Dillard's

a fundamental analysis.

Dillard's

a fundamental analysis

By Manuel Maurício
October 16, 2020

Symbol: DDS (NYSE)
Share Price: $46.17
Market Cap: $1.03 Billion

Introduction

Recently, news came out that Ted Weschler, one of Buffett’s lieutenants, has been building a 6% stake in the giant retailer Dillard’s. When this was made public earlier this week, the stock went up 46% in one day.

For some years, we’ve been witnessing a phenomenon where expensive growth stocks have gone up and cheap value stocks (measured by low valuation multiples) have become cheaper. Today I’m bringing you a classic value stock whose value isn’t in its cash flows, but in a hidden asset. 

Acknowledgements: 

Before I proceed, I must thank Laurent Constanty , Kuppy, and Enrique Garcia for taking their time to teach me about the intricacies of short-selling, short squeezes, and Dillard’s business in general.

Business

Dillard’s is one of the largest department store retailers in the USA. It operates 285 department stores located mostly in suburban shopping-malls or open-air centers. Yes, I know. I’m looking at a brick and mortar department store owner in the midst of a pandemic that is accelerating the demise of traditional retailers. Call me crazy.

Today, everyone thinks about growth. But there’s value in other strategies as well. I’ve been following Enrique Garcia’s work for some time and he makes a compelling case for investing in retailers that are scaling back intelligently.

By slowly and deliberately closing the under-performing stores, these companies are able to generate high amounts of Free-Cash-Flow (forget the earnings) which can then be returned to the shareholders via dividends or buybacks. Shrinking the business to generate value for the shareholder might seem counter-intuitive, but it can be highly effective.

In fact, Dillard’s CEO is the first to acknowledge that what led to the fall of its competitors (JC Penney is currently going through a bankruptcy process and Macy’s is reducing its footprint), was the fact that they didn’t understand that a mature business isn’t a growth business. “Companies must act their age”.

Here’s the always captivating “Dean of Valuation” giving a great lecture about the life cycle of companies. I strongly recommend you to watch it. It’s great entertainment.

Before getting to the meat of the thesis, let’s go through the operating and financial metrics so we can understand the business.

Management and Ownership

The company is run by the Dillard family. There are 2 classes of shares. The Class A  and the Class B shares. The Class B shares are all owned by the family. Although they both have the same voting power, the Class B shares allow for control of 3/4 of the board of directors, so the Dillard family controls the company. 

The family directly owns roughly 16% of the company. Add to that the fact that the NewPort Trust, an entity who owns 33% of the company, is allegedly an investment vehicle run by the family, and the ownership reaches the 50%. It might be a bit more today given that both the company and the family have been buying shares recently.

Number of stores

The company has been steadily reducing the number of stores since 2005. Of the current 282 stores, the company owns 244 together with 10 Distribution Centers. 

Financials

But, instead of seeing the revenue go down proportionately to the number of stores, the company has been able to keep the revenues somewhat flat for the past 10 years.

Same-Store-Sales

That has been achieved because it has been able to offset the shrinking stores with growth in the same-store-sales. 

When we compare the SSS to Macy’s – another giant department store – we can see that these track each other pretty nicely so I would say that the same-store-sales growth varies with the economy, not so much with any single measure taken by the management.

Unfortunately, the company hasn’t been able to keep its profits as steady as its revenues. 

When we compare the share price with the operating margin, you’ll see that there’s a high correlation between the two.

Due to the divesting strategy set by the management team, the Capital Expenditures needed to keep the stores running have been much lower than the Depreciation charge on the Income Statement, leading to a higher Free Cash Flow than Net Income for many years. In layman’s terms, the company has been generating more cash than profits (yeah, I know, accounting!).

This can be seen as a glass-half-full problem. It’s unfortunate that the company hasn’t been able to find ways to reinvest the cash back into the business, but, on the other hand, the management hasn’t been throwing good money after bad pursuing growth (as some hired managers do because their incentives are aligned with growth, not shareholder’s value). 

Dillard’s management team and board of directors knows that this is a mature company whose business is slowly dying so they slowly return the cash back to the shareholders (themselves included).

This is great capital allocation. I bow to the Dillard family – Clap, clap – Well done!

Shares Outstanding

How has the company returned the cash to the shareholders? In great part by repurchasing its own shares.

Since 2004 the company has reduced the share count by 74% (!).

Some people say that the Dillard family is slowly doing a buy-out of the entire company. The more shares the company buys from exiting shareholders, the higher the percentage of ownership of the shareholders that keep their shares. It’s rumored that the Dillard family will take the company private one day. 

And why exactly would the Dillard family want to keep a dying business all to itself, you may ask?

Balance Sheet - the fun part!

I’m glad you asked. You see, there’s more to Dillard’s than meets the eye.

Most of Dillard’s real estate is carried in the balance sheet at cost minus depreciation (like all other companies). It turns out that much of this real estate has been bought decades ago, (mostly in the 80’s and 90’s) and it’s obviously worth a lot more today. How much more, no one really knows. You’d have to sell it to reach a precise figure. Or, alternatively, you could value each store (and land) individually. As much as I would like to spend several weeks doing that, I can’t. 

A good way to confirm that the real estate owned by Dillard’s is worth more than its stated value is the fact that over the years there have been recurring “gains on the sale of assets” whenever the company sells property. 

Because this is no secret, over the years, several high profile investors have tried to force the board of directors to shut down the retail business and lease (or sell) the real-estate. They argued that in both cases, the value created for the shareholder would be huge. But with control of the board, the Dillard family is in no rush. It wants it all for itself. 

“We believe the value of Dillard’s vast real estate holdings is well north of $200 per share. … In fact, our estimated rental value to more productive retail tenants exceeds the company’s entire current income as a retailer.”  – Jeffrey Pierce- Snow Park Managing, 2017

The book value per share has been going up for, at least, the past 15 years. Today, the book value per share is around $61 (it went down due to the losses in the first half of the year). But this book-value is understated because of the depreciated value of the real estate. If we were to value it properly, we would likely see the book value much higher than today. 

Valuation Ratios

When we look at the Price/Free Cash Flow and to the Price to Book value, we can see that both are deeply influenced by the operating margin. If the business goes well, we can expect the share price to go up. 

At 0,8 times the value of a depressed book-value, the company can be considered  to be cheap.

Shorting Stocks and Short Squeeze - Geek's only!

Ok, we’ve concluded that the real estate is what creates the margin of safety here. But there’s more. Buckle up for some financial stuff.

In the financial world there is something called shorting stocks. Shorting stocks has got nothing to do with short or long term. Shorting a stock is betting that the price of that stock will go down. Here’s how it works:

To short a stock, you borrow the stock from another shareholder or from your broker, (you pay a fee for that), you sell the stock right away and you wait for the price to come down. Hopefully, the price will come down significantly so you can buy back that stock and return it to the original owner. You earn the difference. When someone shorts a stock he is called a short-seller. If the price of the stock goes up, the short-seller will immediately be losing money. And he can lose a lot of money.

I mention this because the current amount of Dillard’s stocks that are short is very high. In financial lingo, you say that the short interest is very high. This means that there’s a lot of people (or just a few with deep pockets) betting that Dillard’s will be the next bankrupt retailer just like JC Penney, Macy’s or others (or at least that its share price will go down dramatically). 

Now, when there’s a sudden trigger that makes the stock go up, the short-sellers should buy back the stocks at a higher price (thus losing money) so they can give them back to whomever lent them the stocks in the first place; they will cover their shorts.

In the case of heavily shorted stocks (in relation to the number of shares that are available in the market), there might not be a lot of share for the short-sellers to buy. This will create a supply-demand imbalance that will push the share price higher. This is called a short squeeze. And it can take epic proportions. I’ll write an article about it one day.

Dillard’s has been a heavily shorted stock over the past years. Just recently, Kuppy from adventuresincapitalism.com alerted to the situation where there were more shorted stocks than the ones available to cover. When news came out that Buffett’s protegé had bought 6% of Dillard’s, the shorts had to cover (aka buy stocks in open market) because the lambs would obviously follow Ted. This led the price of the stock up 46% on Monday.

Now, this may not stop here. The squeeze might go on to become an Infinity Squeeze. But no one can say for sure, so I’ll leave that speculation to others.

Competition

There’s a lot of competition (especially with e-commerce booming). Among the most well known peers are Macy’s and J C Penney, two struggling giants.

There’s also the e-commerce players; probably the most important competitors right now.

Risks

  • Margin erosion
  • More shut downs
  • Less foot traffic

Conclusion

Ted probably bought his shares when they were trading in the low twenties. I can see why he did that. It was a cheap asset play with a big margin of safety that might benefit from a number of macro tail winds:

The combination of aggressive share buybacks below book-value and the slow liquidation of real estate above book-value is one of the best examples of great capital allocation I’ve seen so far. But I’m not convinced. All it takes for the company to show losses is a slight decrease in the gross margin. How likely is that to happen? 

The gross margin has been going down since 2014, so I don’t see a reason for it to go back up again. Now, you might say that with more and more of Dillard’s competitors closing shop, the company will gain some pricing power. That might happen, but will it happen? I’m not so sure. 

And yes, even while showing losses on the Income Statement, the company can still generate cash because it will be investing less than the Depreciation charge, and yes, it can still sell property for a gain. 

I’ve thought about this plenty. I’ve played around with the numbers and I still can’t reach a conclusion. I guess what I’m trying to say is that Dillard’s is going to my “too hard” pile for now.

Further research material

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