Buy Dillard’s (DDS) – stock selloff overdone

August 12, 2011
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dillardsDillard’s investment presents an opportunity.

This post is different from a “focus investment” which is a much more in-depth analysis and suitable for longer-term investment. See the post on Guess (GES) with the attached PDF for a “focus investment” selection (we still like Guess btw). This trade idea is an observation on a market dislocation.

Dillard’s (DDS) is down 17.5% on not beating expectations. The results at Dillard’s were not fundamentally bad. EPS were up from $0.10 last year to $0.32 this year (adjusted EPS). Same store sales trends remain healthy (+6% for Q2) and margins are expanding. The key quarter for full year earnings is Q4 – so you have to believe we won’t be in recession by the holidays. But if you believe we avoid recession, Dillard’s is set to earn $4.48 in EPS this year and $5.20 in EPS next year (Crackerjack estimates). Dillard’s is under-followed by Wall Street because the management team doesn’t talk with analysts leading to less “Street sponsorship” which can create investment opportunities.

Dillard’s is a national department store chain that caters to middle to upper-middle income customers across the South, Midwest, and parts of the Northeast. Dillard’s is largely done opening stores (store-count is 291) and the company spends little “growth capex” as they are focusing on using free cash flows to repurchase shares. The company has been able to reduce the current diluted share count from 67.7m shares a year ago to 55.2m shares  in the current quarter. The share count of the company is down 18.5% y/y. This strategy will continue which provides high visibility EPS growth as long as sales can remain stable (they don’t need to grow much). Operating cash flows are running ahead of last year’s levels and we see sustainable free cash flow generation (after capex) of $400M. With a market capitalization for Dillard’s of $2.27B the company is being valued at a free cash flow yield (free cash flow / market cap) of 17.6%. Given that Dillard’s has shown an appetite to purchase shares aggressively, we think there is a high probability that the shares get back to their highs this year ($60) and continue to appreciate at a 15-20% rate each year as the company buys back the public float.

For an example of another company which engaged a very similar capital allocation strategy with aggressive share buyback see the multi-year chart of Autozone (AZO).

Intriguing is that there is a very heavy short interest in Dillard’s 8.2M shares or 25% of the float. We believe that shorts are likely to cover on this pull-back and think the shares are a buy at $41.75. For investors that trade options, another strategy would be to sell the August $42, $41, or $40 strike PUTS. The options expire in 5 trading days (next Friday) and the implied Volatility in Dillard’s shares is very high (70 vicinity) though this will come down with the earnings release being out.

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