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Dillard’s: A department store on sale for investors

The drama in U.S. retailing is at J.C. Penney Co. Inc., where former Apple Inc. executive Ron Johnson, brought in to revitalize the retailer, has instead presided over two disastrous quarters. The company's recent earnings numbers, where the company missed sales expectations, posted a bigger-than-expected loss, and recorded a 22 per cent decline in same-store sales, suggest a company in crisis.

It's enough to make you wonder whether there's any hope for the good old-fashioned department store sector. Yet there is a retailer in Arkansas – not named Wal-Mart – that suggests the answer is yes.

That company is Little Rock-based Dillard's Inc. While J.C. Penney is now down by about one-third year-to-date, Dillard's has gained nearly 65 per cent in 2012 on a series of strong earnings reports.

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Take a look at the results released earlier this month: Net income of 63 cents per share (U.S.) nearly doubled the prior-year's quarter. Same-store sales – those in locations open at least one year – gained 3 per cent. Gross margin improved by seven-tenths of a percentage point.

Why haven't you heard of Dillard's? It's a little inconvenient for Canadians to make a quick cross-border shopping trip, as its northernmost stores, just four of them, are in Montana and Idaho. The company operates across the southern and Midwest U.S., with about one-third of its roughly 300 stores in Texas and Florida.

The company's recent successes, analysts say, comes from a move up the retailing food chain.

"Over the past three years, Dillard's has worked to move its product offering more upscale, focusing on the market opportunity between Macy's and Nordstrom, targeting a higher-income demographic and battling more on fashion than price – separating itself to an extent from moderate peers Macy's, JCPenney, and Kohl's," said Matthew Boss of JPMorgan Chase & Co.

"From a merchandising perspective, the company lightened inventories … beefed up customer service and introduced a number of new brands," he said.

Mr. Boss says his store visits in the recent quarter indicated the company rolled out Under Armour products in its Boys section (with men's and women's products to come); Swatch watches; True Religion fragrances; and Kenneth Cole and Marc Echo menswear.

Analyst Jason Asaeda of Standard & Poor's says Dillard's has "pursued a real estate strategy of entering or further penetrating markets in which it believes it can become the dominant conventional department store operator." Picking spots with low occupancy costs "present an opportunity to generate higher profits on less volume," he says.

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The results: Dillard's has now beaten Wall Street expectations in 12 of the last 14 quarters, after missing them nine quarters in a row over 2007-2008.

Despite the track record, Dillard's is not expensive. With recent trades around $74, the forward price-to-earnings is around 11; Kohl's Corp. and Macy's Inc. trade between 10 and 11, according to Standard & Poor's CapitalIQ. Nordstrom Inc. is at 15, and J.C. Penney, despite its fall, is still at 20. Saks Inc. tops 26.

Dillard's enterprise value, or market capitalization plus net debt, is about 5.4 times forward EBITDA, or earnings before interest, taxes, depreciation and amortization. Kohl's is at 5.3 times, but every other North American department-store chain (the previously named companies, plus Sears Holdings Corp. and Sears Canada Inc.) is more expensive on this basis.

Analysts have been hesitant to place aggressive target prices on the shares, with Mr. Boss raising his target price from $70 to $75 after the recent earnings report and maintaining a "neutral" rating. Michael Exstein of Credit Suisse made the exact same moves. And Asaeda of Standard & Poor's maintained his "hold" rating. (They seem to represent the extent of Dillard's Wall Street following, according to Bloomberg.)

However, both Mr. Boss and Mr. Exstein had "neutral" ratings in place coming out of the company's May earnings report and maintained them as Dillard's shares slipped to the low $60s in mid-July. At around $74, they are now up 13 per cent in the first eight trading days of August, boosted by a 5 per cent jump Aug. 9 on earnings.

It seems J.C. Penney will continue to grab headlines with its mess. In the meantime, investors should consider this under-the-radar winner.

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