Like most value investors, I'm a big fan of investing in companies with unappreciated real estate value. While retail store sales can be subject to the whims of fads, weather, and gas prices, often the underlying real estate steadily and consistently increases in value. Thus, I became very interested in Dillard's (NYSE:DDS), a department-store operator with substantial real estate holdings.

Shares on sale
In the past year alone, Dillard's shares have sunk from a high of $40 to less than $22. The company has performed terribly, and lagging sales caused the company to post a loss in the most recent quarter.

Entrenched management
In the past, Dillard's was an efficient performer with a watchful eye on expenses and strong returns on capital. In 1997, Dillard's generated roughly $694 million of EBITDA with 270 stores. Its advertising costs and its selling, general, and administrative (SG&A) expenses as a percentage of sales were about 24%. Fast-forward to 2006, when Dillard's generated about $562 million of EBITDA with 328 stores and had advertising and SG&A costs as a percentage of sales of about 27%.

So Dillard's now generates less cash flow with more stores and a more bloated cost structure. That 3-percentage-point increase in expenses is unacceptable in the low-margin department-store industry.

So what happened? In 1998, William Dillard II took over as CEO from his father, who founded the company. In 1998, Dillard's also undertook its largest acquisition ever, of Mercantile Stores.

The next year results were disappointing, and to management's credit, Dillard's bought back shares that it thought were undervalued as the stock plummeted. Following the acquisition, the company took numerous impairment charges to close stores and never really got back on track. In fact, shares still trade at a large discount to their share price in 1998.

Still, the biggest mark against the company is that the Dillard clan controls the company through ownership of class B shares, and that ownership allows them to elect two-thirds of the board members.

A retail catalyst
However, it's not all bad. Dillard's owns an enormous amount of prime retail real estate under its stores. At the end of 2006, Dillard's owned 241 of its stores outright. Based on Dillard's 56.5 million in gross square footage, I estimate (on a pro rata basis) that the company owns 41.5 million square feet of real estate.

As we all know, Eddie Lampert famously made billions investing in Kmart -- now a part of Sears Holdings -- thanks to its vast real estate properties. Could this be a similar situation?

Based on Dillard's $3.1 billion enterprise value (market cap plus net debt), I calculate that anyone buying Dillard's shares would be paying $75 per square foot of owned real estate ($3.1 billion/41.5 million).

In this weekend's Barron's, an article argued that Sears Holdings was cheap because the stock market valued Sears' real estate at $33 per square foot (based on enterprise value/average square feet). The article pointed out that comparables such as Inside Value selection Home Depot (NYSE:HD), J.C. Penney (NYSE:JCP), Kohl's (NYSE:KSS), and Target (NYSE:TGT) trade at $277, $144, $319, and $341 per square foot of real estate, respectively.

In addition, Dillard's trades at an enterprise value of just 5.3 times trailing EBITDA, compared with J.C. Penney at 5.8, Nordstrom (NYSE:JWN) at 7.4, and Macy's (NYSE:M) at 6.4.

Hedge funds at the gate
As an added bonus, Barington Capital, a very savvy hedge fund, has been agitating for change. Barington's track record includes helping other retail companies, including Pep Boys (also a real estate play), Syms, Warnaco, and Collective Brands, unlock value.

According to letters Barington wrote to Dillard's management, it appears that the hedge fund has not succeeded so far in getting management to implement shareholder-friendly measures. However, it's always a nice thing to invest alongside funds such as Barington and Third Point (which also owns a stake) that actively work to unlock value.

Stalemate or breakthrough?
It's tough to tell, given management's voting control, what the future holds for Dillard's. However, the company has significant real estate value, trades at very low multiples of sales and cash flow, and has some smart hedge-fund operators involved in the background, so we can at least have some hope that Dillard's shareholders will see their shares climb out of the bargain bin.

Other retail Foolishness:

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.