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This article is part of our Rising Star Portfolios series.
Would you buy a retailer right now? I'm going to.
You may think I'm crazy to invest in a retailer (or invest at all) given today's environment, but it is this very environment that I believe is giving us a messed-up expectation when it comes to Dillard's (NYSE: DDS ) . I'll explain this in just a moment.
Dillard's sells apparel, cosmetics, and home furnishings through its brick-and-mortar stores -- located primarily in the Southeast, Southwest, and Midwest -- and through its online store. Brands include Antonio Melani, Gianni Bini, Roundtree & Yorke, and Daniel Cremieux.
It was founded by, and is still run by, the Dillard family, out of Little Rock, Ark. The family owns roughly 6% of the company, including nearly all of the Class B shares. The latter gives them the right to elect eight of the 12 board members. Holders of the Class A shares -- trading on the NYSE -- elect the other four.
In 2008-2009, the company flirted with bankruptcy, having suffered declines in revenue, net income, and same-store sales. Comparable sales (comps) fell by 7% in 2008 and a whopping 10% in 2009. Thankfully for shareholders, management got its act together and has since turned the company around. Comps were a positive 3% in 2010 and 5% last quarter.
Since those bad times, margins have expanded sharply -- gross margin has improved by 540 basis points over the past two years, while net margin has climbed from -2.5% two years ago to 6.8% for the past 12 months.
As this was happening, management was also returning value to shareholders by reducing the outstanding share count from 73.8 million two years ago to just 50.2 million today, a decrease of over 30%. Better yet, the majority of those shares were purchased at reasonable prices. For instance, this year alone, management purchased shares in the first quarter at an average price of $41.98, did not purchase shares in Q2 as the share price climbed above $50, and then purchased again in Q3 when the share price dropped, averaging $42.66. That tells me that management isn't buying shares just to spend money, unlike so many companies, but is actively making the purchases in order to benefit shareholders. I like it.
The messed-up expectation
Conventional wisdom tells us today that the U.S. is teetering on the brink of a second recession, being driven by the fears about what is happening in Europe and a slowdown in the growth of emerging economies, principally China. In August, Moody's Analytics lowered its U.S. economic outlook thanks to "significantly weaker" prospects. Last month, the Federal Reserve Bank of Philadelphia released results of a survey in which forecasters had revised their outlook to "predict more gloom" than previously. Yet the Washington Post article reporting that survey gives a hint to what I think is going on when it asked, "What's happened in the past three months that's made everyone so gloomy?"
We humans suffer from recency bias, where we take recent events and sentiment and project them into the future. It explains why after a plane crash receives a lot of media attention, some people overestimate the chance of it happening again. It explains why the absolute best time to be investing recently was January through March 2009, right at the "height" of the doom and gloom surrounding the financial crisis. It also explains why now may be a great time to invest in retail. As major clothing companies like Aeropostale (NYSE: ARO ) and American Eagle (NYSE: AEO ) are plagued by low industry expectations, those prospects can spill over to other more stable companies and drag down their prices.
And it explains why, I believe, the market is currently undervaluing Dillard's by expecting less than 0% growth in free cash flow for Dillard's forevermore. What's the saying? "The stock market has called nine of the last five recessions."
I'm not saying that times aren't difficult or likely to remain so for a while. I am saying that it probably won't be as bad as what is currently priced into the company's share price. Supporting indicators come from several disparate areas, including higher Black Friday sales, lower unemployment, higher car sales, increased factory output, and -- just yesterday morning -- the third month in a row of climbing home-builder sentiment. There is lots of data out there that forecasters are ignoring or discounting when they "predict more gloom."
If expectations rose to believing the company could eke out a measly 1% annual growth from here, shares would be worth around $60 instead of last night's $43.
If comps and margins start declining again for two or three quarters, then I'll have to rethink the above. But the company has one great hidden asset that should help protect it if things turn south again.
I'm talking about the fact that it owns nearly all of its stores and the land on which they sit. This is not the case for competitors Macy's (NYSE: M ) or Gap (NYSE: GPS ) , which lease large fractions of their locations. One only has to look at the minimum rent obligations over the next several years to see this: $142 million for Dillard's, $2.67 billion for Macy's, and a whopping $5.1 billion for Gap, as of the end of their last fiscal years. This could, in extremis, allow Dillard's to release a lot of value by selling its stores and the land, similar to what Sears Holdings (Nasdaq: SHLD ) did a few years ago.
Tomorrow, I'll purchase an initial position in Dillard's for my Messed-Up Expectations Rising Star portfolio, representing 2% of investable funds.
Some people may still be skittish about clothing retailers, particularly domestic ones in this economy. That's understandable, but there are still great opportunities out there. For instance, "The Motley Fool's Top Stock for 2012" reveals a broadline retailer that's focusing abroad. They have achieved an amazing 15% growth for 15 straight months, and still have huge opportunity ahead of them. The report is free, but it won't be forever. You can click here to access your copy now. Enjoy, and Fool on!
This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. See all of our Rising Star analysts (and their portfolios).