Why I Don't Believe the Dillard's Story

In many ways, Dillard's (NYSE: DDS  ) seems like the perfect stock. During the Great Recession, Dillard's stock briefly plunged below $3. Now it trades for more than $90, meaning that shareholders have received a better than 3,000% return in less than five years.

DDS Chart

Dillard's 5-Year Price Chart, data by YCharts.

Dillard's gains have been driven by solid earnings growth, which most analysts expect to continue. However, I think that Dillard's is setting investors up for disappointment. The company's revenue momentum has dissipated, and the department store sector will remain as competitive as ever going forward. Accordingly, I expect Dillard's strong run to end this year.

Sales momentum slows
The primary driver of Dillard's strong stock performance over the past five years has been an improvement in sales. Comparable-store sales rose 3% in 2010, rose by another 4% in 2011, and then rose by 4% again in 2012. This appears to indicate strong momentum, but a closer look at quarterly results reveals a deteriorating trend.

Dillard's posted comparable-store sales growth as high as 5% in third-quarter 2012. As I have argued previously, Dillard's probably benefited from last year's sales meltdown at J.C. Penney (NYSE: JCP  ) , one of the largest mall-based department stores. With shoppers abandoning J.C. Penney in droves last year, Dillard's, Macy's (NYSE: M  ) , and other similar retailers experienced a nice sales tailwind.

However, comparable-store sales growth slowed to just 3% in the fourth quarter last year. This caused a brief correction for Dillard's stock before it began marching higher again. Finally, Dillard's comparable-store sales grew by just 1% in first-quarter 2013. The company outperformed on gross margin, which rose from 38.8% to 39.9%, enabling Dillard's to beat the analyst consensus for profit. However, with gross margin approaching 40%, it will be difficult to drive further profit growth through margin expansion alone. Sales growth will be needed.

The slowdown in sales growth is particularly troubling because Dillard's did not face as much of a negative impact related to weather as other competitors, since most of its stores are located in the South. By contrast, Macy's faced a bigger weather-related impact but continued to post strong growth, with comparable-store sales up 3.8% last quarter. If Macy's continues to gain market share from Dillard's, it will be better able to leverage its fixed costs, making it harder for Dillard's to compete.

Competition may heat up
The big risk for Dillard's going forward is that the tailwind it received from J.C. Penney's struggles could reverse later this year. J.C. Penney experienced a big management shakeup last month, with CEO Ron Johnson being replaced by his predecessor, Mike Ullman. Ullman has made it clear that he aims to lure back previous J.C. Penney shoppers by bringing back coupons and frequent sales, while reintroducing popular private brands that were removed during the chain's recent makeover.

While I am far from optimistic about J.C. Penney's long-term prospects, I do think that Ullman's strategy will win back some of the market share that J.C. Penney lost last year. Other mid-range mall-based department stores like Macy's and Dillard's -- which were the primary beneficiaries last year -- will face stiff competition during the back-to-school and holiday seasons. Since Dillard's is already losing some share to Macy's, it could be hit hard by a J.C. Penney sales revival.

Foolish bottom line
While Dillard's has generated strong earnings growth over the past several years, it has become increasingly reliant on margin improvement and share buybacks recently, rather than organic sales growth. Comparable-store sales growth dropped to just 1% last quarter, and Dillard's could face a worsening competitive environment as J.C. Penney moves aggressively to regain share. With the stock trading for nearly 13 times earnings, I think investors should steer clear of Dillard's for now.

What about the JCP story?
J.C. Penney's stock cratered under Ron Johnson's leadership, but could new CEO Mike Ullman present the opportunity investors have been waiting for? If you're wondering whether J.C. Penney is a buy today, you're invited to claim a copy of The Motley Fool's must-read report on the company. Learn everything you need to know about JCP's turnaround -- or lack thereof. Simply click here now for instant access.


Read/Post Comments (3) | Recommend This Article (3)

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  • Report this Comment On May 28, 2013, at 4:24 PM, jamesbonds4 wrote:

    With all due respect, Penney's customers did not trade up to Dillard's. They traded down to Walmart. The Dillard's and Penney customer are completely different animals.

  • Report this Comment On May 29, 2013, at 10:02 AM, TMFGemHunter wrote:

    Thanks for the comment. There's more overlap in the customer bases than you might think. While JCP is obviously downmarket from Dillard's, I know plenty of people who shop everywhere from Target to Nordstrom. Also, Macy's is in the same price range as Dillard's, and its CFO has stated more than once that stores in direct competition with JCP were performing noticeably better than average.

    Plus, Wal-Mart is not mall-based, while Dillard's is. People who come in to a mall and don't find something at Penney's are likely to look at the other dept. stores there (often Macy's and Dillard's), especially if those stores are running big promotions.

    Adam

  • Report this Comment On May 30, 2013, at 1:21 PM, jamesbonds4 wrote:

    Hi Adam, your points are noted. The only issue I have with your article is the part about Dillard's facing stiff competition from Penney if that store should make a successful comeback. I think the mentality of the Penney shopper and the Dillard's shopper are very different, having grown up in the South all my life where both Penney and Dillard's have a strong presence. Penney was always the store where my grandmother, aunts and mother shopped regularly. Dillard's was the place to go to for something special: that special Easter dress, that great pair of shoes for church, the suit for graduation, etc. While that perception has changed somewhat, I believe it is still valid, especially for the Penney shopper, and especially since Dillard's has worked hard and successfully over the past few years to upgrade its merchandise selection. I can't see extremely price-conscious coupon-shopping shoppers who are used to paying ten dollars for a t-shirt at Penney going to Dillard's to buy t-shirts, where they will cost more.

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