Should You Buy Designer Brands for Its Dividend?

Designer Brands (NYSE: DBI) is a retail company with over 500 physical locations under the name DSW, specializing in name brand footwear and accessories. The company also owns several private labels and sells directly to consumers through an e-commerce platform. The consumer discretionary stock is down 65% from its all-time high in 2013 and 33% year-to-date, which could signal an interesting entry point, assuming its fundamentals are stable.

Designer Brands delivers a high dividend yield, but is it sustainable?

Designer Brands is paying a 6.04% dividend yield, which, in its peer group, is only approached or exceeded by Gap (NYSE: GPS) at 5.78% and L Brands (NYSE: LB) at 6.98%. None of the other major apparel stores deliver a dividend yield above 5%. However, Designer Brands has a higher dividend payout ratio, at 1.45, than Gap’s 0.4 or L Brands’ 0.87. That means that earnings or cash flow have to increase substantially for the company’s dividend yield to be sustainable over the long term. It certainly casts doubt on the likelihood of dividend growth for the foreseeable future, which is not a bullish signal for any investors employing the dividend discount model for valuation.

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Defensive investors seeking dividend income with some downside protection will find a mixed bag when analyzing Designer Brands. The stock has a low forward price-to-earnings ratio of only 7.54. However, its price-to-free cash flow is very high at 44.3, price to book exceeds industry averages at 1.67, and its EV/EBITDA is triple the industry average at 31.6. Investors can find more downside protection with similar dividend yields elsewhere in the apparel store industry.

While retailers are exposed to cyclicality and rely on consumer confidence across market cycles, DSW did show resilience through the last recession. Designer Brands delivered 4.7% revenue growth in the fiscal year ended January 2009, though same-store sales dropped 5%.

The bounce back in the following year was substantial, with 15% top-line expansion. It would appear that DSW’s offering is somewhat defensive, and there might be some benefit as people abandon more expensive alternatives and shop there during a weak economy. That said, the stock lagged behind the S&P and the SPDR Retail Sector ETF during the last major market downturn, falling 70.3% from July 2007 to July 2009, while the S&P and sector ETF only dropped 42% and 40%, respectively.

Designer Brands is hoping to reverse uninspiring operating performance

Designer Brands has been delivering low, positive revenue growth in 2019, and it has a low-to-mid single-digit growth outlook over the medium term. These findings are almost universal among publicly traded apparel stores with a market capitalization above $1 billion.

Designer Brands lags behind its peers based on profitability and returns. Its 2.9% operating margin is narrow, and most of the other apparel stores are between 5% and 10%. That slim margin drives its return on assets to only 2.6%, vs. an industry average of 8.3%, and a return on invested capital of 2.4% vs. an industry average of 13.9%. The company was in line with industry averages as recently as 2017, but it has struggled to sustain those results in a competitive landscape. The company is not utilizing its resources to deliver financial returns efficiently.

This issue compounds when evaluating Designer Brands’ financial health. The company issued $235 million in debt over the past year, but its current ratio of 1.4 and debt-to-equity of 0.29 will not catch anyone’s eye as particularly risky metrics. Its interest coverage of 20.7 is also indicative of minimal risk. However, its debt to EBITDA of 17.1 is somewhat less enticing.

If the company continues to deliver narrow margins, it might struggle to maintain an advantageous cost of capital and could be forced to dilute equity holders to meet obligations. That is an avoidable longer-term threat, but something needs to change fundamentally to prevent a slide in that direction.

Designer Brands is hoping that private label offerings will catalyze sales and support improved profitability. If that plan comes to fruition, and margins are restored to prior levels, this is an excellent value play with a great dividend yield to produce income or deliver returns during market downturns. The evolved retail landscape is highly competitive and subject to economic cycles, so investors need to beware of the risks inherent in any company that’s experiencing sluggishness at this point in the business cycle. The list of failed or drastically reduced retailers is long, and chasing dividend yield in a stock that’s experiencing struggles opens investors up to that possibility.

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Ryan Patrick has no position in any of the stocks mentioned. The Motley Fool recommends Designer Brands Inc. The Motley Fool has a disclosure policy.

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