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Dillard's Daunting Dilemma
By Nathan Parmelee (TMF Scrap)
May 24, 2005

Department store operator Dillard's (NYSE: DDS) reported a rather steep earnings decline this morning, because sales were softer than expected.

This problem isn't exclusive to Dillard's. Many retailers have reported soft or declining numbers this quarter. I think we're on the verge of seeing some bargains among retailers. That said, when it comes to retailers it's going to take a phenomenal valuation to attract me to a department store chain. I can't help but wonder how investors can be surprised when a department store chain disappoints...
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I can't fault your reasoning for some of Dillard's problems. However, does that make it a bad investment at this point? I'm not inclined to believe that.

First, the company is trading at 15% discount to book value. I didn't dig into the financial statement footnotes, so I don't know how good the book is. For the sake of argument, I'll assume that it's good for now.

Second, I made a couple of adjustments to the book value just for giggles. Let's say in a breakup situation Dillard's current inventory is worth 50% or $1,036.9 million. Working that through the statements, Dillard's would be worth about $15.80 per diluted share and would currently be trading at 1.5X my adjusted book.

Of course, a standard theme among private equity players and other folks is that the often times the property, plant, and equipment of the big retailers (Sear's) is undervalued on the balance sheet. Let's say that Dillard's PPE ($3,202.7) is undervalued by a conservative 10%. So, maybe the property is really worth $3,558.6 million. Working this and the adjustment to inventory through the balance sheet provides a breakup value of $20.11 per diluted share, so the stock is currently trading at 1.2X my adjusted book.

For reference, Federated is currently trading at 1.83X book (mrq). May is at 2.52X book (mrq). Saks is at 1.26X boor (mrq). These multiples carry no adjustments from what's reported. So, at the least Dillard's trading at a discount to its peers. At the most, the inventory is worth more than 50% in liquidation and the property is worth much more than book meaning that selling at a discount to book is probably unfounded.

Third, the company just announced a $200 million share buyback. I believe that Warren Buffett would be applauding this. The current shareholders are buying back chunks of their own company at a discount to book. That's a beautiful share buyback plus the company is paying a small dividend which should probably be raised if they have the cash flow.

Fourth, earnings estimates were forecast to be decrease this year compared to last and increase by around 25% for the next year. If it comes true life is good. If not book value will provide a margin of safety.

Fifth, the company does business in the southeast, southwest, and midwest parts of the U.S. Considering, the population growth in the southeast and southwest parts of the United States particularly among department store shoppers (retirees), I can think of worse places to be in business (Ohio). Just look at the store closings and openings for last quarter. The company opened new stores in Atlanta (one of the fastest growing urban areas), Jacksonville (one of the fastest growing urban areas), and some place in southern California (nuff said) while closing stores in Cleveland and Cincinatti.

Sixth, I have faith in the founding family to get stuff sorted out on the merchandising side of things.

All in all, this seems like a strong buy. Due to a lack of investible funds, however, I don't own this stock.

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Hey Builder62,

Excellent post.

Before I delve into some of the above let me point out what the article that ran on the site is one of our shorter form pieces. Given what I had to work with I chose to focus on the long-term viability of the business, which I consider poor instead of a detailed analysis of whether or not the company is attractive at today's prices.

Given that you've put a lot of Foolish effort into the above, I'd like to continue the discussion. You raise a number of goods points and there are a few mutual funds that I respect that happen to agree with you. Still, after taking a look at the most recent 10-K and proxy statement there are a handful of things that have me disinterested in this business unless it was trading at a large fraction to book value.

- Dual class share structure is being abused. Dillard's has two share classes. One is publicly traded (class A) and has the right to elect 1/3 of the board of directors, the other is not public traded (class B) and has the right to elect 2/3 of the board of directors. The Dillard family holds the shares that are not publicly traded and in effect control the company from top to bottom.

- The current earnings are at or near the top of the cycle as the economy has rebounded since 2001-2002. Couple this with declining sales despite the fact that the store count has been fairly stable.

- Abysmal return on equity, which is somewhat amazing given their use of leverage.

- Declining book value. This doesn't concern me as much, because we're talking about real estate and P&E being depreciated due to accounting rules, where as the value of the real estate is almost certainly more than they paid for it years ago. Share repurchases will also decrease the value of shareholder's equity and book value, but I view this as being offset by the net losses run in previous years. Still it's a negative sign to see book value in a declining trend.

- A qualifier to your analysis of book value regarding the value of the stores. They only own 80% of their stores, the other 20% are leased. I'm not sure if you factored that into your assumptions.

I believe the company trades at a low book value multiple primarily because it is a business in decline with a poor ownership structure. To me this means that holders of the class A common are not likely to get much out of the business even if they do sell off the assets, because the Class B shareholders have almost complete control over how the gains from the sales will be distributed (ie via bonuses, stock options, etc.).

As it stands today, it's not a terrible business. It's an ok business with a terrible ownership structure and a poor long-term outlook. At certain prices an investor can wring out some profits here. I don't doubt that... I'm just not sure it's worth the trouble in comparison to other retailers out there.


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I would agree that the dual class structure is a problem. I'm not a big fan. I think that you can see similar problems with Viacom's stock (class B) due to Redstone's absolute control of the company. Viacom trades at 1.39X book even with some of the greatest brands in cable media (Nickelodeon, MTV) while Disney (ESPN - the third pillar of cable tv) trades at 2.14X. Besides the obvious asset makeup differences, I would say that a lot of the price difference is due to the lack of a possible takeover at Viacom. The same would be true at Dillard's. A privatey equity buyout is almost eliminated at Dillard's by the family control.

However, even at a company without the control issues of Dillard's before taking a position an investor should ask themselves if they trust management. This is even more crucial at Dillard's. If you do trust Dillard's management (family) though then you might be getting a deal.

As for the other issues you raised, I didn't take the time to look. I did a fly-by on the balance sheet and quickly crunched some numbers. Like you I did see some mutual funds that I respect in the stock and that always gives me cause to pause and ask some questions.



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However, even at a company without the control issues of Dillard's before taking a position an investor should ask themselves if they trust management. This is even more crucial at Dillard's. If you do trust Dillard's management (family) though then you might be getting a deal.

It's interesting that you raise the question above of trusting management. I didn't elaborate on it initially, but the existence of a dual-class structure where one group gets 10x voting rights and therefore control of management, the board, and by extension compesation tells me trusting management means I'm taking on extra risk. Very large amounts of risk.

I can understand that historical performance of certain companies may indictate otherwise, but the lack of a gatekeeper keeps me away except for some rare deep-value situations.

There are a couple cases where I've thought long and hard on the past. Claire's and Boston Beer Works. Neither has been deep-value for a while, but thus far they're the only two where over a long peroid of time I've talked myself into taking a small "chance" on a dual-class structure investment.


Nate Parmelee
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