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Margin Pressure Continues at Dillard's

By Adam Levine-Weinberg - Updated May 16, 2019 at 9:17AM

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The enigmatic department store chain suffered a sharp gross margin decline last quarter.

Dillard's (DDS -5.32%) has taken shareholders on a roller-coaster ride in recent years, with huge volatility around its quarterly earnings reports. The regional department store chain doesn't hold quarterly earnings calls, present at industry conferences, or provide sales and earnings guidance, so investors never quite know what to expect.

That said, margin compression has been a fairly consistent theme at Dillard's since 2015. In a worrisome sign for investors, that trend continued last quarter and shows no sign of abating.

Profitability has been shrinking

Weak mall traffic and the rise of e-commerce and off-price competition have hurt Dillard's and rivals such as Macy's (M -4.14%) over the past few years. It has become harder than ever to generate sales growth. Meanwhile, price transparency and the cost of shipping e-commerce orders have weighed on gross margin.

Indeed, Dillard's adjusted pre-tax margin hit a recent peak of 7.6% in fiscal 2014 but has been falling ever since. By fiscal 2018, its pre-tax margin had sunk to just 3.3%.

The company has offset some of the pressure from its margin declines through an aggressive share buyback program. Tax reform also provided an earnings boost last year. Nevertheless, adjusted earnings per share plunged from $7.70 in fiscal 2014 to $6.12 in fiscal 2018.

The exterior of a Dillard's store.

Dillard's pre-tax margin has fallen by more than half since fiscal 2014. Image source: Author.

Dillard's misses the mark in Q1

Like Macy's, Dillard's returned to positive comps in late 2017 and posted a 2% comp sales gain last year. That included a 2% comp in the fourth quarter.

However, Dillard's sales momentum slowed last quarter. On Wednesday afternoon, the company reported flat comp sales for the first quarter of fiscal 2019. That was worse than the 0.7% increase that Macy's posted earlier in the day. Total sales increased slightly to $1.47 billion but missed the analyst consensus of $1.49 billion.

This sales slowdown was particularly unfortunate because Dillard's entered the quarter with elevated inventory levels. As a result, retail gross margin fell by about 1.4 percentage points year over year, which was nearly double the gross margin decline at Macy's.

Dillard's did manage to reduce its operating expenses slightly on a year-over-year basis. Interest expense also fell, as the company repaid $162 million of debt last year. Even so, Dillard's adjusted pre-tax profit (excluding asset sale gains) fell to $93 million from $103 million in the prior-year period. Adjusted EPS declined 4% year over year to $2.77, falling a little short of the average analyst estimate of $2.80.

Conditions won't get any easier

At first glance, it may appear that Dillard's recent margin pressure is no big deal. After all, its adjusted EPS barely fell last quarter, compared to a double-digit decline at Macy's (also excluding asset sale gains).

However, the first quarter is typically one of the strongest parts of the year for Dillard's, due to the retailer's geographic concentration in Sun Belt states where the spring begins early. Dillard's actually lost money in the second quarter in each of the past two years and was barely profitable in the third quarter last year. By contrast, Macy's -- which has a big presence in the Northeast and Midwest -- tends to be more profitable in the second quarter than in the first quarter.

Dillard's exited Q1 with inventory up 3% year over year, well ahead of its sales growth pace. That's very dangerous entering a seasonally weaker part of the year, as it could exacerbate the department store chain's gross margin declines. Rising tariffs are yet another threat to Dillard's gross margin.

Additionally, Dillard's interest savings will fade after the company laps its debt repayment from last summer. Depreciation and amortization expense will increase modestly over the course of 2019 as well, adding further margin pressure. As a result, gross margin declines would have a much bigger impact on EPS during the rest of the year than they did in Q1.

Given these headwinds, it's hard to justify the company's stock's recent valuation of about 12 times forward earnings -- a huge premium to Macy's shares. Thus, it was no surprise that Dillard's stock cratered during after-hours trading following the subpar earnings report.

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Stocks Mentioned

Dillard's, Inc. Stock Quote
Dillard's, Inc.
$235.74 (-5.32%) $-13.24
Macy's, Inc. Stock Quote
Macy's, Inc.
$17.61 (-4.14%) $0.76

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