Before the COVID-19 pandemic, Dillard's (DDS 2.44%) was struggling with stagnant sales and steadily eroding margins. In fiscal 2019, the regional department store chain recorded revenue of $6.3 billion and a woeful adjusted pre-tax margin of 1.8%. That translated to adjusted earnings per share (EPS) of just $3.56. Five years earlier, revenue totaled $6.8 billion and Dillard's posted a 7.6% adjusted pre-tax margin, enabling it to generate adjusted EPS of $7.70.
Surprisingly, though, the company's sales and profitability have rocketed far beyond pre-pandemic heights in 2021, driving the stock into the stratosphere. Last week, the retailer reported a big earnings beat for the third quarter, igniting another rally. But with the stock having quintupled year to date -- outpacing the gains of other department store stocks -- investors appear to have unrealistic expectations for the company's long-term prospects.
Margins surge -- and then sales
In the first quarter of fiscal 2021, retail sales rebounded to $1.3 billion: up 73% year over year but down from $1.43 billion two years earlier.
While sales remained well shy of pre-pandemic levels, tight inventory management and cost control paved the way for a big improvement in profitability. Adjusted EPS more than doubled relative to Q1 2019, reaching $6.37. This crushed the analyst consensus of $1.20.
Demand accelerated further in the second quarter. Three months ago, Dillard's reported that retail sales surpassed $1.5 billion in the period, up 72% year over year and -- more remarkably -- up 12% compared to the second quarter of fiscal 2019.
Robust demand and an extraordinarily tame promotional environment allowed Dillard's to continue expanding its margins, too. Retail gross margin surged to 41.7%, up from 28.7% in Q2 2019. This enabled the department store operator to log a 15.3% pre-tax margin, translating to EPS of $8.81. In 2019, Dillard's lost money in the second quarter, and analysts had expected a similar result in this year's second quarter.
More of the same in the third quarter
Dillard's maintained its incredible momentum last quarter. Third-quarter retail sales totaled approximately $1.5 billion: up 47% year over year and up 9% from the third quarter of 2019.
Retail gross margin surged to a new record of 46.7%, compared to 36.6% in Q3 2020 and 34.5% in Q3 2019. Meanwhile, operating expenses remained unusually low due to reduced store operating hours and staffing shortages.
The net result was that pre-tax margin reached 17.2% and EPS surged to $9.81. This again crushed the analyst consensus of $5.52. Two years ago, Dillard's barely made money in the third quarter, logging adjusted EPS of $0.12.
This won't last
Management has done an excellent job of navigating a very unusual operating environment to maximize profits this year. The company is on track to post full-year EPS well above $30. That means Dillard's stock trades for just 10 times its likely current-year earnings.
However, Dillard's won't be able to sustain its current level of profitability. The global supply chain meltdown has created industrywide inventory shortages this year. That has driven huge gross margin gains for most department stores. As promotional retailers, they can simply cut back on discounts when demand exceeds supply, padding their profits.
Over the next couple of years, production of apparel, accessories, and home furnishings will likely return to normal. That will force retailers to start fighting for customers again. Even if Dillard's continues to manage inventories better than before the pandemic, gross margin will decline significantly compared to 2021 levels. Additionally, Dillard's will need to raise wages and improve staffing levels to provide adequate customer service in the long run, reversing its recent expense savings.
As a result, annual earnings will probably plunge by more than half within a few years (and possibly quite a bit more). As the company's profitability recedes, the stock should come back to earth, too.