Is Dillard's a Good Bet in Broadline Retail?

Family-run retailer Dillard's (NYSE: DDS  ) has created substantial shareholder value over the past five years by sticking to its core competencies, offering branded and private-label merchandise at affordable prices, and limiting its operations to its Southern and Midwestern home base. 

The company has also avoided the limelight, something that can't be said of major competitors J.C. Penney (NYSE: JCP  ) and Macy's (NYSE: M  ) , which have seen their battles escalate from the shopping mall to the courtroom over the past two years. So, should investors bet on this family affair?

What's the value?
Dillard's operates a midsize chain of department stores, with roughly 300 domestic stores that cater to its value-conscious customer base at relatively affordable price points. The company ended 2012 with its fifth straight year of merchandise margin gains, a trend that has benefited from greater exposure to the women's accessories category, accounting for approximately 15% of total sales. 

Like other department stores, Dillard's has also improved its margin by increasing its private-label offerings, including company-owned brands like Antonio Melani and Roundtree & Yorke.

In fiscal year 2013, though, Dillard's has found top-line growth hard to come by, hurt by lower overall sales volumes as a result of its decision to prune select underperforming stores from its network. However, the company's operating profitability has continued to improve in the current year, partially due to solid fee growth in the credit area, where it has a partnership alliance with GE's financial arm. 

The net result has been strong operating cash flow for Dillard's, approximately $173 million, which management is primarily using to enhance shareholder value, including a new $250 million stock-repurchase program announced in November.

Of course, investors are interested in future growth opportunities for the company, which seem limited at best, given management's plans to continue culling underperforming stores from its base. In addition, the company is currently forecasting only two new stores for fiscal year 2014. That said, Dillard's is financially well-positioned to pick up stores from any liquidity-constrained competitors that might be looking to sell, like J.C. Penney.

The once-proud retailer founded by James Penney in 1902 has been in survival mode in fiscal year 2013, raising nearly $3 billion through debt and equity underwriting activities that have allowed it to fund operating losses and maintenance-capital needs. Current management is attempting to overhaul its store base and return the company to its traditional promotional marketing strategy, a sharp reversal from former CEO Ron Johnson's "everyday low price" strategy that bombed with customers and led to lower sales and a large operating loss in 2012.

Lately, J.C. Penney's business retrofit seems to be taking hold to a degree, with management reporting a comparable-store sales gain of 10% in November. However, its sub-30% gross margin in the current year, due partially to inventory clearance markdowns, has led to a continuation of operating losses and an increasingly tenuous financial profile.  Barring a business resurgence, the company seems likely to eventually prune its network of more than 1,100 stores, which would play into the hands of Dillard's.

Follow the leader
In the meantime, Dillard's should follow the lead of industry giant Macy's in pursuing higher per-store productivity by focusing on growing product areas, like women's accessories and home goods. Indeed, at roughly 54% of total sales, the two categories are key product areas for Macy's and have been among its better-performing segments lately, helping the company to generate a comparable-store sales gain in fiscal year 2013. 

In contrast, Dillard's generates roughly 19% from the two categories, despite the women's accessories category accounting for its highest sales gain in the current period.

The bottom line
Dillard's runs a tight ship, which is not surprising given that members of the founding family are large shareholders and maintain management control. At roughly 26%, the company's spending on SG&A, or overhead, runs circles around similar ratios at both J.C.Penney and Macy's. 

Given its efficiency, though, the company's future profit growth will increasingly need to come from the top line, in the form of higher same-store sales or an expansion of its store base. Since the latter is unlikely in the near term and growth in the former has been creeping toward the flat line, investors would be wise to hold off on the story and stick with the industry's best of breed, Macy's.

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