Description

Introduction

Dillard’s is a contrarian deep value investment with greater than 50% upside in our base case with significant incremental upside from the prospect of strategic actions.   Investors seems to be eager to buy retail hard asset/ real estate plays with turnaround potential (see SHLD or JCP) that are cheap on normalized 2015-2017earnings but appear to be disinterested in a massively cash generative business with significant unencumbered real estate (already tax efficiently placed in a REIT structure!) and a management team focused on returning capital to shareholders.  For the current year, we believe that DDS will generate in excess of $10 per share of FCF (which at the current quote is roughly a 13% FCF yield) and in excess of $12.50 of FCF in their next fiscal year (roughly calendar 2014). The company has historically (and we expect on a forward looking basis) used free cash flow to repurchase shares. Insiders own 41.5% of the current outstanding equity and have not been sellers of stock.  As a result, DDS has been repurchasing roughly 20% of the float annually. At the current quote, DDS will retire the entire public float in 4 years.  At 10x FCF, DDS shares will be worth $120 each by year end in our base case, and there is substantial incremental upside if DDS were to monetize its internal REIT (87% of real estate is owned), offer itself for sale in an auction process, or accelerate the pace of its buyback program. DDS is not well covered by Wall Street analysts, rarely meets or speaks with investors, and does not host quarterly earnings calls. As a result, the DDS story is not well understood by the market, creating an opportunity for value investors.

Overview

Following the financial crisis, DDS embarked on a strategic shift from the lower / mid-tier (KSS, Macy’s) up to Bloomingdale’s / Nordstrom’s merchandise assortments, customers, and ultimately price points. DDS has focused on higher margin segments such as handbags, accessories, footwear, and luggage. As a result, DDS has improved retail gross margins YoY and posted positive SSS growth in 10 straight quarters while keeping SG&A flat. DDS has reduced the diluted shares O/S from 55.2mm in Q2 2011 to 46.3mm in Q2 2013 (even though no shares were repurchased in Q2 2013).

Despite this exceptional performance, management is not well regarded by the few analysts who cover it, due in part to their lack of interaction with the Street and the perception that it is run like a private company by the Dillard family (which is true). Street estimates for 2014 are too low and do not give DDS the benefit for using its FCF, which they have said will be put towards share repurchases.

Valuation

We forecast that DDS will generate $500mm of FCF, or $12.50 per share, in excess of our forecasted $10+ EPS, due to cap-ex at levels well below D&A (2013 forecast cap ex: $125mm and D&A: $261mm). YTD, DDS has invested $146mm in working capital, which should reverse through year end, implying $400mm of FCF in the 2H of 2013, which should effectively all be used to repurchase shares. Valuing DDS at 10x 2014 FCF of $500mm implies a share price of $120 at year end, after giving credit for 2H FCF. We believe this 10% FCF yield is conservative, given the stability in DDS business (evidenced by the 2Q positive gross margin expansion and SSS growth despite the weak retail environment) and its excellent capital allocation policies (substantially all FCF to share repurchases).

Upside Opportunities

We believe DDS has several potential avenues to unlock its significant underlying value in excess of the valuation described above, which assumes DDS continues on its current stated course. Curiously, DDS did not buy back a single share in the 2Q 2013, despite weakness in its share price after a JPMorgan report erroneously reported they believed the company had indicated its gross margin would contract in the quarter vs. the prior year. Despite issuing a non-committal press release, DDS did not buy back any stock during the quarter, before or after this incident. Although the press release did not mention the lack of repurchases, and it is possible it was simply cash management during a negative working capital period, we believe the lack of any repurchase was fishy, to say the least. 

This is a quote from their annual meeting:

May 18, 2013 -Little Rock,Ark.- Dillard's, Inc. (DDS-NYSE) (the "Company" or "Dillard's") conducted its annual meeting of shareholders today inLittle Rock,Arkansas.

Dillard's Chief Executive Officer, William Dillard, II, provided an overview of the Company's fiscal year 2012 and first quarter 2013 performances. During the meeting, Mr. Dillard reflected on Dillard's favorable financial results in the periods discussed and stated that the Company should generate more cash in the near term than is required for operations. He noted the Company will consider uses for the potential excess cash which could include increased dividends and/or share repurchases.

Since that announcement, Dillard’s increased the quarterly dividend from 5 cents to 6 cents and repurchased zero shares.  That incremental 4 pennies a year is utilizing 1.8mm of the 500mm in excess free cash flow.

Options to create significant shareholder Value

1)       REIT: DDS owns 87% of its real estate, and set up an internal REIT during calendar 2011 to house it. DDS in its 10-K described the timing as taking advantage of expiring tax benefits, and since has not given any indications on its plans for the REIT. We believe that spinning out or partially monetizing the REIT would create significant value for shareholders (and remember insiders are >40% of the shareholders). DDS is earning FCF far in excess of its requirements currently and could invest some of that in rent, and the tax / multiple arbitrage would create more value than its current plan of repurchasing shares today

2)       M&A: DDS’ stable and strong cash flows would make it an ideal target for private equity, who could probably wring out even more efficiencies from the essentially family-run business. In addition, Saks and Neiman Marcus have both recently been sold to private equity making  a combination, with significant synergies, possible.

3)       Capital allocation strategy update: In Q3 2012, DDS did not repurchase any shares under its programs, and subsequently announced a large special dividend. While this was likely for tax reasons before 2013 changes, it is possible DDS could be gearing up for a change in capital allocation policy, either through an accelerated buyback or dividend of some kind

4)       The four year going private plan:  At the current quote, the company will become private in four years.  We think the market will become smart to this plan at some point, and will force the company to pay a premium for taking the company private by re-rating the equity valuation.  This outcome should generate outsized returns on the value of the remaining public float.

Bear Case and Guidance

The bear case on DDS (outside of the issues described above with regard to Wall Street coverage and their communications with the Street) is currently based on elevated inventory levels at the end of Q2, and the potential for mark-downs in Q3 and Q4 hitting gross margins. DDS stated in its 10-Q: “Inventory in total and comparable stores increased 7% and 8%, respectively, as of August 3, 2013 compared to July 28, 2012.  A 1% change in the dollar amount of markdowns would have impacted net income by approximately $3 million and $4 million for the three and six months ended August 3, 2013, respectively.”

We believe the inventory levels are potentially ~$70mm elevated, and the risk to margins is already more than reflected in the current share price, after trading down post earnings. Assuming 20-30% markdowns to this “excess inventory”, we believe the risk is $14-21mm dollars in Q3, or $.20 - .30 EPS or roughly 2-3% of annual free cash flow.

Although DDS does not host investor calls, they did provide substantive guidance in the recent 10-Q, which is the basis for our annual estimates:

Net sales: “We believe that we may continue to see some sales growth in the retail operations segment during fiscal 2013 as compared to fiscal 2012; however, there is no guarantee of improved sales performance.”

Gross profit: “We believe that gross profit from retail operations will improve slightly during fiscal 2013 as compared to fiscal 2012; however, there is no guarantee of improved gross profit performance.”

SG&A: “We believe that SG&A will improve slightly as a percentage of sales during fiscal 2013 as compared to fiscal 2012; however, there is no guarantee of improved SG&A performance.”

Rental expense: “We believe that rental expense will decline during fiscal 2013, with a current projected reduction of $8 million from fiscal 2012, primarily as a result of the expiration of certain equipment leases.”

DDS guided cap ex for 2013 of $125mm following 2Q, compared to its previous guidance of $175mm.

Catalyst