Description

Thesis:

At current levels, Dillard’s (DDS) provides a compelling risk reward. This write up will be short as the investment thesis is rather straightforward.

Along with the rest of the department store channel, DDS has sold off massively in the last few months after reporting ugly numbers (YTD the stock is down 36% with some of the initial fizzle stemming from a realization that DDS does not intend to monetize its Real Estate). 

Investment Highlights

That being said, the following holds true about DDS:

·        FCF: DDS remains highly free cash flow generative.

·        Capital Deployment: DDS is in the process of an implicit gradual take private or thereabout given its rapid share repurchases. At current trading levels, even with large haircuts to earnings, buybacks are quite accretive and make sense (12% FCF yield to the equity assuming $620mm EBITDA versus 2016 consensus of $714mm).

·        Prudent Balance Sheet: Dillard’s has low net leverage at just 1.1x LTM EBITDA. Along with minimal off balance sheet lease liability, DDS’s has arguably the most conservative balance sheet in comparison to its department store peers. One can argue that the BS is too conservative and at current levels adding additional leverage to buyback more of the company would be further value enhancing.

·        Real Estate Owned: High ownership of its RE (internal REIT) minimizes off balance sheet lease liability / always a lurking potential for monetization should RE monetization become an attractive path for the company (sell properties to HBC…sell whole business to HBC…?).

·        Insider alignment: Meaningful insider ownership as well as voting control via Class B shares by the Dillard family puts management in alignment with investors.

·        Sale as downside?: Sale as potential exit (speculation): We think at a certain point, it is conceivable that the company could consider a sale in the face of a market giving little value to its retail and or RE value. A natural buyer would seemingly be the likes of Hudson’s Bay and would provide DDS with a means to monetize its retail presence and importantly Real Estate which HBC is keener to place value on.

·        Simplicity to the story: Outside of the obvious, namely SSS and margin trends, DDS is about as simple a thesis as they come: the business generates consistent FCF, plows it into its shares which trade cheap on just about any metric and over time unless one assumes a secular shift leading to fundamental impairment to the value of the department chain channel, that value creation will accrue to shareholders as share count goes down. This is good ole’ company generated financial engineering to enhance value for shareholders that stick around at its best. To allay the hand throwing by those long M and HBC we note the following: M and HBC may also be very (or very very) cheap but we view those as having additional drivers and thus they have different theses then what we think underlies a DDS investment case. M stock has HF noise (Starboard among others) both operationally and from a trading standpoint as well as what we would argue is an unresolved RE plan despite what M has recently said in rejection of Opco/Propco. Similarly, at HBC, it is Opco/Proco and M&A which currently drives the upside case which may mean more upside but also execution risk and more moving parts. Bluntly, the aim here is not to debate DDS vs. M vs. HBC (all may be longs in some capacity, hedged or unhedged) but rather to simply show why we think DDS offers a compelling risk reward on its own.

Business Overview

Most investors are familiar with DDS and view it as the quiet sister in the corner to the likes of M, JWN, HBC, KSS etc. Simply put, DDS is a regional department store which operates 297 stores in 29 states primarily in the southwest, southeast and midwest regions of the US. Importantly, the company as of 1/31/15 owned 44.9mm of the 50.5mm sq. ft. that it operated, or ~89%. 

Capital Deployment

The best part of the DDS story is the simplicity of the capital deployment which is always top of mind when we evaluate a company. Since 2005 and through the last quarter, DDS has generated cumulative FCF (defined as CFO-Capex) of $2,904mm while spending $2,890mm on share repurchases or to be precise 99.5% of available FCF. Capex would appear to be primarily maintenance or maintenance like as the company has been a net closer of stores over the last decade: the company reported operating 330 stores in 29 states in its 2005 10K (CY 06, FY 05) compared to 297 in its most recent 10K.While we cannot predict that history will repeat itself in the future, the Dillard family involvement makes us comfortable betting that capital deployment will remain prudent and focused (i.e. we are less concerned with M&A or speculative investment risk than otherwise would be the case for a highly FCF generative business) and at current valuation levels are happy to see the company continue to shrink the share count. Over this same time period, shares have been reduced from 76mm to 37mm a roughly 50% reduction.

Brief Review of How we Got Here

In April of 2014, Marcato Capital publicly outlined a ‘passive’ investment in Dillard’s which is basically in line with the thesis outlined here. Marcato pegged value at $155 a share. Later that year in November 2014 (roughly a year ago), Marcato upped the ante and publicly called for Dillard’s to monetize its Real Estate via an Opco/Propco structure. Marcato pegged value under this structure at ~$193 (mid case) which assumed 6.0x retail (Opco) EBITDA and 15.0 Propco EBITDA. On the heels of steady though not spectacular performance (DDS had an uninspiring 1% SSS comp in 2014 with not all quarters positive), continued redeployment of the FCF into share buy backs and the help of Marcato involvement/REIT euphoria, DDS stock climbed from the $90 level it was at in early 2014 to a peak of $142.22 in April of 2015. Since its April peak the stock is down roughly 50%. After Q1 results were reported in May, the stock began its decline as it was the second quarter in a row that the company had no buybacks and a lackluster SSS comp (down 1%) began to put some investors on the sidelines. At its shareholder meeting on May16, 2015, the company put to rest any excitement investors may have had surrounding Opco/Propco to create value in the near term. The following summary was put in an 8K:

Mr. Dillard provided his current thoughts on the business. Referring to the disappointing first quarter performance reported this week and the stock price decline, Mr. Dillard noted that the Company had experienced weeks of greater decline over the past five-year period. Mr. Dillard stated that the past week’s performance was not indicative of the Company’s performance over the past five years, reiterating that Dillard’s operates with a long-term view of shareholder value. As reference, Mr. Dillard cited the five-year cumulative total return graph in the Company’s Annual Report on Form 10-K as a better representation of the Company’s long-term performance. Mr. Dillard further commented that the industry’s utilization of REIT structures in a single-payer context would not likely increase long-term shareholder value.

From May, the shares began a gradual decline into the $80-90 zone which became more aggressive following a surprising weak earnings results from Macy’s on 11/11/15 and then its own weak earnings on 11/16/15. DDS reported SSS decline of 4% while Gross Margins declined only 30bps and EBITDA margins declined 82bps. At Friday’s (12/18/15) close of $67.62, the stock is down 24% from its pre Macy’s report close of $89.14 on 11/10/15.

Valuation 

Near term we would expect to see continued SSS weakness and in the current quarter specifically likely margin pressure due to the below mentioned likely excess inventory on the books. Assuming a negative 5% comp and 1% hit to YoY GM in Q415, we could see 2015 EBITDA at $730mm , more or less in line with consensus. We are much harsher though than consensus when looking at 2016 which is the base year off of which we think about valuation. Assuming a further 2.5% SSS hit and ~75bps in GM implies a base scenario of $620mm of 2016E EBITDA. We of course do not pretend to have any idea on SSS or GM but think these assumptions provide a decent base off of which to sensitize numbers. We think an appropriate range to think about on the downside and upside would be EBITDA in the $550mm to $685mm zone. $685mm is not heroic and would indicate that the consumer comes back or at least stabilizes, there is nothing wrong with the department store channel or the DDS footprint in particular and SSS is flattish to up in 2016 or at least looking into 2017 as 2016 evolves. $550mm conversely would indicate the consumer is badly hurt and or DDS has idiosyncratic problems that may not even be shared by other broad retailers or department stores in particular. Here is a snapshot of what we see as EBITDA sensitized across SSS and GM declines in 2016:

Here is what current valuation looks like using our assumptions for 2016 as well as consensus numbers:

Finally here is what we think is a reasonable way to frame the bookends on the numbers and valuation.

Ultimately we like a upside/downside risk reward under these scenarios especially when 1) the consumer slowdown risk which would be necessary to take EBITDA to the high $500 level in the Low case (down meaningfully from 2015E EBITDA) can we partially hedged against the XRT (in a ratio to each investors liking), 2) the company serving as a constant buyer in the market both from a support standpoint and more importantly a value creation standpoint.

Risks: 

High inventory levels coming into Q415: While total sales declined 1.7% in Q315, inventory grew 5.5% which likely means there is excess merchandise in the system which may need to be marked down in the current quarter. Assuming parity in growth, inventory would be roughly $133mm higher than appropriate (1.7% decline to prior year inventory). GM were 34% in Q414. Using crude math, that implies a 1.9x sales to inventory (=COGs) ratio so that $133mm in excess inventory could reflect ~$250mm in sales potential that would have had a 34% margin but perhaps due to discounting of say 20-30% will sell for $190mm which with $133mm in cost leaves $57mm in cash gross profit (ignoring any non-cash COGs for the moment). That compares with what would have been $250mm less $133mm = $117mm, or a difference of $60mm. This is admittedly very crude math and while $60mm is meaningful, we do not see a reason for why discounting would be a recurring phenomenon (i.e. we would expect inventory to get back in line with sales). 

Channel Broken: We think there are two broad explanations for the DDS comp this past quarter (and similar weak results at other retailers): 1) weak consumer = not idiosyncratic to DDS per se and can be hedged in some manner with the XRT; 2) Softening in brick and mortar department store channel due to online encroachment on the DDS customer = idiosyncratic to the DDS (and other department stores) business model and thus XRT as a hedge would prove ineffective

Texas /Oil exposure: 59 of its 297 stores (20%) are in Texas with another 14 in Louisiana and 10 in Oklahoma; difficult to quantify the oil hit and while many have outlined bearish consumer theses re: Texas, I have had anecdotal discussions with those involved in TX real estate who note their residential apartment units are actually performing stronger than other parts of the country so I leave it as an unknown as to whether the DDS TX consumer is going to be a cause of further deterioration to DDS results and frankly whether the TX consumer in the first place was the cause of the bad comp in the last quarter. The latest 10Q for what it is worth makes no mention of the word Texas.

Catalyst

Improved SSS

Aggressive buybacks

Speculative: If stock remains depressed could see family tender for shares and or look to monetize the business which may include a sale of a portion or all of the assets?