By Damion Rallis, Senior Research Associate
While share prices at retailer Dillard's, Inc. (NYSE:DDS) continue to soar to unprecedented levels, recent events serve as a reminder that the company's long-term prospects may be muddled by a self-serving ownership and leadership structure dominated by Dillard family members. Despite a recent $5 special dividend along with impressive year-over-year and third quarter results, a sagging retail industry, active insider trading, and another multi-million dollar fine for discrimination remind us why, only five years ago, investors were calling for the end of Dillard-family control.
At GMI Ratings, we have identified several red flags that contribute to an ESG Rating of "D" and a Litigation Risk Model assessment of "Moderate Risk." In our view, while recent trading history at Dillard's shows a clear potential for short-term gains, the company's governance profile could pose material roadblocks to long-term prosperity.
At the end of November, Dillard's declared two cash dividends-including a special, one-time dividend of $5.00 per share-payable to its Class A and Class B common stockholders. While cash dividends are frequently considered a reason for shareholders to celebrate, minority shareholders at Dillard's should consider that the primary beneficiary to such special cash dividends are in fact the company's primary owners, the Dillard family. Not only does the Dillard's Inc. Retirement Trust control 25.5% of Class A shares as of March 2012, but the family also individually accounts for an additional 11.2% of Class A shares and 99.4% of all outstanding Class B shares so that the $5 cash dividend turned into a Christmas bonus check of more than $103 million for the family.
Since the beginning of November, Dillard's insiders have sold over $121 million in shares, compared to less than $9 million in sales over the first ten months of 2012. True, the special dividends and recent flurry of insider deals may be attributed to last-minute attempts to mitigate the impact of fiscal 2013 tax increases. However, unless insiders start buying back shares, the recent increase in insider sales could suggest that aging family members and executives are questioning the sustainability of the stock's multi-year upward trajectory.
Insider sales of this magnitude along with special cash dividends force us to question the motives of the company's controlling ownership. Dillard's was founded in 1938 by William Dillard and has been in the hands of the Dillard family ever since. Currently, the company's leadership structure is dominated by Dillard family members who are not only board members but named executive officers as well: 1) CEO and Chairman William Dillard II, 2) President Alex Dillard, 3) Executive Vice President Mike Dillard, and 4) Executive Vice President Drue Matheny. Significantly, the youngest of these four executives is already over 60 years old, which begs the question, what exactly happens to Dillard's once the Dillard family members cede control?
Joining the four Dillard executives on the company's board is CFO James Freeman, meaning that 5 of 12 Dillard's board members are named executive officers. In fact, eight directors are elected solely by the Dillard family, as Class B shareholders hold the power to elect two-thirds of the board. Overall, the board is dominated by insiders and Dillard family members. Even Compensation Committee chair Robert Connor cannot be considered truly independent as he has served on the board for over 25 years. Long-tenured directors can often form relationships that may compromise their independence and therefore hinder their ability to provide effective oversight. Also, director Warren Stephens is not independent as he is involved in several related-party transactions with the company worth an aggregate of nearly $5 million in fiscal 2011. In all, the board is not an effective counterbalance to management.
Dillard's qualifies as a "controlled company" under the NYSE corporate governance rules due to the Dillard family's ownership. In accordance with a provision in NYSE rules for controlled companies, the company is not required to comply with NYSE corporate governance rules that provide for a majority of the Board of Directors being composed of independent directors and a nominating/corporate governance committee composed solely of independent directors. In evaluating the corporate governance of these companies, our primary focus is on determining whether the actions of the board are excessively aligned with the interests of the controlling shareholders, a scenario that further magnifies the risks involved. In Dillard's case, the actions of the board greatly benefit members of the Dillard family.
Not only does the family benefit from the company's recent special dividend, but numerous family members are company hires and, regarding executive compensation practices, we note that the top four named executive officers are all Dillard-family members. Despite their considerable equity holdings, the Dillard family executives continue to participate in the company's annual and long-term incentive compensation plans and have accumulated pension value worth an aggregate total of about $81 million. Despite it all, family members are even eligible for airplane use benefits, company contributions to their retirement plans, and insurance premiums paid by the company.
Despite the company's recent success, we stand by Dillard's "D" rating. The same governance issues that caused investors to call for the breakup of the Dillard family monopoly only a few years ago are still very much in place today. In 2008, on the heels of the company's sagging financial results and stock price, investors attempted to break up the board and oust CEO William Dillard II. In a letter to shareholders, activist investors "urged the three independent Class B directors to start looking immediately for a CEO to replace William Dillard II" and suggested that the other members of the Dillard family "should follow him out the door." The letter went on to say that "the Dillard family is overpaid and under-qualified for the positions they hold and can be readily replaced with more talented retailers." While investors were able to persuade the company to appoint four independent board members in 2008, they were ultimately unable to wrest company control from the Dillard family and instead filed at least two derivative lawsuits in 2009.
While activist investors have been quiet ever since-certainly the company's recent success has been a great pacifier-the problems stemming from concentrated control by insider continue to raise questions.. Moreover, while minority shareholders are satisfied with surging share prices, not all members of Dillard's immediate community have been so lucky. For too many years now, the retail company has been implicated over and over again in numerous discrimination allegations and settlements. A week before Christmas, in fact, Dillard's agreed to pay $2 million to settle a class-action lawsuit accusing the retailer of breaking federal disability laws by requiring workers asking for sick leave to disclose private medical conditions. But this was just the latest in a long line of discrimination-related embarrassments over the past 20 years:
In 2009, the U.S. Equal Employment Opportunity Commission (EEOC) fined the company $110,000 to provide significant remedial relief to settle a same-sex harassment lawsuit involving two male victims. According to the EEOC's suit, Dillard's permitted a sexually hostile work environment for men at its Fashion Square Mall store in Florida. The EEOC said that Dillard's ignored complaints about the harasser.
- In 2005, a federal lawsuit alleged that the department store chain wrongly accused black customers of shoplifting. That same year, Dillard's was the target of a federal class-action suit that accused its hair salons of a racially motivated dual-pricing system.
- In 2002, a lawsuit in Texas claimed that Dillard's was systematically targeting minority and low-income shoppers for surveillance and intimidation. According toreports, the company's controversial practice of using only armed, off-duty law enforcement officers as in-store security had led to the deaths of at least six people after confrontations with Dillard's security officers, a figure unmatched by any other major retailer.
- Also in 2002, a $550,000 judgment was upheld against Dillard's for age discrimination.
- In 2001, Dillard's agreed to pay $5.6 million to settle a race discrimination lawsuit brought by black employees alleging discriminatory treatment in hiring, pay, promotion, job assignments, termination, and working conditions.
- Also in 2001, an appeals court upheld a $1.2 million jury award to a black woman who said she was denied a free cologne sample at a Kansas store because of her race.
- Other notable cases include a $22.5 million judgment against Dillard's for an incident that occurred in Texas.
Dillard's woes made national news when its discriminatory practices were highlighted on CBS' "60 Minutes" program in which security officers themselves corroborated the company's illegal practices. Accordingly, GMI Ratings' Litigation Risk model-a measure of the probability of shareholder class action litigation-shows that Dillard's litigation risk assessment continues to be at "Moderate Risk," placing them in the 15th percentile of all companies in North America, indicating higher shareholder class action litigation risk than 85% of all rated companies in this region.
No matter how strong Dillard's sales are in the short-term, ongoing and public cases of discrimination yielding million dollar payouts will not only affect the company's bottom line, but will undoubtedly tarnish the company's reputation, something that a national retailer can ill-afford. Furthermore, there is plenty to suggest that consumer spending could be sluggish in 2013. An article yesterday on Seeking Alpha suggests that "retailers dependent on discretionary spending will be hard pressed to maintain profits at 2012 levels" and that department stores appealing to the middle/upper middle class such as Dillard's "are likely to be particularly hard hit, because they sell discretionary items, and their customers will have significantly lower disposable income next year." While the Dillard family admirably rescued itself from its lows of 2008 and 2009, we wonder how long it can stay successful completely devoid of sound and balanced independent oversight.
GMI Ratings is an independent provider of research and ratings on environmental, social, governance (ESG) and accounting-related risks affecting the performance of public companies. GMI Ratings is a registered investment adviser and is therefore subject to certain reporting requirements. Specifically, per our ethics policy, our analysts are precluded from engaging in any transactions involving any companies we follow. Our ratings and supporting research are intended to provide investors with an effective summary of ESG and forensic accounting factors that can and do impact issuer risk. They are not, however, intended for stand-alone use and should not be considered as simple Buy, Sell or Hold recommendations. We encourage investment professionals to regard these ratings as a specialized, proprietary input to be used in combination with existing fundamental analysis or other approaches and to help comply with the UN-PRI (United Nations Principles of Responsible Investing) and similar standards.