Is There More Upside Ahead for Dillard's or is J.C. Penney the Way to Go?

Shareholders in department-store operator Dillard's have been a happy lot, as better-than- expected profitability has driven a strong gain in its stock price over the past year. Is the company still a good bet?

Jun 24, 2014 at 11:00AM

Regional department-store operator Dillard's (NYSE:DDS) stay-small operating strategy has been working financial wonders for the company. That's in stark contrast to the troubles that continue to plague other players in the sector like Sears Holdings (NASDAQ:SHLD) and J.C. Penney (NYSE:JCP). Dillard's has rung up a big increase in operating profit over the past few years, thanks in part to consistent comparable-store sales growth, a trend that has led a very favorable, long-term run for its stock price. 

Dillard's performance in its latest financial update was no exception, as it reported another increase in comparable-store sales and better-than-expected profitability, data points that produced a subsequent double-digit spike in its share price. So, after a big price jump, is the company a good bet for investors? 

What's it worth?
Dillard's operates a regional chain of traditional department stores in 29 states, mostly in the Southeast and Midwest sections of the U.S. The company has been ably guided by members of its founding family, who seem to have kept Dillard's focus on the bottom line; it's a mind-set that has favored flexibility, both in terms of its geographic presence and its overall product selection. The net result for Dillard's has been steadily improving financial metrics, highlighted by 15 straight quarters of positive comparable-store sales growth.

In its latest fiscal year, it was more of the same for Dillard's, evidenced by a slight gain in comparable-store sales, thanks in part to a strong performance from the women's accessories category. While the company's gross margin was negatively affected by a highly promotional selling environment during the period, Dillard's benefited from higher credit income and the maintenance of a relatively low overhead cost structure, enabling it to post its highest adjusted operating margin of the past five years. Consequently, Dillard's enjoyed continued strong operating cash flow, fueling the further pursuit of shareholder-friendly activities, like share repurchases. 

A boat that you don't want to be in
On the downside, though, Dillard's customer-traffic trend has started to turn negative, down 4% during FY 2013, which doesn't bode well for its ability to continue generating positive comparable-store sales gains going forward. In that respect, the company seems to be in the same boat as some of its competitors that have had difficulty winning over larger numbers of customers, like Sears. 

The iconic retailer has had little positive momentum lately, reporting consistently negative comparable-store sales growth, including a 3.8% decline for its domestic operations in its latest fiscal year. More importantly, the poor customer traffic has led to a need to engage in significant promotional activity, hurting its gross margin and ultimately leading to an unending string of operating losses. The net result for Sears has been generally poor cash flow and seemingly continuous cash-raising activities, highlighted by the sales of its Sears Hometown & Outlet and Lands' End units in 2012 and 2014, respectively.

Likewise, J.C. Penney's customer base has been on a downward trajectory over the past few years, due in part to a failed makeover campaign that didn't resonate well with its core customers, evidenced by comparable-store sales declines in the past two fiscal years. While J.C. Penney appears to have won back some of its lost customers lately, thanks to a return to its traditional promotional merchandising strategy, its continued operating losses in FY 2014 bring into question its long-term ability to recapture its customer base with the current strategy. 

The bottom line
Dillard's has been a winner in a sector that has been difficult for almost everyone to navigate successfully. However, with its customer volume growth faltering, Dillard's might have a harder time finding profit growth in the future, especially since its operating margin is sitting at a near-term high. As such, investors might want to wait for a pullback prior to pulling the trigger on this gem.

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Robert Hanley owns shares of Dillard's and Sears Holdings. The Motley Fool owns shares of Dillard's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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