Description

Like an old-fashioned “2 for 1” sale, patient investors can choose whether to pay for the retailer or real estate and get the other for free. Ignoring the real estate completely, Dillard’s is a very conservatively capitalized retailer (<1.0x net debt / EBITDAR) that is growing comparable sales, opening new stores in new markets and yielding 15% (FCFE). Excess cash is being used to repurchase shares, which is highly accretive below $85 per share. 

The investment thesis for Dillard’s isn’t radically new. Rather, this is a proven long-term compounder with aligned stakeholders, a superior capital allocation track record and prudent managers who care deeply about their name on the building. What is new is that the current risk-reward is, arguably, the most compelling in recent history based on retail free cash flow (yield and stability) as well as multiple data points that suggest the real estate could be worth as much as the entire retail enterprise.

Dillard’s owns 90% of its real estate. No other department store owns anywhere near that amount. Before delving into what this could be worth on its own, it’s an important consideration when looking at Dillard’s as a pure retailer (assuming that the department store is the highest and best use for the real estate). Depreciation has been coming down from $260m per year in 2010 to $225m expected in 2018 while capital expenditures has remained between $95m to $165m with $140m expected in 2018. The D&A less capital expenditures “pick-up” of $85m equals +$3 per share. For anyone looking at reported EPS of ~$7.50 per share, the cash earnings are +40% higher.

Dillard’s comparable store sales track close enough to Kohl’s and Macy’s while everyone seems to be lagging Nordstrom’s. As such, it doesn’t seem as though the D&A less capex “pick-up” represents underinvestment. An often overlooked aspect of the business is that Dillard’s owns the construction company that does most of the development, which keeps costs down. Cost management is a clear focus, which makes sense given the high insider ownership.

At a 10% FCFE yield on an underleveraged retailer, shares of Dillard’s would trade at ~$110 per share. The share price would represent <14x EPS and ~5.5x EBITDA.

A final consideration before addressing the owned real estate is the shareholder composition. The Dillard family owns all of the 4m Class B shares and insiders own ~3.4m of the 23.6m Class A shares outstanding. The employee ownership program (held through Newport Trust) owns 7.25m Class A shares bringing the total insider ownership to ~14.65m shares of a total 27.6m Class A and B shares outstanding (53%). There are ~6m shares short (~45% of the float not counting Capital Research – 7%, Blackrock – 7.7%, Dimensional – 7% and Vanguard – 5.4% who aren’t likely sellers). At $77 per share, Dillard’s could buy back +3.5m shares (+25% float) with annual FCFE.

The large short position coupled with a company that provides no earnings guidance and hosts no investor calls or meetings results in frequent short squeezes and general volatility in the share price. Barring a market meltdown, one could expect the next squeeze before year end. 

The real estate portfolio is quite valuable and frequently targeted by activists who feel compelled to point out something of which the Board is very aware. It’s not an accident that Dillard’s owns 90% of its real estate. Nor should it be overlooked that Dillard’s is the only department store with two CFOs (one who’s background is with the real estate and construction businesses). 

Ignoring the retail business that generates $300m of annual FCFE, it’s worth considering what the real estate could be worth on its own; what could Dillard’s realize if it pursued an orderly liquidation? The current tangible book values is $1,675m ($61 per share). Dillard’s owns ~44 million square feet of retail real estate that has been on the balance sheet for a long time. Occasionally a property trades and in the last 5-6 years, 10 locations have been sold for redevelopment (some retail, other for residential re-zoning, one for a church) with an average gain of $3.5 million per location (~$20/sq.ft.). These weren’t the better properties but assuming they represent an average of the “unbooked” real estate value on the balance sheet, there would be an extra $900 million (+$30 per share) of liquidation value; a mark-to-market on tangible BV would be +$90/share. Hence the high accretion on buybacks.

Retail redevelopment, densification and the introduction of mixed-use tenants to high traffic retail real estate has been a common theme amongst real estate firms. Brookfield just closed their acquisition of GGP – much has been said about that transaction, including by Brookfield. Seritage has also been getting a lot of headlines these days. Eddie Lampert and Warren Buffett have both backed this retail real estate recapture and redevelopment enterprise. 

Seritage was spun-out from Sears Holdings as a “fully integrated REIT” that owned ~40 million square feet in 258 shopping centers across 49 states. Sears made up 82% of leased footage and 56% of rent for Seritage, which had recapture rights on 22 million sq.ft. leased to Sears. The average Sears rent is ~$4.50/sq.ft. Seritage intends to recapture, redevelop and release at 4.0x – 5.0x lease spreads and generate +10% unlevered returns. On a consolidated basis, Seritage trades at +$105/sq.ft. which would equate to ~$150 per share for Dillard’s, net of the debt and ignoring the +$300m (+$11 per share) of annual free cash flow from retail. In fairness, Dillard’s doesn’t have Seritage’s management team or financing to pursue redevelopments.

Also, real estate is tricky. Every retail land owner has a file on each of their properties with traffic, demographic trends, new construction activities, current retailer performance, likely vacancies and ideal tenants who could replace add to the existing asset. As well, every piece of real estate owned is its own unique legal agreement.

Rather than assume the Sears portfolio is approximately representative of the Dillard’s portfolio, one can just focus on the best Dillard’s properties. There are ~80 locations in “Tier 1” malls operated by Simon Properties and GGP as well as another ~20 locations in malls operated by other “A-mall” owners (i.e. Macerich, Westfield). These ~100 locations represent ~15.0 million sq.ft. of owned real estate. 

When Seritage was originally spun-out from Sears, all of the properties were individually valued. There were 31 Tier 1 properties put into JV-structures with GGP, Simon and Macerich as partners. These 31 properties were initially valued at $157/sq.ft. Last year, GGP purchased the remaining 50% of eight of the original 12 assets in the JV for $120/sq.ft. as well as a new 50% interest in an additional five properties (Tier 2) that would be added to the JV-structue. For the Tier 2 properties, GGP paid $47/sq.ft. for 50% ($94/sq.ft. for 100%). 

On the Q2’17 conference call, GGP commented that market rates on the properties were $30/sq.ft. and $25/sq.ft. for the Tier 1 & 2 properties, respectively. Based on Q2’18 calls from Macerich and Simon Properties, brick-and-mortar retail activity has increased and leasing demand is accelerating. 

Assuming a required unlevered return of 8.0% - 10.0%, these properties would be valued at ~$280 - $350/sq.ft. once developed and released. Seritage and other mall operators have redeveloped properties at costs of $100 - $200 per square foot. The implication is that someone could pay ~$150/sq.ft. for the right to recapture mall real estate, redevelop, release and earn 8.0% - 10.0% unlevered. 

Being a bit conservative, at $125/sq.ft., the Tier 1 Dillard’s real estate would be worth ~$1,900 million to a developer. Assuming Dillard’s could use $300m of annual FCFE to pay off $500m in net debt and sever any retail severance and store closure liabilities, Dillard’s should receive ~$70 per share for just its best properties.

The real magic happens if and when Dillard’s gains the confidence that it can downsize its locations and maintain profitability. Mirroring the Seritage structure, Dillard’s could pay a 7.0% cap rate ($133 million or $8.75/sq.ft. per annum) and receive $1,900 million from a developer for just its best real estate (1/3 of owned properties). Assuming Dillard’s could move in the same direction of other retailers with a smaller footprint while retaining the same quantum of sales and profits, a sum-of-the-parts value of ~$110 - $135 per share seems attainable near-term without any upside from higher future rents. 

The key takeaway on the real estate is that shares of Dillard’s embed the value of a Seritage, some permutation of which is likely where this ends up, at some point in the future.

Catalyst

Strong sales, earnings, cash flow expected in H2'18; possible short squeeze; opportunistic and material insider buying makes MBO unlikely. 
Proxy statement review reveals potential lack of 3rd generation succession planning (no Board representation) and large financial payoff from a change of control transaction, however unlikely.