Entering 2020, Dillard's (DDS 0.77%) seemed to be a business on the decline. Net income and earnings per share had plummeted over the previous several years, due to subpar sales trends and steady margin compression.
Then, the COVID-19 pandemic hit, crushing sales and causing Dillard's to report a massive loss for the first quarter of fiscal 2020.
However, since then, a funny thing has happened. Demand has come roaring back -- and Dillard's has gotten more aggressive about inventory management. That enabled the regional department store chain to post a record quarterly profit for the second straight quarter this week.
Dillard's was struggling before the pandemic
Not that long ago, Dillard's seemed to be stuck in a downward spiral. In fiscal 2014, the company generated $6.78 billion of revenue and a solid net margin of 5%. Adjusted net income totaled $328 million ($7.70 per share).
By fiscal 2019, revenue had receded to $6.35 billion. Moreover, the company experienced severe margin compression over that five-year period. It posted a full-year profit of $111 million ($4.38 per share) in fiscal 2019. Excluding asset sale gains and a one-time tax benefit, it recorded an adjusted profit of $90 million and adjusted earnings per share (EPS) of $3.56. This put its adjusted net margin at an abysmal 1.4%.
Stiff retail-industry competition drove the bulk of this revenue decline and margin deterioration. However, management aggravated the company's margin pressure by repeatedly buying too much inventory and subsequently being forced to offer deep discounts to clear it out.
A successful pandemic reset
Over the past year, Dillard's -- like many other retailers -- has significantly improved its inventory management. For example, it entered the second quarter with $1.31 billion of inventory, down from $1.57 billion a year earlier and $1.83 billion the year before that. This enabled it to cut down on discounting and achieve record earnings in the first quarter. Adjusted EPS more than doubled compared to first-quarter 2019, despite lower sales.
Dillard's second-quarter performance was even more impressive. Retail sales jumped 72% year over year and 12% compared to fiscal 2019, reaching $1.54 billion. Management noted that sales in the ladies' apparel and footwear categories significantly outperformed other departments.
Meanwhile, retail gross margin soared to 41.7%, up from 31.1% a year ago and just 28.7% in the second quarter of 2019. Moreover, Dillard's managed to post this sales growth while reducing its store hours compared to 2019 and thus cutting labor costs. As a result, operating expenses remained 11% below the level of Q2 2019. This enabled the company to post a profit of $186 million ($8.81 per share). Dillard's hadn't made money in the second quarter since 2016.
Clearly, Dillard's is benefiting tremendously from pent-up consumer demand. And with U.S. consumers reportedly sitting on $2.6 trillion of excess savings as of the end of March, retailers haven't needed to offer discounts to entice shoppers to open up their wallets.
This isn't sustainable
In the near term, Dillard's will probably keep posting incredible results. Pent-up demand could continue to lift sales of clothing and accessories for a few more quarters. Meanwhile, global supply chain challenges are helping to enforce lean inventory management across the retail industry. That should keep gross margin up significantly relative to 2019.
However, the fundamental challenges facing department stores haven't changed. As demand normalizes and supply chain constraints ease, discounts will inevitably return as retailers start fighting for market share again. Furthermore, traffic to the low-quality malls where many Dillard's stores are located will probably continue to sag in the years ahead, weighing on sales.
Dillard's recent success has left it with more cash than debt. The company appears poised to use much of its $670 million cash hoard to buy back stock. That said, Dillard's market cap has surged from well under $1 billion a year ago to over $4 billion today. To justify this price, Dillard's will need to keep churning out extremely strong profits for years to come -- and that may be too much to ask.