Dillard’s Inc. (DDS, Financial) - the U.S.-based apparel, cosmetics and home furnishings retailer - has recently taken a beating in the stock market. The stock has declined over 30% in the last 12 months, and economic uncertainty is keeping the price volatile. Although buying at this time may seem like an attempt to catch a falling knife, there are more than a few bright spots where an opportune investor will see a diamond in the rough.
Strengths
Broad customer base
Headquartered in Little Rock, Arkansas, the company operates 272 Dillard’s locations and 22 clearance centers across 29 states. Additionally, it has an online store. The expanse of its operations ranks Dillard’s among the nation’s largest fashion apparel, cosmetics and home furnishings retailers. In fiscal year 2015, the firm’s total sales were $6.75 billion.
Dillard's Locations Nationwide
Profitability
Dillard's strong competitive advantage is demonstrated by its phenomenal profitability ratios. Over the last 5 years, the company's return on equity (ROE) has averaged over 17%. Additionally, Dillard’s has returned 12.4% ROE during the most recent trailing twelve month (TTM) period. This is compared to the industry average ROE of basically zero. The company's strong track record over the last 5 years notably exhibits its consistent ability to produce high levels of profit relative to shareholders’ equity.
The department store industry traditionally has relatively low profit margins of just a few percentage points. With annual revenue consistently topping $6 billion, Dillard’s does not need more than 1% or 2% margins to report a sizeable profit. That being said, the company's operating profit margins are substantially higher than the industry average. As a whole, department store firms have reported operating margins of just under 2.5%, while Dillard’s is showing 5.8%. The company's 5-year average operating profit margin is slightly over 7.5%. This establishes Dillard's ability to fend off competitors looking to capture a portion of its market share.
Balance sheet
Investors can find comfort in the strength of the company's balance sheet and the financial structure of the business. With zero short-term debt, minimal long-term debt ($613 million) and a large cash reserve, Dillard’s has nearly a billion dollars more in current assets ($1.7 billion) than current liabilities ($764 million). After reporting $128 million in total cash and another $1.5 billion in receivables and inventories, the company is well-equipped to cover all of its financial obligations and weather any industry downturn - including the present slowdown. It's worth noting that Dillard’s debt-to-equity is only 46% and its current ratio is over 2.25.
Low price ratios
The sharp decline in the stock price over the past several months has allowed the company to trade at low price ratios across the board. At less than $60 per share (based on a closing price on Oct. 17 of $57.90) the stock has a price-earnings (P/E) of roughly 10, a price-book (P/B) of 1.2 and a price-to-free cash flow (P/FCF) of 7. According to the Contrarian Approach stock screen, when looking at stocks with strong balance sheets and market caps over $1 billion, Dillard’s has the lowest combined price ratios.
Countless studies have shown that stocks with low price ratios consistently outperform stocks with high price ratios. Most often, when a stock has low valuations, the market is overreacting and is valuing the stock lower than it should be. So, in the case of Dillard’s, has the pendulum swung too far, or are current valuations justified?
Out-of-favor
With a solid balance sheet, high profitability and a wide customer base, why is the stock valued as low as it is? There are several factors which have rightly contributed to negative investor sentiment, but at the same time, appear to be overblown.
Poor same-store sales
It appears that a steady decline in quarterly sales and threats of market disrupters have investors worried. The chart below says it all. Identical store sales at Dillard’s – and department stores in general – are steadily declining.
As discussed here, here and here, this is an issue of great concern for investors.
Weak outlook
During the second quarter earnings release, management was less than convincing when trying to be optimistic.
Dillard’s CEO William T. Dillard II said:
"The challenges facing apparel retailers continued through the second quarter, and our poor results reflect this…While we continue to deal with weakness in the fashion retail industry, we believe we are in good financial shape for the long term."
Negative growth
Investors are attracted to companies with strong growth records and positive future prospects. Dillard's performance in recent years does not provide either scenario. The company reported year-over-year revenue growth of -0.4% in 2015, and its 3-year revenue growth rate is basically flat at 0.01%.
The lack of revenue growth has spilled over to net income and earnings per share. Net Income was -18.83% year-over-year and -7.1% over the last 3 years. Earnings per share was down -11.3% in 2015 and hardly budged during the last 3-year period with a 0.19% growth rate.
Disappointing lower same-store sales, a poor outlook and negative growth rates may appear to justify the stock's poor performance, but further evidence suggests the current valuation levels make Dillard's an attractive investment.
Catalysts
Behavioral finance experts have sound data which suggests investors too often extrapolate recent events into the future. Although there is no saying how long the sluggish retail market will last, or when sales will pick up for Dillard’s, there are several highly probable catalysts which could work in the company’s favor.
Activist involvement
The company has an exceptionally padded balance sheet, and it can be argued that management is not deploying investor capital in the most effective manner. In today's low interest rate environment, a large cash pile and low debt levels suggests that money is not being efficiently allocated. This is a situation that is ripe for activist investors to jump into and force management's hand. Now would be a great time to expand on the already implemented share buyback program or distribute a special dividend.
Earnings beat
It's no secret that analysts tend to miscalculate projected earnings. After several quarters of sub-par results, it is only a matter of time until Dillard’s reports a positive surprise. The stock's low valuation is indicative of the market's minuscule expectations. Investors appear to be pricing in future earnings misses. David Dreman (Trades, Portfolio)'s book, "Contrarian Investment Strategies,"Â goes into great detail to show the enormous impact positive earnings surprises have on out-of-favor stocks. According to Dreman, low P/E stocks consistently outperform the market by large margins well after the one year mark of reporting a beat.
Industry turnaround
The most likely catalyst to occur is an improvement in the operating performance of the industry. There is no sense in attempting to predict how long department store sales will stay depressed, but it is almost a sure bet that things will turn around. As Howard Marks (Trades, Portfolio) has famously said:
"Those who believe that the pendulum will move in one direction forever—or reside at an extreme forever— eventually will lose huge sums. Those who understand the pendulum's behavior, can benefit enormously."
Conclusion
Dillard’s Inc. is a geographically diversified, well-financed and highly profitable company currently suffering through a sluggish economic environment. The market may be skittish, but the odds are in the favor of investors who buy into the stock at this time. Investing now, and taking advantage of time arbitrage by patiently waiting out the instability, should inevitably prove profitable.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
This article appeared first on The Stock Market Blueprint Blog.
Start a free 7-day trial of Premium Membership to GuruFocus.
