An investor in 2009 needed to know three things: was DDS financially stable, was management responding sensibly to the oncoming recession, and was the company undervalued with a margin of safety?
Midway through 2008 ratings agencies began to downgrade Dillard’s [sticking to Moody's here because they provide historical ratings and press releases]. Moody’s dropped the DDS corporate family rating from Ba3 to B1 in April, then down to B2 in January’09 with outlook negative.
For some perspective, here are the financials. The balance sheet as of Q3 2008 and at the end of FY 2008:
Cash flows as of Q3 and full year:
Here’s a press release from 10/31/08, shortly after Moody’s put DDS on review for the second downgrade. This sums up the situation and addresses a few of the major issues facing the company in the 2008/2009 period.
-We maintain a $1.2 billion revolving credit facility with JP Morgan Chase Bank as the lead agent. The credit agreement expires December 12, 2012. There are no financial covenants under this facility provided availability exceeds $100 million. Even at peak working capital requirements in late November, availability should well exceed $500 million.
-After we pay the $100 million 6.625% notes maturing on November 15, 2008, total maturities of long-term debt over the next two years are less than $26 million.
-We have announced the closure of 20 under-performing stores in 2008 to date. This action will result in over $50 million less working capital requirement from inventory alone. We are continually evaluating the store base and anticipate more closures in 2009.
-New store openings in 2009 have been reduced to two compared to ten in 2008. Capital expenditures for 2009 have been trimmed to approximately $120 million from approximately $204 million in fiscal 2008 following $396 million in fiscal 2007. Rating agency metrics ignore the greatly enhanced cash flows from this significant reduction in capital expenditures.
-We expect over $50 million of savings in advertising, selling, administrative and general expenses in fiscal 2008 as a result of measures implemented earlier in the year. We continually review our expenses for additional reduction.
The most relevant point for the immediate situation was the debt maturing at the end of the year. As mentioned in the press release $100M was maturing November 15th. After that, DDS was out of the woods in the short term:
The next two years amounted to <$26M as the press release pointed out. 2011 and 2012 only had about $56M each. That's only about 20% of the OCF of even a poor year for DDS, so that would have been manageable if DDS was unable to roll it over for some reason.
Historically the company was a cash generator with significantly positive cash flow back to 1997, which was as far as I checked. That's a mundane positive, but in a deep recession it's hard to get excited about a company with a history of relying on infusions of cash to funds its operations. Following the big expansion period at the end of the 90s when they acquired Mercantile Stores Company and jacked up the store count from 250 to 328 in the space of two years (and that's after selling 26 stores post-deal to raise cash - the net gain would have been 104 otherwise!), DDS has generally funded its capex internally (exceptions in '07 and '05). Excess cash went to pay down the acquisition debt ($2B) or buy back shares.
Regarding capex, Dillard's doesn't need it in the literal sense, but requires it in the staying-relevant-and-not-looking-like-Sears-inside sense. If you look at the capex in the FY 1999-2007 period (the post-MSC acquisition period) it averaged $295.8M. Even if the company dialed down its growth plans – which it had by this time – it probably needs at least $200M annually to keep current. It could get by with less, but only as a short-term measure.
Operating leases are something to keep in mind since they tend to make a retailer’s balance sheet look more pristine that it is in real terms. Luckily DDS owned 77% of its stores outright, with some level of partial ownership of another 9.5%.
Finally, I wanted to know what the industry as a whole looked like comp-wise. Behold:
DDS was the cheapest of them all in P/B terms. It was also the second cheapest by P/S, behind only BONT and its miniscule holy-shit-we-have-a-giant-pile-of-debt-and-here’s-a-recession market cap (BONT leases 239 of its 280 stores, so effective leverage is even higher than it looks). If you go by EV/S instead, DDS is once again the cheapest. Compared to its peers DDS’ D/E of .536 put it in the bottom half of the group. The four companies with negative net income for FY 2008 were generally speaking the cheapest as a result. The exception there is SHLD, which I would speculate is near the bottom because, y’know…it’s Sears. Initially I didn’t see why DDS was crushed so much relative to most of its money-losing peers. BONT made sense – it was highly leveraged, so I can see investors tossing it overboard when there’s a banking crisis. I broke out the gross margin trends and the cause became a lot clearer:
The companies that had investors deserting in droves were the ones that suffered huge declines in gross margin. DDS and SKS were in the gross margin hall of shame, with declines of 4.14% and 7.17% respectively. Add in BONT and their collective chart looks like this:
data by YCharts
Whereas the other five looked like this (someone forgot to tell Kohl’s about the bear market…):
data by YCharts
So, I think it’s fair to say that gross margin is a lot of what the valuation hinged on at the time.
Was management making the right moves? I would say tentatively yes (2008 annual report). Even though gross margin is a big issue, I think it’s important that management was prioritizing cost savings because that’s the factor they would have the most control over. Not rocket science, but a really important basic point for a company looking to rapidly improve its operations – if they’re overlooking that it’s a big “look elsewhere” sign.
The first test is how management performed at meeting the goal outlined in the press release above. $50M+ in savings isn’t a lot relative to the size of total expenditure, so it makes a good benchmark to evaluate performance. If DDS failed to reach even that meager goal, red flag. If it exceeded, it’s a sign management has their eye on the ball. The results are under the year ended Jan. 31, 2009 below:
The actual reduction ended up being $131M. For perspective, this is by far the lowest – by over $90M – SG&A has been since 2003. I also checked how volatile SG&A has been in the past since a big move in a volatile category is meaningless if it’s been historically jumpy. The standard deviation pre-2009 was only about $43M, making a 3+ SD move. I’d count that as significant. So management wasn’t asleep at the wheel and they were targeting an additional $200M in reductions for FY2009. What could an investor project for the future? A few scenarios below, alongside the actual results:
Case A is what it would have looked like if sales declined 10%, gross margin reverted to the recent historical average (33.63%), and management hit their goal of $200M in expense reductions [the D&A and interest expense estimates came from the FY 2008 annual report]. Case B is the ugly case, what it would have looked like if sales plunged 20%, margins remained at the ugly FY 2008 levels, and expense reductions totaled only $100M. Management had exceeded their expense target for ’08 so I think Case B is overly pessimistic, but where investors stand would depend on how confident they feel about margin mean reversion in the context of the recession and how much they trusted management.
The first concrete indicator of how the situation was progressing came in mid-2009 with the Q1 2009 10-Q. As it happens, DDS killed it. Gross margin was up to almost 35% and the annualized SG&A reduction was over $200M. At that point it was definitely clear that management was handling the crisis well.
For valuation, I like tables like this that visually emphasize the distribution of the possibilities:
And in percentage terms, relative to EV at $7/share:
If you believed that gross margin was likely to revert to pre-recession levels, the valuation at $7/share was compelling. If you were a “show me” sort of fellow and waited to see the Q1 2009 10-Q, the valuation table looked like this ($10/share):
A lot more red, but in this case an investor would have the comfort of knowing for a fact that management had gotten margins way up and expenses down in line with their targets. For reference, the current EV of DDS is 4.593B – way off the far optimistic end of this table. More on that later though…
To answer the article’s initial question, investors could have responded affirmatively to all three questions. How soon they could have done it just depended whether they were more comfortable trusting in margin reversion following an eventual return to business as usual in the overall economy or whether they needed to see hard evidence first.