2023-03-30 09:24:49 ET
Summary
- Dillard's, Inc. runs department stores across the US.
- Dillard's has stagnated for a decade, although has seen an improvement in performance post-pandemic.
- Margins have improved noticeably but we struggle to see how these can be maintained. The company is facing a tough 12-24 months ahead.
- When compared to other retailers, Dillard's underperforms regarding growth, both forecast, and actuals.
- Dillard's valuation suggests the company is overvalued.
Investment thesis
Dillard's ( DDS ) is finally experiencing a normalization of trading conditions following the Covid-19 period. With a history of struggling with growth, our objective is to assess if the company has turned a corner and can now sustainably grow, or if things will revert. We will do this by assessing short and medium-term factors, both financial and commercial.
Company description
Dillard's, Inc. runs department stores across the southeastern, southwestern, and midwestern regions of the United States. The stores sell a range of products, including clothing and accessories for women, men, and children, cosmetics, home furnishings, and other consumer goods. Additionally, the company is involved in general contracting and construction activities.
Share price
Dillard's share price performed poorly for most of the last decade, as the company struggled to achieve consistent growth. Conversely, the pandemic triggered a resurgence in demand as consumers flocked to brick-and-mortar retailers following the end of the lockdowns, driving gains.
Financial analysis
Dillard's Financial analysis (TIkr Terminal)
Presented above is Dillard's financial performance for the last decade. It can be best described as stagnation.
Revenue has essentially not grown, with a CAGR of less than 1%. This is due to several factors, the biggest in our view being the rise of e-commerce. Many online retailers began rising to prominence in the early part of the decade, competing aggressively on price while offering the convenience of at-home shopping. These affordable prices stem from the lack of administrative costs, such as retail locations and staff. Dillard's and many of its peers, were slow to transition to online services, focusing on delivering a shopping experience. Research by McKinsey during this period supports the idea that growth was driven by tighter margins.
McKinsey Digital Growth analysis (McKinsey)
The problem for Dillard's is that many of these businesses will transition toward profitability while retaining many of the customers they have taken. This is a classic strategy of coming into an industry far below the incumbents to gain market share, before lifting prices to reach a sustainable level.
This does not explain the most recent increase in sales, which we attribute to the most-pandemic surge in retail footfall. Consumers, who were locked away for an extended period, made an active effort to shop in-store as part of a wider improvement in consumer sentiment. It is difficult to see where these levels will normalize but this is evidence that consumers highly value brick-and-mortar retailers and the concept is not going away.
In the most recent year, Dillard's achieved a 6% increase in sales, driven primarily by comparable store sales, the highest quality of sales. This bucks the trend we have seen with other retailers, such as Kohl's ( KSS ) and Macy's ( M ), who have seen negative/flat growth. This suggests a level of resilience above the industry, which is impressive given that we are experiencing an economic slowdown.
Dillard's has seen its GP increase across the last decade, driven by improving price action and cost controls. This again goes against the retail trend, as many have been increasingly discounting products due to the slowdown in demand. Dillard's did see margins contract in Q4-22, however, suggesting they are slowly feeling the impact of this. Regardless, the company has done well so far.
S&A expenses have remained constrained, declining as a percentage of revenue. This is primarily driven by an increase in sales but also strong cost controls. This is important as when sales are stagnating, it is key to make operational improvements as a means of improving the company's short-term performance as Management focuses on kickstarting growth. Between FY21 and FY22, this expense was trending down but has faced inflationary headwinds due to increased payroll costs.
The net impact of this is an EBITDA margin of 19% and a FCF margin of 9%. This is far in excess of prior periods. We will later assess if this is sustainable.
Moving onto the balance sheet, operational excellence continues, with inventory turnover increasing and CCC declining. With demand slowing, it is very easy for retailers to accumulate inventory, which later results in discounts being applied causing margin contraction. If we compare Dillard's to the same two businesses again, Kohl's saw its IT decline 9.5% and Macy's experienced a decline of 3.5%. This should bode well in FY23 for margin protection.
Management has used the recent boost in profitability to aggressively reward shareholders, with large distributions. Despite this, cash has been able to accumulate, suggesting at least FY23 is defensible, regardless of economic conditions.
Management has also financed the business conservatively, with Dillard's in a negative net debt position. This insulates the business against any external shocks, while also allowing for flexibility should the market present opportunities/threats.
Overall, we believe Dillard's financial profile is "middle-of-the-road". Management has done well operationally but leaves a lot to be desired growth-wise.
Outlook
With the current profitability profile Dillard's has, even inflationary growth could return healthy value to investors through capital distributions. The issues as there are risks around the sustainability of these levels. History suggests Dillard's normalized performance is closer to an EBITDA margin of 8-12%, with a FCF conversion of 4-7%. This represents a large delta and so is the key risk to a bull thesis.
According to Seeking Alpha's growth rating, Dillard's receives an F. This is primarily because analysts are forecasting revenue growth of (0.36)%, far below the sector average. Further, EBITDA is forecast to decline at a greater rate, estimated at (22.42)%.
Growth (Seeking Alpha)
Our view is that the drivers of this are twofold. Firstly, short-term economic headwinds. Inflationary pressure is deteriorating consumers' discretionary income, contributing to a decline in retail spending due to defensive behaviors. Although Dillard's has done well so far, demand will inevitably slow to a degree. This being said, the sector as a whole is facing this threat and so does not explain the whole of the delta. Secondly, the company is seeing margins contract, with GPM in the most recent quarter at 37.7%. This will result in an outsized impact on EBITDA, especially if things continue to slide.
Although the FY figures suggest margins are somewhat steady, the quarterlies suggest Dillard's is a falling knife. Our view is that we could see a rapid reversion toward the level we stated above.
Peer analysis
Retailer industry (Tikr Terminal)
Presented above is a cohort of B-A-M retailers operating primarily in the US.
Dillard's current margin performance is far superior to the market, generating substantially higher levels than the market. Assuming our normalized levels are more representative of the go-forward level Dillard's will generate, the company looks far more average.
Looking at growth, Dillard's has, and is forecast to, underperformed. It is unsurprising to see that two of the other underperforming businesses are also in apparel.
Based on these factors, Dillard's should be trading at a discount to its peers to reflect the inferior growth.
Valuation
Dillard's valuation (Tikr Terminal)
Presented above is the valuation of the cohort, alongside our calculation of Dillard's fair value.
Dillard's is trading at a discount to its peers on a Forward basis, reflecting the inferior performance we have noted.
To derive our fair value EBITDA multiple, we have taken the average of Kohl's, Macy's, Williams-Sonoma (WSM), and Nordstrom ( JWN ). These businesses are the most comparable and operate at a similar level.
Based on this, we see a downside of 6%, similar to that of Dillard's historic mean multiple. Analysts are far less forgiving, suggesting a downside of 14%.
Final thoughts
Dillard's has done well taking advantage of the pandemic-driven demand, lifting revenues to levels it has not seen since the GFC. Management has also done well to achieve operational efficiencies, specifically around inventory and pricing. This being said, the company will likely experience a rapid decline in margins, potentially reverting to its pre-pandemic levels. It is facing short-term headwinds, which are contributing to softening demand and discount pricing. Conversely, it is certainly possible that margins normalize to levels above our expectations, however, it is not possible to quantify the likelihood.
Based on Dillard's current relative performance and valuation, we do not see the upside available to justify the risks around buying today.
For further details see:
Dillard's: Weakening Financial Performance Ahead