DDS - Dillard's Remains Very Attractive Despite A 414% 5-Year TSR

2023-08-15 05:04:08 ET

Summary

• Dillard's has outperformed the market with a 5-year total shareholder return of over 369%.
• The company has strong fundamentals, with compounding free cash flows and net income.
• DDS has de-risked its business by reducing debt and focusing on profitability instead of asset growth.

Dillard's, Inc. ( DDS ) is one of the unsung performers of the last five years, with a 5-year total shareholder return (TSR) of over 414%. This run has been built on fantastic fundamentals, with the free cash flows ((FCF)) compounding at 29.7%, and net income compounding at 39.26% a year in that period. The firm's capital returns have been similarly rich, compounding at 38.72% a year. Management has also used its FCF to de-risk the business, reducing outstanding debt in an era that has seen the rise of zombie businesses. In this era of cheap capital, the firm has also resisted the urge to grow assets, focusing on profitability instead. Gross profitability has risen from 0.61 in 2018 to 0.78 in 2023. The firm is attractively valued, with a price/earnings (P/E) multiple of 7.45, and a FCF yield of 20%. This is a business that retail investors should invest in.

Dillard's Easily Beat the Market

In the last five years, Dillard's share price has risen by over 353%, compared to more than 58% for the SPDR S&P 500 ETF Trust ( SPY ), which tracks the S&P 500 ( SPX ), and over 48% for the Morningstar Global Apparel Retail GR USD (F0000115F3), which will serve as a proxy for the apparel retail industry. Taking dividends into account, Dillard's TSR was nearly 414%, compared to over 72% for the SPDR S&P 500 ETF Trust, and nearly 49% for the Morningstar Global Apparel Retail GR USD.

Free Cash Flows Support Growing Capital Returns

Our first port of call will be an analysis of Dillard's ability to grow capital returns over the next few years, especially in light of its $500 million share repurchase program and $0.20 quarterly dividend. What we want to understand is if those capital returns have been responsible and if they have been made with enough margin for safety for there to be rational expectations for growth.

In the last five years, FCF has risen from $232.23 million in 2018 to $853.35 million in 2022, compounding at 29.7% per annum. In the last twelve months (LTM), FCF was $1.2 billion. Since 2018, the firm has over $3.99 billion in FCF, which equates to about 67% of its market cap. Dividend payments have risen from $11.11 million in 2018 to $271.31 million in 2022, compounding at 89.5% a year. In the LTM, the company has paid out $274 million in dividends. On a per share basis , dividends have grown from $0.40 per share in 2018 to $0.80 per share in 2022 (a year which included a $15 special dividend), compounding at 14.87% a year (excluding the special dividend). Now, regarding share repurchases, Dillard's has grown repurchases from $129.88 million in 2018 to $452.83 million in 2022, compounding at 28.37% a year. In the LTM, share repurchases have totalled nearly $351 million. The above gives us a growth in total capital returns from $140.99 million in 2018 to $724.14 million in 2022, compounding at 38.72% a year. Since 2018, the firm has returned $2.6 billion to shareholders, equating to about 43% of its market cap.

De-Risking the Business

In the post-Great Recession period, the world has experienced an era of declining interest rates. The most widely reported effect of this has been rising valuations, but a less reported effect has been a rise in the appetite. This is not an all-together irresponsible thing: pecking order theory tells us that firms tend to favor internal sources of funding, then debt, and after that, equity raising as a "last resort". However, debt obviously comes with risks that do not exist for equity, and, given the tendency of managers whose businesses have positive FCF to overestimate future FCF arising from their undertakings, these managers are apt to turn their businesses into zombie firms . Research shows that the share of zombie firms has risen in recent years, to roughly a tenth of publicly listed firms. With rising interest rates, there are fears that these zombie firms will not survive .

It is a sign of management's prudence then, that they have gone the other direction, executing a nine decade old policy of solid, conservative fiscal management. This is clearly visible over the last five years, with the firm repaying $161 million of maturing debt in 2018, leaving $565.6 million in total debt outstanding, whereas in 2022, the firm repaid $45 million of maturing debt, with $521.4 million in total debt outstanding (excluding operating leases). Net interest and debt expense has declined from $52.52 million in 2018 to $30.53 million in 2022, compounding at -10.28% a year. In the LTM, net interest and debt expense has declined to $20.09 million. The firm now owns 92% of its store square footage unencumbered, and has a very low debt burden compared to its peers.

The company has also given itself optionality and strengthened its balance sheet by growing cash and short-term investments from $123.5 million in 2018 to $809 million in 2022. As of 2Q23 , the firm had $924.5 million in cash and short-term investments. Dillard's has enough resources to meet its outstanding debt, or, to pursue any initiatives management sees fit.

Perhaps the best way to show how the firm's prudence has been rational, is in a simple observation: total assets have remained relatively flat since 2018, when they were worth $3.43 billion, to $3.33 billion in 2022. Research shows that there is an inverse relationship between asset growth and future returns, a relationship likely driven by managerial overconfidence and resultant misallocation of capital. The asset growth effect has also been referred to as the "capital cycle" by London-based fund manager, Marathon Asset Management.

Dillard's is not a very "ambitious" business, and this is a good thing. They have not had to close as many stores as rivals such as Macy's ( M ), J.C. Penney (JCP), and Kohl's ( KSS ), precisely because they have been very careful about business expansion, and seldom been subject to the managerial overconfidence that has inflicted many managers in the industry. This strength really shines during downtowns, as happened in the pandemic era.

The Core Business is Stronger than GAAP Earnings Suggest

In the wake of Dillard's 2Q23 earnings, the share price took off once again, because most investors were caught off by the size of the firm's earnings. This is not the first time that investors have underappreciated the firm's profitability. Indeed, this is not the first time this has happened, and the quality of the business is often masked by GAAP earnings.

GAAP Net income is an obviously flawed metric. In order to truly understand how profitable the business is, we have to strip away the effects of ancillary business activities and transitory shocks, which, as Dillard's 2020 results show, can be significant. In doing so, we arrive at a measure of the core earnings of the business, that is, a measure of the profitability of the business founded on the recurring elements of net income. A fascinating paper "Core Earnings: New Data & Evidence" , finds that "trading strategies that exploit non-core earnings produce abnormal returns of 8% per year. Now, Dillard's core earnings, which strip away the effects of non-recurring or non-core elements, gives us a more robust idea of the firm's profitability.

Core earnings have obviously exceeded GAAP earnings throughout the post 2018 period, indeed, core earnings would have alerted investors to the fact that year-over-year (YoY) percentage change in core earnings was greater than GAAP earnings. In the LTM period, core earnings have actually declined by 9.68%, compared to 9.14%, which is not a great difference. Zooming out, over the post-2018 period, core earnings have enjoyed a superior YoY percentage growth, compared to GAAP earnings, although the magnitude of this difference, 208% a year for core earnings compared to 179% for GAAP earnings, is driven by the 2021 bounce.

In the long run, we should expect this situation to remain: GAAP earnings will continue to understate the profitability and robustness of the core business.

Low Share Supply Will Drive Prices Higher

One of the reasons that share buybacks are so valued - even though there is a strong argument that managers tend to buy at elevated prices, destroying shareholder value - is that, theoretically, by reducing the number of outstanding shares, the value of each share increases. Let's start with that general position and look at the ownership structure at Dillard's. In essence, the Dillard's family and employees own the vast majority of shares -with workers owning around 40% of the firm's stock through retirement plans-, and this has left the number of shares available to investors very thin, and this problem, if you like, has grown as the firm has bought back shares. With the supply of these shares so low, and, in fact, declining, shares in the company are more likely to aggressively rise in response to any good news.

Rising Profitability

Gross margin from retail operations has risen from 33.6% in 2018 to a record 43% in 2022. In the LTM, gross margin has dipped slightly, to 42%. Dillard's gross profitability has risen as well, aided by relatively flat asset growth, from 0.61 in 2018 to 0.9 in 2022. In the LTM, gross profitability declined somewhat to 0.83. The firm's gross profitability is well above the 0.33 threshold that research finds marks out a stock as attractive.

Dillard's net income has risen from $170.26 million in 2018 to $891.64 million in 2022, compounding at 39.26% a year. In the LTM, net income was $810.1 million.

Valuation

Despite quite sensational stock market results, the firm's P/E multiple is just 7.45, compared to 25.48 for the S&P 500 and 26.05 for the Morningstar Global Apparel Retail GR USD. The firm's relative stock valuation is not the only thing that is attractive: we have already seen that its gross profitability of 0.78 is well above the 0.33 threshold, indicating very attractive profits. Finally, with $1.2 billion in FCF in the LTM, and an enterprise value of $5.6 billion, Dillard's has a FCF yield of 21%, which is also well above the market's FCF yield of 2.3% , according to New Construct's calculations, indicating the likelihood of the firm's stock beating the market.

Conclusion

Dillard's is a firm that most investors would ordinarily overlook, given its size. However, its track record of growing FCF, well supported capital returns, solid, conservative fiscal management, and rising profitability, suggest that this is a business that retail investors should pay attention to. On a relative basis, and in terms of its gross profitability and FCF yield, the firm seems very attractive.

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