A quick look at DSW Inc. (NYSE:DSW) investors' news release page shows that the shoe retailer opened up stores at a quick pace at the end of September and early October. The recent flurry brings its store count up to around 497 from 483 at the end of August and shouldn't surprise anyone - holiday sales in 2016 are expected to be stronger than average this year and having more storefronts in different areas means more access to customers' wallets.
New stores will also enable DSW to build from its performance in the first half of its current fiscal year (which ended on July 30th) when it saw sales grow by 4.5% despite seeing its comps slide by 1.2%.
As we move toward the holiday season, retail stocks such as DSW will receive more focus. We're a bit curious about DSW as a potentially undervalued play because its shares are down 11% in the year to date and it has a dividend yield of 3.8%.
At its current level, DSW's yield is close to 170 basis points better than the S&P 500's. It's also nearly 62% higher than the 2.35% yield of its peer group. Thus, an investor who buys $10,000 worth of DSW shares today can expect to receive around $380 in total dividend checks after a year's time.
That being said, DSW's shares are down for the year and the top-end of its earnings guidance suggests that its earnings-per-share will fall by 7.8% from a year earlier. In that sense, investors will wonder whether DSW is worth buying or whether it's prudent to wait for an opening later on. Let's see.
New Stores And Acquisitions: Waiting for Traction
A drop in profits is probably not the scenario that DSW investors were looking forward to this year. After all, the company acquired online discount footwear retailer EBuys for $62.5 million earlier in the year and its recent flurry of store openings is part of a strategy to grow its store base by around 10%. In that regard, it hasn't exactly failed to deliver - as mentioned, DSW's sales grew by 4.5% in its first half and the new stores it has opened (and will be opening) should also boost its top line.
While sales weren't exactly disappointing, DSW's second quarter margin was actually 217 basis points lower than it was a year earlier. Consequently, DSW's current net margin has slipped to just 3.8%, which is 110 basis points lower than its peer groups. While investors should accept that, as primarily a discount chain, DSW's gross margin is understandably lower than its industry's gross margin, it has usually made up for it with its bottom line. To wit, its net margin (i.e. the ratio of its net income to its net sales) has been 80 basis points better than its peer group's over the last five years.
Yet gross margins still matter. To illustrate: had DSW simply retained its 30.5% gross margin from a year earlier, its current net margin would have been at 4.63% - or within 30 basis points of its peer group's average - not exactly at its level of the last five years but certainly within a tolerable range of the industry average.
Partly culpable is EBuys, since its gross margin is just 9% - but its revenue contribution is small at just 3% of overall sales, so its drag on margins in negligible (for now). More worrying is the margin slippage of DSW's main segment. DSW has basically had to induce customer traffic with markdowns suggesting that customers simply aren't as attracted to DSW's offerings as they used to be. Of course, it's early days - one of the putative benefits of the EBuys acquisition was better sourcing so this could help to address both DSW's margin and its selection of inventory.
In any case, investors should note that despite DSW's tepid second quarter results the company still reiterated its full-year guidance so there's likely to be a pickup in the coming months. In our view, we should see DSW's full-year earnings come in at around $1.39 per share, which is right along the consensus estimate.
Strong Balance Sheet Supports the Dividend
Despite its trying times, one thing that should give investors comfort is DSW's fairly robust balance sheet. While DSW's cash liquidity profile is only slightly better than average for a company in the retail industry, its overall working capital profile is very healthy with the company carrying $2.45 of working capital for every dollar of its short-term liabilities. What's more, DSW doesn't carry any long-term debt and has just $0.55 of liabilities (such as accounts payable to its suppliers) for each dollar of equity it has. DSW also generated $84.3 million in free cash flow over the past 12 months.
With DSW paying just around $65 million each year in dividends, the company's strong equity and asset base - not to mention its solid free cash flow generation - should enable it to continue making dividend payments indefinitely.
Only a Slight Discount
DSW is currently trading at just 17-times its trailing earnings. This goes down to a multiple of 15-times earnings if we use our full-year earnings estimate. Both these readings are below the 24.6-times multiple of the S&P 500. While 2016 is expected to be a down year for DSW, it isn't all that different from the S&P 500 since index companies, on aggregate, have had six straight quarters of negative earnings.
On a forward basis, we expect DSW to recover and post 10% earnings growth to $1.53 per share, driven by its expansion, the full integration of EBuys and better inventory sourced (also helped by the EBuys acquisition). This implies a forward multiple of just 13.8-times earnings compared to 18.4-times earnings for the S&P 500. We believe that there should be some modest compression in this valuation gap and expect DSW to trade at a multiple of 15 times forward earnings for an implied target price of $22.94 per share, which is below the consensus target price of $23.33. This means that DSW is trading at only a slight discount to its fair value.
Considering the limited upside for the stock and expected volatility ahead of DSW's forthcoming third quarter earnings announcement in late November, we don't recommend buying its stock today.
Instead, we would prefer to see three straight quarters of positive comparable sales and earnings growth as a sign that its recent acquisitions and expansion have helped it turn the corner. Right now, we're a little skeptical that its current strategy of lower markups and further discounting to attract customers creates value for shareholders.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Black Coral Research, Inc. is a team of writers who provide unique perspective to help inform dividend investors. This article was written by Jonathan Lara, one of our Senior Analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article. Company financial data is taken from the company’s latest SEC filings unless attributed elsewhere. Black Coral Research, Inc. is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.