FOOL ON THE HILL
An Investment Opinion
Department Store Blues Warren Gump (TMF Gump)
August 20, 1999
Just two days after retailer Saks (NYSE: SKS) announced worsening problems, competitor Dillard's (NYSE: DDS) missed Q2 earnings estimates and indicated that Q3 earnings might also fall below plan. Dillard's Q2 net income fell from $0.45 per share last year to $0.34 this year, a number that compared even less favorably to the $0.48 First Call earnings estimate. The shortfall was blamed primarily on stores added to its portfolio through last year's acquisition of Mercantile Stores, which experienced a 19% sales decline from the prior year. (Not coincidentally, some of Saks' problems were also attributed to acquisitions -- including 15 former Mercantile stores purchased from Dillard's.)
The company says that it expected some sales declines as it integrated the former Mercantile stores away from promotional pricing (lots of big sales) to Dillard's "everyday value" strategy. The 19% plunge, nonetheless, was far beyond what the company and analysts had anticipated. Making matters worse, these falling sales were made on significantly lower margins. Dillard's had to reduce prices on truckloads of excess merchandise since sales were below expectations.
As if those problems weren't bad enough, margins were already projected to be tight because of the liquidation of branded product lines and private label goods that Dillard's discontinued. The gross margin contribution from Mercantile's anemic sales totaled $25 million less than what Dillard's would have earned if the sales had been completed at the margins achieved by Dillard's core stores. The company says it has "some concern that these trends will continue, although at a reduced level, through the third quarter of 1999."
Dillard's stock is now trading for less than 10x trailing earnings and 0.85x book value. If the problems at the Mercantile stores were to subside as management projects, and Dillard's resumes a "normal" growth track, the stock price's 20% drop today would seem to represent a buying opportunity. At the same time, what kind of future does Dillard's and other department store chains really have?
Other retailing concepts have emerged that deliver a much better value. If you need to buy goods for your house, why go to a department store when you can get a much better selection and probably better prices from Bed Bath & Beyond (Nasdaq: BBBY) or Linens 'N Things (NYSE: LIN)? You can do the same with men's suits from a store like The Men's Wearhouse (Nasdaq: SUIT). Other major categories have similar superstore competition, usually located together in the same shopping center.
Some might argue that these superstores aren't comparable to department stores because department stores offer so many more benefits like attentive customer service and easy credit. I'm not sure that department stores have a substantial edge here. The past few times I've drifted into a department stores, help in the men's and housewares department has been virtually impossible to find.
In their effort to contain costs, department stores seem to have cut employee staffing levels below minimum standards of decency (unless you like spending five minutes to find someone who will accept payment for an overpriced wedding gift). As to credit availability, almost every store (department, specialty, or discounter) is willing to help you get credit, as long as you don't mind paying an exorbitant rate of 19.8% or higher. (If you fall in that category, you might want to check out the Fool School's credit section.)
Department stores do provide the only venue to attain certain branded goods in a lot of the nation's smaller communities. If you need to get a Nautica Enterprises (Nasdaq: NAUT) shirt, Tommy Hilfiger Corp. (NYSE: TOM) pants, or Estee Lauder Companies (NYSE: EL) high-brow cosmetics like Clinique or MAC, your local department store might be your only hope. But how much longer will that last with the proliferation of the Internet and other powerful distribution mechanisms? Department stores will retain some customers, but I can't envision substantial growth.
Dillard's and Saks aren't the only department store companies struggling. On the low-end of the price spectrum, midscale department stores JCPenney (NYSE: JCP) and Sears (NYSE: S) have been struggling to figure out how to fulfill customer needs as competition from discounters and specialty stores intensify. On the upper-end, Neiman-Marcus Group (NYSE: NMG) and Nordstrom (NYSE: JWN) have issued earnings warnings this year. Federated Department Stores (NYSE: FD) and May Department Stores (NYSE: MAY) are the only two major chains that have been meeting or exceeding estimates during this period of enormous consumer spending and record economic prosperity. What's going to happen during tougher economic conditions?
I don't think that department stores are going to become extinct anytime soon. But they don't appear to offer substantial growth opportunities as a retailing concept. Some chains will undoubtedly figure out a way to leverage their customer relationships, buying expertise, and real estate locations into profitable growth. Until there are signs that such strategies are being developed and implemented, the picture looks too gloomy for me to be attracted by today's seemingly cheap valuations. I fear that most companies in the industry will continue to lose market share and not achieve long-term growth; that makes them look fairly expensive at today's prices.
(Remember... this is just one person's opinion. You should evaluate the industry yourself and come up with your own perspective.)