and Vice President.

Catalyst

Acquisition (unlikely), turnaround in earnings (likely), or the market's recognition of the company's high quality assets (I can dream, can't I).