Jhe COVID-19 pandemic has had a devastating impact on many businesses. Department stores have been among the biggest losers due to their focus on selling clothing and their continued reliance on in-store sales, often in malls.
A U.S. department store chain actually improved year-over-year earnings for two consecutive quarters, however: Dillard’s (NYSE:DDS). Nonetheless, shares of Dillard ended November down 36% year-to-date. As the retail sector recovers in 2021, this department store stock could hit a multi-year high.
Dillard’s stock performance. Data by YCharts.
Inventory discipline yields better results
The pandemic has forced Dillard’s to manage its inventory much more carefully than in the past. The retailer entered fiscal 2020 with inventory down 4% year-over-year. By the end of the first fiscal quarter in early May, inventory was down 14%. Dillard’s ended the fiscal second quarter with inventory down 20%. By the end of the third quarter, inventory was down 22% year over year.
This tight inventory management allowed Dillard’s to reduce clearance discounts despite unusually low traffic in its stores. In the second quarter, retail gross margin increased 2.4 percentage points year over year despite a 35% decline in retail sales. Dillard’s performance in the third quarter was similar: retail sales fell 25%, but retail gross margin improved 2.1 percentage points year-over-year.
These gross margin increases — along with significant expense reductions — enabled Dillard to significantly improve its year-over-year profitability in the second quarter. Profit rose again last quarter, although it was roughly flat compared to the third quarter of 2019 on a pre-tax basis. Those are impressive results considering the high-level pressure Dillard has been under. With equal attention to inventory management, the retailer could potentially top its 2019 earnings even if revenue never fully recovers to pre-pandemic levels.
Dillard’s is a cash cow – and spends that money predictably
Last year, Dillard reported a pretax profit of $114 million, excluding gains on the sale of assets. This translated into a meager pre-tax margin of 1.8%. Net profit totaled just $111 million, or $95 million excluding gains on the sale of assets. However, Dillard’s free cash flow typically exceeds his net income by a wide margin.
Dillard’s net income versus free cash flow. Data by YCharts.
There’s a simple reason for this discrepancy: Dillard’s tightly manages capital spending. Non-cash amortization expenses have been around $220 million a year recently, but even before the pandemic Dillard was only spending $100-150 million a year on capex. This cautious attitude towards capital spending is wise given that the department store industry is in decline. Other department store chains that have invested more aggressively in their businesses have received poor returns from those investments. As a result, their shares have underperformed Dillard’s shares over the past decade.
In recent years, Dillard’s has typically generated about $250 million in free cash flow per year. Its quarterly dividend of $0.15 per share will only cost it $14 million this year. That leaves the vast majority of its cash flow available for debt reduction and stock buybacks.
Between fiscal 2016 and fiscal 2019, Dillard paid off $257 million in debt and spent $724 million on buyouts. It has a very clean balance sheet today, having ended the third quarter with just $581 million in debt. As a result, investors can expect the company to continue to devote the majority of its free cash flow to redemptions.
Image source: author.
Dillard’s market capitalization is just over $1 billion. With profitability matching or exceeding 2019 levels in each of the last two quarters despite weak sales and vaccines on the way, it is entirely possible that free cash flow will rebound to $250 million or more in the coming months. during the 2021 financial year. This would allow Dillard to reduce its share count quickly, potentially triggering a short pressure that could send the stock soaring.
A merchant or a real estate company?
Many investors may be skeptical about buying stock in a department store, no matter how strong its cash flow. Dillard’s business has been in decline for several years. What happens if the rate of decline accelerates? Fortunately, Dillard’s offers investors an extra margin of safety due to its extensive real estate holdings.
By the end of October, Dillard’s liabilities stood at less than $2 billion. Meanwhile, the company had more than $1.8 billion in current assets (mostly inventory): enough to pay off nearly all of its debt. In effect, shareholders own Dillard’s real estate virtually freely and clearly. These properties total 43.7 million square feet of store space (and thousands of acres of associated land), as well as 3.9 million square feet of office, distribution and warehousing space.
Dillard’s store real estate includes a number of locations in valuable A-grade malls. But while most of its stores aren’t very useful for retail, many could be repurposed as malls. last mile distribution, doctor’s surgeries or for many other purposes. Others could be demolished and the land sold to multi-family developers. At a very modest average valuation of just $50 per square foot, Dillard’s real estate portfolio would be worth almost $2.4 billion, more than double the company’s current market capitalization.
Lack of stock is a sure thing. Between Dillard’s surprisingly strong second and third quarter results, strong cash flow track record, and extensive real estate holdings, however, the odds are in favor of this department store stock.
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Adam Levine-Weinberg owns shares of Dillard’s. The Motley Fool has no position in the stocks mentioned. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
