DSW Milestone: The Financial State

Call them an investor darling.

DSW’s stock is rated “buy” on the lists of at least three analysts contacted by Footwear News, thanks to its strong management team, possibilities for expansion, favorable earnings growth potential and large reserve of cash.

Analysts also noted that the firm has one of the highest operating margins in the industry, at 9.5 percent.

“I don’t think any footwear retailer, particularly an off-mall retailer, has ever achieved or sustained a 10 percent operating margin, which is what DSW targets for next year,” said Scott Krasik, an analyst at BB&T Capital Markets, which has covered the company since the summer of 2010.

“But given their mix of businesses — women’s fashion, which makes up 70 percent of their business, has better margins and turns more quickly — it could come in even higher. And the better they get at their systems, the more likely it is they’ll sustain that position,” added Krasik, whose target price for the stock is $60 (it was trading around $45 at press time).

DSW’s operating model is, in fact, what analysts laud the most.

“It’s a very compelling proposition for anybody looking for shoes who can’t stand waiting in Macy’s for some bloke to keep going back to a stock room looking for shoes,” said Christopher Svezia, an analyst at Susquehanna Financial.

Sterne Agee analyst Sam Poser noted that DSW excels in “delivering the right thing in the right place at the right time.”

And Steven Marotta, an analyst at CL King & Associates, called DSW “a terrific concept that is very difficult to replicate given their size
and scale.”

Plus, he added, “they have an insane balance sheet, which from an investors’ standpoint, offers some downside protection and flexibility as it relates to either acquisitions, for a rainy day, or for share repurchases.”

As far as DSW is concerned, the key to its financial success is that it stays focused on giving the customers what they want.

“It starts with the merchant team picking the right product because we can’t buy every shoe,” said Douglas Probst, EVP and CFO of the firm. “We focus on putting value on the floor and getting it on time and efficiently.”

But there are still issues to contend with, said Probst. He is most concerned with product cost increases into 2012 because consumer confidence has hit a new low.

“Although we’ve been dealing with that for a couple of years, it reminds us to remain a value concept,” Probst said. “We have to be very careful where we pass along increased costs, and we’ll just have to take lower margin on some product.”

Addressing the firm’s healthy cash and investment balance of about $400 million, Probst said it’s mainly used to return value to shareholders — another reason the firm is popular with Wall Street. Sweetening the investment appeal is the fact that DSW last month declared a special dividend of $2 a share and announced it will pay an ongoing dividend of 15 cents a share every quarter.

“We’re confident we can continue to generate cash in our business and pay that out. When you’re a growth company and paying dividends, that’s special. It says we have confidence in the business. We might even increase the payout over time,” Probst said.

As for acquisitions, the CFO noted, “There’s nothing imminent, but we look at a lot of things and we’re pretty disciplined. If it’s too large, it could be really distracting, but obviously we have a lot of options with our financial strength.”

Krasik agreed a deal is “not at the top of their list of priorities as they have a lot on their plate right now.” That said, he believes another e-commerce business could be an asset to the firm, or a footwear concept with more of an athletic focus.

All told, DSW is a success story that is just beginning, said Svezia: “They have chopped a lot of dead wood. The next phase that will unfold over the next two years are these systems they have in place [and] what they can do to help manage inventory and assortment and drive better inventory turns.”

Other analysts noted that Michael MacDonald has implemented numerous productive changes since becoming CEO, including testing different store layouts and sizes.

“They aim to open 18 new stores in 2011 and at least 20 more in 2012, but we think they could continue opening a similar number each year after that,” said Krasik.

Also, from an investment standpoint, the firm’s recent completion of a reverse merger boosted confidence in the organization. As part of the deal, parent Retail Ventures Inc., which had held 61 percent of DSW’s stock, transitioned to become a DSW subsidiary, thus streamlining the corporate structure.

Among the biggest benefits of the reverse merger is that DSW now holds the tax benefits RVI had accrued over the years but couldn’t use because it wasn’t making money.

But one question looms: How sustainable is DSW’s impressive growth rate?

“People won’t stop buying shoes, [and] I don’t know anybody out there that operates a better box, and there’s no one else really at their heels. If they can improve productivity of individual stores, this could become a 12 percent to 13 percent margin business,” said Svezia.

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