Three months ago, Dillard's (NYSE:DDS) reported that its profitability improved year over year in its fiscal second quarter, which ended Aug 1. While the regional department store chain still reported a small quarterly loss, this was a surprisingly good result, considering how the COVID-19 pandemic is crushing most department stores' revenue.

Notwithstanding the company's Q2 outperformance, retail analysts still had low expectations for its fiscal third quarter, which ended Oct. 31. On Thursday afternoon, Dillard's proved the doubters wrong again, posting a surprise quarterly profit.

Gross margin drives another earnings surprise

Inventory management was the key to Dillard's big fiscal Q2 earnings beat. The onset of the pandemic caused it to report a massive loss in the first quarter of its fiscal 2020, but aggressive inventory clearance measures did allow the retailer to exit the period with inventory down more than 14% year over year. That contrasted with the frequent inventory gluts that have hurt Dillard's gross margin in recent years.

DDS Inventories (Quarterly YoY Growth) Chart

Dillard's year-over-year inventory growth, data by YCharts.

As a result, while the chain's retail sales plunged 35% year over year in its fiscal Q2, retail gross margin increased to 31.1% from 28.7% in the prior-year period. Combined with sharp cost reductions, this paved the way for a $24 million year-over-year improvement in the company's adjusted pre-tax loss.

Just as importantly, Dillard's continued to clean up its inventory, exiting the period with inventory down 20% year over year. This enabled it to boost its retail gross margin to 36.6% in the fiscal third quarter from 34.5% a year earlier. That increase of 2.1 percentage points was particularly noteworthy because the department store chain faced a tougher year-over-year comparison in its Q3 than in its Q2.

Sales trends remained weak during the chain's third quarter but improved sequentially. Comparable sales fell 24% and total retail sales declined 25%. Once again, Dillard's was able to offset this sales pressure by tightly managing expenses. It reduced total retail expenses 24% year over year, keeping costs roughly flat as a percentage of revenue.

That was just enough to allow Dillard's to post a $2.5 million adjusted pre-tax profit for fiscal Q3, down from $3.2 million a year earlier. Under generally accepted accounting principles (GAAP), net income jumped to $31.9 million ($1.43 per share) from $5.5 million ($0.22 per share) a year earlier, due to tax benefits expected this year. The analysts' consensus had called for a loss of $0.86 per share.

Cash flow improves

In the first half of fiscal 2020, Dillard's burned $333 million of cash. While it's typical for the department store chain to be negative on that metric in the first half of the year, that result was considerably worse than its $57 million of cash burn in the first half of fiscal 2019.

By contrast, Dillard's generated over $200 million of free cash flow last quarter, reducing its year-to-date cash burn to $115 million. This compares to $48 million of cash burn in the first nine months of fiscal 2019. Strong cash flow last quarter helped Dillard's reduce its short-term borrowings dramatically -- both sequentially and on a year-over-year basis -- to just $15 million.

Investors are still underestimating Dillard's

Dillard's stock surged last month following news that Berkshire Hathaway portfolio manager Ted Weschler had purchased a sizable stake in the company with his own money. However, the stock has surrendered some of those gains in recent weeks, perhaps due to investors' growing concerns about the sharply rising numbers of U.S. COVID-19 cases.

The parking lot and exterior of a Dillard's store

Image source: Author.

Yet these concerns seem misguided. Dillard's exited its third quarter with inventory down 22% year over year -- its biggest inventory reduction yet. Even if sales trends slow sequentially in the current quarter (which is far from certain), the chain should be able to hold profitability roughly flat through a combination of gross margin expansion and tight cost management.

Looking ahead, recent news from the pharmaceutical industry suggests that effective COVID-19 vaccines could be broadly available within a year or less. Meanwhile, Dillard's will be facing less competition next year after a slew of store closures by its competitors. This sets the stage for a sales recovery in 2021, particularly in the second half of the year.

Analysts are currently forecasting that the retailer will post a small loss in fiscal 2021. But given that it's already generating earnings in line with (if not better than) its 2019 results, Dillard's could easily surpass its 2019 adjusted earnings per share of $3.56 next year, with further improvement likely in 2022 as sales continue to recover. This looks like a recipe for Dillard's stock to keep rallying.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.