Dillard's Is Playing a Dangerous Game

Source: Wikimedia Commons.

In a bid to keep EPS growing, Dillard's (NYSE: DDS  ) has aggressively bought back its stock over the last few years. Since 2007, it has shrunk its share count from nearly 80 million to just 45.2 million as of last quarter. These buybacks have magnified Dillard's rebounding earnings since the Great Recession. The results have been fantastic for shareholders.

DDS Chart

Dillard's 5 Year Stock Chart, data by YCharts.

However, Dillard's is becoming a share-buyback junkie. Having been so successful with share repurchases in the past, the company seems unable to take its foot off the gas pedal. For years, Dillard's has cut capital spending to the bone in order to buy back more stock. Now, it's also tapping its revolving credit line to do so -- despite deteriorating business fundamentals. This is a dangerous strategy that could easily backfire.

Sales growth slows
During 2012, Dillard's was able to generate strong earnings growth organically -- by growing comparable-store sales by 4% for the full year while boosting gross margin and keeping expenses in line.

However, Dillard's sales gains last year may have had more to do with J.C. Penney's (NYSE: JCP  ) terrible performance than the things Dillard's did right. There is significant overlap between the two chains' store bases, meaning that Dillard's was well positioned to capture a portion of the billions of dollars in sales lost by J.C. Penney.

Regardless of the explanation, sales growth has come to a screeching halt this year. Year to date, revenue is up fractionally, and comparable-store sales have increased by just 1% each quarter. Moreover, weak sales growth is starting to have a ripple effect on margins.

Rising inventory, falling gross margin
While Dillard's is notoriously secretive about its performance, the company seems to be missing its sales goals this year. The tip-off is rising inventory. Whereas Dillard's entered the year with inventory slightly down year over year, inventory was up 3% year over year at the end of the first quarter and 7% at the end of the second quarter.

In the retail industry, it's almost never a good thing for inventory to rise much faster than sales; the typical result is big clearance markdowns that hurt gross margin. (This has been a key factor exacerbating J.C. Penney's big losses recently.) Sure enough, in the third quarter, gross margin broke out of its long uptrend, falling 40 basis points year over year.

At the end of the third quarter, inventory was still up 6.2% year over year. While much of that increase can be attributed to a shift in the retail calendar, the increase is too big for investors to be comfortable. By contrast, Macy's (NYSE: M  ) inventory was up 7% year over year at the end of the third quarter, but its comparable-store sales are growing faster (3.5% in the third quarter). Meanwhile, inventories are up just 2.2% year over year at Kohl's (NYSE: KSS  ) , where sales have been stagnant this year.

Dillard's decision to "honor Thanksgiving" adds to the company's inventory risk. While every other mid-price department store chain is opening at 8 p.m. on Thanksgiving -- including Macy's, Kohl's, and J.C. Penney -- Dillard's will open for Black Friday at 8 a.m.

I admire management's courage, but there is a big risk that many shoppers will go out on Thursday night anyway, and Dillard's will just miss out on sales. It would be especially tough to recover from a weak Black Friday this year, due to the compressed holiday shopping season.

Risky business
The fundamentals of Dillard's business are thus shaky at best, compared to the recent past. In this context, it is particularly disturbing that management decided to buy back $187 million of stock last quarter without having the cash on hand to do so. The company borrowed $170 million on its credit line, which it intends to repay after the holiday season.

Dillard's generated about $300 million in operating cash flow in the fourth quarter last year. So even if sales come in below target yet again this quarter, Dillard's should still be able to generate enough cash to pay back the loan. However, not only would Dillard's take an immediate earnings hit (if sales disappoint), but the share buyback machine would have to slow down because the company's cash flow will be soaked up by the loan repayment.

Higher capital spending is also likely to constrain share buybacks next year. One reason Dillard's has generated so much cash recently is that it has not opened a new store since 2010. However, the company has three new stores planned for next fall, and the necessary capital spending will lead to lower free cash flow.

Foolish bottom line
Dillard's has had a great run over the last five years, but its luck appears to be running out. Sales growth is tapering off, and inventories are uncomfortably high entering the holiday season. Meanwhile, the company is pouring ever more money into share buybacks to keep EPS growing rapidly, even buying back shares on short-term credit. Unless sales growth accelerates during the holiday shopping season, Dillard's shareholders could be in for a lot of pain in the next year.

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Read/Post Comments (3) | Recommend This Article (0)

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  • Report this Comment On November 21, 2013, at 8:58 AM, Momintn wrote:

    I completely disagree with you. Dillard's is a leading department store, especially in apparel, and rivals Macy's. There is no comparison at all with JCPenney's. What Dillard's has is very attentive customer sales and service staff who give personal attention to customers. You don't find this at many stores any more. And there are certain items, like men's sweater vests for large men or white dress shirts or name-brand business suits, that you cannot find anywhere else. Their inventory is the reason that people shop there and if they had less inventory, it could turn away their devoted clients. When people have special events and require dress attire, they go to Dillard's. The dressing room is full of women going to bridal or graduation events.

    Few people want to go shopping on Thanksgiving Day. Especially when you know Dillard's clients and have been assisted by their service reps, there is little reason to be open. Friday is traditionally the day to shop. No one wants to try on clothes or carry large bags after eating a big dinner, or say goodbye to their friends and family to go shopping on Thursday. I believe it says a lot about Dillard's that they put the Thanksgiving tradition first, and most likely things like this is the reason you see the very best service when you go into the store.

    As far as the stock, I wish they paid more of a dividend. But the buyback is better for long term shareholders as you do not have to pay personal income taxes on any gains. Going forward, there are going to be less companies who can afford to buy back their stock, so it is wise to note those who are still announcing plans to do so. The stock is still very cheap here, even cheaper than Macy's, and I'm thinking about adding it to my portfolio. I do not know why both stocks are so very inexpensive, especially compared to the rest of retail.

  • Report this Comment On November 21, 2013, at 5:23 PM, TMFGemHunter wrote:

    I agree that Dillard's is similar to Macy's. But Macy's execs have stated quite clearly that they benefited last year from the big mess at J.C. Penney, and that's actually a big reason why I believe that Dillard's also benefited. Dillard's basically tells investors nothing more than they are required by law to do, so it's impossible to do anything more than surmise.

    I think you're wrong about few people wanting to go shopping on Thanksgiving Day. You'd have to believe that the leaders of 8-10 of the top retailers in the country are incompetent. They know their employees don't want to be working, so why would they open unless they think customers will shop?

    If you told me that only a quarter of the country will shop Thanksgiving night, I wouldn't be surprised. But that's still a lot of volume to be giving up. Also, since the other retailers are open all night, people who are early risers can be in at 6 am on Black Friday, before Dillard's is open.

    Adam

  • Report this Comment On January 14, 2014, at 5:06 PM, ElCid16 wrote:

    This article's biggest argument is that Dillard's didn't open Thanksgiving night!

    So, what if the company doesn't buy back any more shares? Is the company now going to go into free fall? Of course not! EPS might not rise as fast as in the past, but why is that a problem?

    The company set out on a mission to lower their number of diluted shares because they felt that the company was far too undervalued. And guess what? They succeeded far more successfully than most companies could dream of! Now that they took care of GREATLY increasing shareholder value, they turn their focus toward CapEx.

    You cite inventory as an issue. Let me give you the year-end inventory values over the past 4 years:

    $1.3B

    $1.3B

    $1.3B

    $1.3B

    no problem there. Let's move on.

    You cite cash decreases and borrowing increases to fuel buybacks. Let's take a look:

    Cash & Eq the past 4 years:

    $340M

    $340M

    $225M

    $125M

    Total debt the past 4 years:

    $975M

    $960M

    $900M

    $825M

    The drop in cash is almost perfectly in line with their drop in total debt!

    I realize you are looking at quarterly numbers, but this is a retail company! Working capital and short term borrowings drastically change for EVERY major retailer going into the holiday season.

    What is the dangerous game?

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