Margin and Inventory Trends Are Worrisome for Dillard's, Inc.

Shares of regional department store operator Dillard's (NYSE: DDS  ) have been on a five-year tear, rising from a low of $2.50 in late 2008 to nearly $100. These gains have been propelled by several initiatives, including closing unprofitable stores, reducing overhead, boosting gross margin through careful inventory management, and buying back lots of shares.

DDS Chart

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

However, Dillard's may have reached the limits of this strategy. After routinely posting record earnings each quarter, Dillard's experienced a year-over-year earnings decline last quarter. Furthermore, gross margin and inventory trends are headed in the wrong direction. Accordingly, Dillard's does not look like an attractive investment compared to competitors with better growth prospects, such as Nordstrom (NYSE: JWN  ) .

Two troubling trends
For most of the last few years, Dillard's has carefully kept inventory increases below the rate of sales growth. This has allowed it to keep discounts within reasonable levels, rather than taking big markdowns to clear old merchandise.

Dillard's exited the 2012 fiscal year with comparable-store inventory down 1% year over year. This helped it achieve a 110-basis-point gain in merchandise margin in Q1 last year, leading to record earnings. However, the trend of keeping inventory lean started to break down after that. It did not take long for rising inventory levels to translate into lower gross margin.

Careful inventory management was one of the keys to Dillard's comeback.
Source: Wikimedia Commons.

Dillard's ended Q1 with inventory up 3% year over year. As a result, merchandise gross margin improved by only 10 basis points in Q2. Moreover, inventory was up 7% year over year by the end of that quarter. Part of that increase was attributable to the timing of deliveries, but the increase was still too large given that comparable-store sales growth had fallen to just 1%.

In Q3, merchandise gross margin dropped for the first time in many quarters. Dillard's was able to offset the 40-basis-point gross margin decline with strong expense management in order to keep profits growing. In Q4, the company wasn't so fortunate. Dillard's had to take significant markdowns to get sales moving, leading to a 180-basis-point merchandise gross margin decline and a year-over-year profit decline.

Despite these markdowns, Dillard's ended Q4 with inventory up 4%, while sales growth remained at a sluggish 1% pace. (There were no significant delivery timing issues causing this inventory increase.) As long as this inventory overhang remains, Dillard's gross margin performance is likely to disappoint investors.

No growth here
Dillard's period of margin recovery appears to have ended, and this leaves very little reason for investors to stick around. The company's long-term fate is tied to mall traffic, and Americans are spending less time at the mall as time goes on.

Acknowledging this trend, Dillard's has been steadily downsizing. In the last five years, Dillard's has closed 21 stores, while opening just two new ones, thereby shrinking its total store count by about 6%. The company does plan to open two new stores later this year, but the general trend is one of gradual decline.

While falling mall traffic affects all department store operators, others have moved more quickly to diversify. For example, Nordstrom has invested heavily in its online operations, and the result has been three consecutive years of at least 30% growth.

Nordstrom plans to continue pouring money into technology to bolster online sales. Nordstrom will spend $1.2 billion on technology alone in the next five years. For comparison, Dillard's spent less than $100 million on capex last year -- which includes both store renovations and technology investments.

The growth of Nordstrom Rack reduces Nordstrom's exposure to mall traffic trends.

Nordstrom is also rapidly growing its Nordstrom Rack off-price division, for which most of the locations are not in traditional malls. In mid-2012, the company announced plans to double the number of Nordstrom Rack stores by the end of 2016. This growth will help Nordstrom reach a goal of getting 50% of its sales from Nordstrom Rack and online channels in the next few years.

Foolish bottom line
Dillard's was a great stock for investors as long as the company's margins were recovering from the Great Recession. However, sales growth has slowed to a crawl, inventory has started rising at an uncomfortable pace, and as a result, Dillard's margins appear to have peaked. Given the lack of a long-term growth story, there's no good reason to invest in Dillard's if margin growth is a thing of the past.

Nordstrom looks like a more appealing investment opportunity, because it has invested in diversifying its business. This will make its earnings growth sustainable, even if visiting the mall continues to go out of style among American consumers.

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