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With the start of the holiday shopping season, my attention turned to the retail sector for investment opportunities. Dillard's (NYSE:DDS) is mid-size fashion apparel, cosmetics and home furnishing retailer operating in the Southwest, Southeast and Mid-West areas of the U.S. Our contention is that Dillard's is profitable, has a strong balance sheet and is a good cash generator.

Industry Overview

We are beginning to see some signs that the economy is recovering and that there is some growth. There is some evidence that we consumers are spending again despite the high unemployment and the continuing decline in real disposable income.

Consumers cut back so much over the past few years, it appears that pent-up demand is appearing. Interest rates remain at historic lows which may suggest that consumers are willing to take on more debt. I think there is some reason to expect that consumer spending will pick up for the holiday season and for the coming year. Consumers will remain price-sensitive and growth will be modest but positive.

As a general statement, retailers posted October same-store sales that topped analyst expectations. Consumer confidence climbed to a five-year high as unemployment declined slightly and property values rose.

Income Statement Highlights

In the second quarter ending July 2012, comparable store sales were up for the eighth consecutive quarter. Same store sales increased by 3.3 percent. Gross margins from retail operations improved by 70 basis points and SG&A expenses decreased. The company reported net income of $31.0 million, a 76.6% increase over the prior year second quarter. Dillard's also repurchased $134.6 million (2.1 million shares) of Class "A" Common Stock. The quarterly EPS of $0.63 represents a 96.9% increase over the prior year quarter.

Gross profit as a percentage of net sales was 33.6% in 2Q13 as compared to 33.2% in the prior year. Retail sales per square foot increased to $28 from $27. On a trailing twelve month basis, gross income increased by 2.3% when compared with F12. Operating income increased by 31.7% and net income increased by 6.8%. EPS-DC grew by 12.7%.

Thomson Reuters reports only one analyst estimating revenues for the year ending 01/28/13. His estimate is $6,691 million and would represent a 4.6% increase over F13. There are just two estimates for F14 and they average $6,711.8 million or 4.9% higher than F12.

Balance Sheet Highlights

As of July 28, 2012, the company had working capital of $727.0 million, cash and cash equivalents of $162.5 million and $914.6 million of total debt outstanding, excluding capital lease obligations.

Cash decreased by 9.5% and accounts receivable increased by 70.4% when compared to the year ago quarter. Short term debt increased by 98.4% and long term debt decreased by 9.2% year-over-year. Comparing the trailing twelve months ending July 28, 2012 with F12, cash decreased by 27.6% and accounts receivable increased by 16.4%. Short term debt increased by 29.2% and long term debt decreased by 0.1%. Book value increased by 9.2%.

The company has kept its current ratio at 1.8X. Its ability to pay interest has improved to 7.4X from 6.4X as measured by Times Interest Earned. Long term debt to capital has remained fairly steady at about 28.9% and long term debt to equity is 40.7%. Inventory turnover has slowed to 2.8X from 3.1X.

Long term debt to free cash is about 219% and long term debt to working capital is about 113%. I consider both metrics within reason.

Capital Allocation

Dillard's spent $134.6 million to buy back 2.1 shares of Class "A" Common Stock. The company also pays an indicated dividend of $0.20 which yields 0.3%. The payout ratio is just 2.0% and payout as a percentage of free cash is just 2.57%. With free cash of $375.4 million and the company expending $134.6 million on share buybacks and $10.3 million on dividends, Dillard's clearly has the capacity to both grow its dividend more aggressively and expand its share buyback program and still have cash available for expansion.

At current levels of profitability, Dillard's provides a return on equity of 24.1%. More telling is that the return on invested capital is a strong 15.89%. The company turns 71.5% of its operating income to free cash. With this high level of free cash, the cash return on invested capital is 13.2%.

Valuation

Dillard's has a trailing PE of 8.3X versus an industry median of 15.3X. For the next fiscal year, analyst estimates provide a forward PE of 13.2X compared to the industry median of 15.8X.

Trailing enterprise value to EBITDA is 5.87X compared to the industry median of 8.04X and free cash to price is 9.81X compared to the industry median value of 4.44X.

Conclusion

It appears to me that Dillard's is doing quite well considering the economic constraints and is selling at a low valuation relative to both the market and its industry. It is profitable and financially strong. It offers the potential of greater dividend payouts and share buybacks with significant price appreciation.

Source: Dillard's: A Great Retail Sector Opportunity