Dillard's Inc. (NYSE: DDS) announced an agreement with many of its dissident shareholders in a move designed to avoid an expensive proxy contest. Activist hedge funds Barington Capital and the Clinton Group agreed to forgo a proxy contest in exchange for the voluntary nomination of four of its proposed directors. Additionally, the board agreed to review whether the company's real estate assets and capital are being optimally deployed to build shareholder value.

"We are pleased to have reached an agreement with Barington and Clinton," Chairman and CEO William Dillard. "Both the Board and management welcome the perspectives and insights of our proposed new directors. The Class B board members are committed to working with the new Class A board members to ensure that the best operating plan and management team possible are in place."

Specifically, Dillard's agreed to close under-performing stores in order to rationalize real estate as soon as possible, cut unnecessary costs, and subject all future commitments for new stores to strict return on capital requirements that will be set by the board and management. These measures will help the company improve its bottom-line by reducing unnecessary expenses while ensuring that its assets are being monetized to drive profitability.

The activists' nominees will be designated Class A directors and have a term that will explore at the 2009 annual meeting. Under the agreement, they will have all the same rights and abilities and the original Class B directors while focusing on ways to implement the activist agenda. This agenda consists of three tremendous opportunities for improvement:

1. Dillard’s $7.5 billion revenue base offers significant margin leverage capable of producing sizable cash flow gains from any future operating improvements. The Company’s geographic concentration, especially in high-growth areas of the Southeast and Southwest United States, offers unique regional opportunities for its 331-store portfolio. Furthermore, the Dillard’s brand name is well-regarded in the department store sector and the Company has received above average scores in the area of customer loyalty according to a recently released survey by Brand Keys. Clearly, Dillard’s has the scale and brand recognition to be a successful retailer.
2. As Dillard’s trailing twelve month operating free cash flow margin is 2.4% versus 7.7% for its department store peer group, we believe that stockholders can realize enormous upside if margins can be improved to the levels achieved by the Company’s peers. We see a number of opportunities to immediately reduce the Company’s cost base, including by improving sourcing, rationalizing SG&A expenses and lowering capital expenditures. We also believe that there are a host of initiatives in inventory management and merchandising that can drive customer traffic and enhance margins. Among other things, we believe that Dillard’s needs to tighten its current assortment of offerings and vendors and consider a more regular promotional cadence, as its stores, in our opinion, are over-inventoried. In addition, we believe that Dillard’s needs to embark upon an aggressive re-merchandising effort that features new vendors (including exclusive offerings) and updated private label and in-house collections to differentiate its value proposition for customers. Furthermore, it is our belief that the Company needs to enhance its brand marketing by adding more image and lifestyle campaigns that communicate a revitalized message to the marketplace. We are convinced that each of these initiatives would add excitement and newness to the Dillard’s shopping experience and attract customers to its stores.
3. Dillard’s owns approximately 75% of its store portfolio, comprised of approximately 42 million square feet of retail real estate. Currently, the Company’s shares trade at only 0.5x its tangible book value of approximately $32.50 per share. This represents a significant discount to the Company’s peer group, which trades at an average tangible book value multiple of approximately 2.0x. We also believe that Dillard’s tangible book value is understated, since the current market value of the Company’s owned real estate far exceeds its depreciated book value. In fact, in a November 26, 2007 research report, Deutsche Bank estimated Dillard’s net asset value before taxes to be $59 per share. Deutsche Bank also notes that “actions taken to unlock the Company’s real estate value would be positive for the shares, as the NAV [net asset value] for Dillard’s [is] greater than the value based solely on operating fundamentals.” It is our belief that there are a number of measures that the Company can take to enhance the value of its real estate portfolio, including converting certain properties to higher and better use, closing underperforming stores and engaging in sale/leaseback transactions.

These proposals have a lot of merit and would unlock substantial value if implemented. The fact that the activist investors will now hold seats on the board of directors significantly increases the likelihood of change. This makes DDS a stock worth watching closely over the next few months.

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