Overview:

We will examine the reasons why Dillard's stock is attractive and why value investors including, David Einhorn, have been buying.

Dillard's (NYSE:DDS) encompasses numerous value metrics I look for in an undervalued situation.

Dillard's has: ample liquidity, low debt, positive earnings, low p/e, strong balance sheet, a large stock buyback program, strong cash flows, and is temporarily out of favor with investors.

The company:

Dillard's, Inc. ranks among the nation's largest fashion apparel, cosmetics and home furnishings retailers with annual sales exceeding $6.5 billion. The Company focuses on delivering style, service and value to its shoppers by offering compelling apparel, cosmetics and home selections complemented by exceptional customer care. Dillard's stores offer a broad selection of merchandise and feature products from both national and exclusive brand sources. The Company operates 271 Dillard's locations and 23 clearance centers spanning 29 states plus an Internet store at www.dillards.com. (Source: Dillard's website:)

Recent Earnings and Sales:

First Quarter Results

• Dillard’s reported net income for the 13 weeks ended April 29, 2017 of $66.3 million, or $2.12 per share, compared to net income of $77.4 million, or $2.17 per share, for the prior year first quarter.
• Net sales for the 13 weeks ended April 29, 2017 were $1.418 billion and $1.503 billion for the 13 weeks ended April 30, 2016. Net sales includes the operations of the Company’s construction business, CDI Contractors, LLC (“CDI”).
• Total merchandise sales decreased 4% for the 13-week period ended April 29, 2017. Sales in comparable stores for the period also decreased 4%.

Dillard’s Chief Executive Officer, William T. Dillard, II, stated, “While our sales decline weighed heavily on our operating results, we remained active in returning cash to shareholders through $93 million of share repurchase and dividends. We still ended the quarter with $302 million of cash largely due to better cash management.”(Einhorn picks DDS)

It's logical to assume that famed value investor, David Einhorn, recognizes the potential in Dillard's due to the attractive valuation we will examine next. However, each investor must do their own due diligence.

From the recent Greenlight Shareholder Letter ...

Long a variety of low-multiple, tax-paying, U.S. value stocks. Corporate tax cuts provide the most benefit to companies that have profits on which to pay taxes. AMERCO, CC, Dillard's, and DSW (NYSE:DSW) are all generally full federal tax-payers with healthy profits. - David Einhorn/ Greenlight Capital Letter (source: Valuewalk)

Why Dillard's is attractive:

Balance Sheet Strength:

As a value investor, I tend to focus on current assets in evaluating a company. Liquid assets and cash are my favorites. I would like to see the current ratio at or above 2x. The company is extremely close.

DDS data by YCharts

(via Dillard's quarterly report)

Cash Flow:

In spite of the weakness in retail, the company is still able to generate tremendous cash flows.

DDS Net Income (Annual) data by YCharts

Oversold and Out of Favor:

Dillard's stock has been hammered along with other retailers. As you can see from the chart, DDS, which traded above $140 in 2015 now languishes around $49. As a value investor, these are all positive factors in our search for out of favor situations.

DDS data by YCharts

Earnings & Low P/E:

The Trailing 12-month p/e is just above 10 versus a historical p/e of about 15. This discount represents the negative sentiment of the retail sector and uncertainty. When the stock was trading at $144, the p/e was close to 20. Wall Street makes you pay dearly for certainty.

Competitive Advantage:

Lending companies are now asking for a surcharge of up to 2% on riskier retail companies like Neiman Marcus, Bergdorf Goodman, and Barneys New York.

Lenders who finance luxe shopping chains are nervous for the holidays

 

Some lenders who finance retail vendors are getting skittish about the holiday prospects for luxe chains Neiman Marcus, Bergdorf Goodman and Barneys New York,

“We are fully supporting the Neiman Marcus Group and we are approving all orders,” said Gary Wassner, CEO of Hilldun Corp., a factor. “But the shifting marketplace for retailers today has increased the risk assessment, and thus the credit community has imposed surcharges.”

Dillard's has the advantage of a solid balance sheet and $302M in cash. This allows the company flexibility to invest either online or in their stores. While others in retail are cutting back due to debt, Dillard's has the ultimate competitive advantage, cash and liquidity.

Liquidity and Stock Buybacks:

Current Assets ~$1.8B and cash of $304M. During the year, the Company purchased $246.2 million of Class A Common Stock under its share repurchase authorization.

(via Dillard's results).

Concerns:

Amazon (Nasdaq:AMZN) as a competitive threat:

As a value investor, we seek opportunities where an industry is out of favor. In this case, the fear of Amazon has been so overpriced by investors, that it allows one to purchase Dillard's at a very attractive price based on the fundamentals of the company. We are aware that same-store sales slipped in the recent quarter, however, the pessimistic view is priced into the shares at current levels.

Get paid to wait:

Sell a put:

Why its attractive: selling a put allows us to profit even if the stock stays where it is. Also, it allows us to acquire shares below the current price and thus, at a discount. This allows us to increase returns while reducing risk.

1. Sell a Put: DDS is ~$50, so we're selling the put below the market.

Sell: July 21 $45 put for .85

Premium received: 1.93% for 45 days or Annualized at 15.44%

If the stock trades below our $45 strike, the cost basis would be $44.15 (we would then own the stock at ~11.50% discount from today's price).

This is my preferred method in a situation like this. The shares are undervalued, but there is not an imminent catalyst. They could remain undervalued and trade sideways. Either I will profit in the position or I will receive the shares at a more attractive valuation. Win/ Win.

Buy the stock/write a call:

2. Buy the stock and sell a higher priced call:

We would buy Dillard's stock at $49.89 and sell the July 21 $55 call for .78. This limits the upside to the position beyond the $55 level but also brings in .78 for 6 weeks of holding the stock.

At $55: 11.84% return and ~94.70% Annualized

Again, we will be able to profit if the stock moves higher, stays at the same level, or even if it goes down a little. Win/Win/Win

Conclusion:

Dillard's is attractive based on all of the important metrics that smart value investors like David Einhorn look for: earnings, low p/e, stock buybacks, solid free cash flow, in a stock and sector that is out of favor with investors.

To add an extra layer of safety, we look to initiate a position either by selling a put or buying the stock and selling a call. This allows the investor to profit in many different scenarios, enhancing total returns and reducing the overall risk.