Research Note on Dillard’s Department Stores
A Real-estate Play Masquerading as a Women’s Apparel Retailer
Company Name: Dillard’s
Ticker: DDS (NYSE)
Market Capitalization: $1.97 Billion
Share Price: $57.94 on 9/21/16
Shares Outstanding: 34.5 Million
Enterprise Value: $2.66 Billion
Dillard’s is a consistently profitable retailer that specializes in aspirational women’s apparel at compelling price points. I have been a loyal Dillard’s customer since I was fourteen because I love their styling, designs and fabrics. Their buyers and merchandising specialists definitely know what they are doing.
While being a customer led me to look at their financials, I soon realized that this is a deeply undervalued gem with a plethora of hidden and incredibly valuable real-estate assets. In 1996, the Dillard family held a 7 million share stake and owned a 6% economic interest in the business. Today they own 7.4 million shares. While their shares held has increases by just 5%, their economic ownership has increased from 6% to nearly 22%! How did that happen? In 1996, Dillard’s has 116 million shares outstanding. With one of the most aggressive buyback programs of any NYSE listed business, shares outstanding have shrunk to just 34.5 million – a greater than 70% reduction in share count. The company is not done yet. With a market cap under $2 billion, the Dillard’s board authorized another $500 million stock buyback earlier this year. I estimate that over the next 4-5 years Dillard’s will spend a billion or more buying back shares. They intend to buy back a billion dollars worth of shares of a company with a market cap of just $2 billion!
So, while the outsiders are busy selling their shares to the company, the insiders sit pat and are on track to quadruple their interest in the business soon. Another long-term holder of Dillard’, Evercore Trust, owns nearly 8 million shares and a 25% interest in the business. And then finally there is David Einhorn of Greenlight Capital. Greenlight owns 2 million shares of Dillard’s. Einhorn has been steadily increasing Greenlight’s stake in Dillard’s. A year ago, he owned just 1.2 million shares. Einhorn began buying Dillard’s in Q2 2015.
Clearly David Einhorn, Evercore and the Dillard Family are long and strong with Dillard’s. Between them they own over half the business. In an era where retail is dying, why are these folks so deeply pregnant with Dillard’s? What are they seeing that is perhaps not visible to the rest of the market?
William T. Dillard opened the first Dillard’s in Nashville, Arkansas in 1938 with $8,000 borrowed from his father. With his wife, he created quite the successful enterprise. Today Dillard’s has $6.6 billion in annual revenues and net income is over $250 million. Let’s drill down on Dillard’s real-estate assets. The 330 stores that Dillard’s operates in 28 states stand on 50.1 million sq. ft. of retail store space. The company owns 44.4 million sq. ft. of this space.
The multi-billion dollar question is: What is the underlying market value of this 44.4 million sq. ft.? It’s probable that the army of analysts at Greenlight have drilled down on every store to make an accessment. As a busy Berkeley senior, I was limited to a statistically significant sampling. From Loopnet, I pulled approximate valuations on 28 of their 330 stores. These 28 stores are quite diverse and I believe a fair representation of Dillard’s entire portfolio.
As can be gleaned, Dillard’s 44.4 million sq. ft likely has a market value approximating $6.8 billion versus a balance sheet book value of about $3 billion.
So, how will Dillard’s monetize this incredible asset? Dillard’s has already put these assets in an internal REIT as a first step. While the company does not break it out, clearly there are likely atleast a few dozen stores that are losing money that can be closed and liquidated. The economics would be similar to Seritage taking over an existing Sears mall store. It costs Seritage about $100/sq. ft. to redevelop and release these Sears stores. The average new rental is approximately $20/sq. ft for a triple-net lease.
For Dillard’s, let’s say it reduces its retail footprint at the rate of 2 million sq. ft a year. And let’s also assume that their net income drops by $16 million/year. In other words, 5% of 2015 pretax earnings; presumably they are closing mostly the money losers and the income drop is far lower with the difference being store closing expenses. Inventories can mostly be re-purposed to other stores or their dedicated warehouse for Internet sales.
When the 2 million square feet is re-developed, it will cost Dillard’s about $200 million. After it is re-leased, the rental income is $40 million a year, which would value the property at $500-800 million (based on a cap rate of 5-8%). Let’s assume an average value of $650 million. Dillard’s can get any bank to finance the property with a 70% loan to value. In other words, Dillard’s would receive $455 million from such a financing. It would have netted $255 million. In addition, the annual rent of $40 million would lead to about $10 million in cash flow after interest payments. The economics are stellar! Let’s assume Dillard’s embarks on this plan in 2017 and rents start arriving in 2018.
If Dillard’s re-develops and leases 2 million sq. ft. a year, it will generate $265 million of cash flows annually. In ten years these cash flows would be $350 million+. So as the retail cash flows decline, the real-estate cash flows more than make up for them. Companywide cash flows likely are always over $400 million. Dillard’s does not break out its catalog and internet sales. The company can eventually have a strong online business supported by perhaps 30 top-performing stores, including a few flagships.
If the company completes its present buyback at an average price of $80/share, there are just 28.3 million shares left. By 2018, cash flows are $10-14/share (the REIT structure is quite tax efficient). That’s an intrinsic value north of $150/share by 2019.
Possible Case
Avg. Buy price in 2016: $60
Avg. Sell Price in 2019: $150
Annualized Return: 36%
If Dillard’s does not re-develop the space, but simply closes and sells 1 million sq. ft. a year, it will generate $150 million/yr, from these sales. Even with declining retail cash flows, it can continue its $250 million/year buybacks. If it has the same 28.3 million shares outstanding by 2018, and cash flows are over $10/share. The stock should trade in the $100-150 range – especially as the real estate value becomes more transparent.
Probable Case
Avg. Buy price in 2016: $60
Avg. Sell Price in 2019: $125
Annualized Return: 28%
The Bear Case
The above plans require the Dillard family to be willing to do a faster liquidation of a retail empire than they have shown a stomach to do in recent years. What if they liquidate very slowly and store closing costs eat away most of the value of the excess real-estate? What if cash-flows decline by 5% annually? What does this melting ice-cube look like:
2016-17 buybacks: $450 million @ $70/share
2018-19 buybacks: $400 million @ $80/share
2019 Shares Outstanding: 24 million
2019 Cash Flow: $200 million; $8.33/share
The Bear Case
Avg. Buy price in 2016: $60
Avg. Sell Price in 2019: $80
Annualized Return: 10%
The Amazon Threat
We know that Amazon is gunning for Dillard’s business. However, women’s fashion apparel is one of the most difficult categories to kill. Also, Dillard’s footprint is not on the coasts, which are the early-adopters. The Dillard’s customer is probable the hardest to move online. Therefore, I think modeling a 5% annual decline is reasonable.
Conclusion
At its current stock price, Dillard’s offers a free option to “look-see.” The company has already moved the real-estate into a private REIT. If they follow the Seritage playbook, this is a home run. If not, we still likely beat the S&P 500.