Is DSW an Undervalued Dividend Stock With a 4% Yield?

MarketsMotley Fool

Shares of DSW (NYSE: DSW) rallied 8% on Dec. 11 after the footwear and athletic apparel retailer's third quarter numbers cleared analysts' expectations. Its revenue rose 17% annually to $833 million, beating estimates by nearly $38 million, and its comparable store sales rose 7.3%.

DSW's adjusted net income rose 56% to $57.9 million, or $0.70 per share, which topped expectations by $0.18. On a reported basis -- which includes acquisitions, lease exit costs, and other one-time charges -- DSW's net income jumped nearly tenfold to $39.3 million.

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DSW expects its revenue to rise 12%-14% for the full year, compared to its prior guidance for 6%-9% growth. It expects its adjusted EPS to grow 12%-22%, which also exceeds its earlier forecast for 5%-15% growth. That EPS forecast includes a loss of $0.05-$0.10 per share from its Camuto Group acquisition, but excludes its year-to-date losses of $0.07 per share from the closure of weaker banners like Town Shoes.

Based on that forecast, DSW trades at just 14 times this year's earnings, while paying a decent forward dividend yield of 3.9%. So is DSW an undervalued income stock at these levels? Let's take a closer look at its core business to find out.

How did DSW turn around its business?

DSW previously struggled with competition from more diversified retailers, the saturation of the North American footwear market, the bankruptcies of big footwear retailers flooding the market with cheap shoes, and top footwear brands launching their own direct-to-consumer channels and brick-and-mortar stores. DSW tried to curb its downturn with acquisitions, but that strategy didn't generate consistent returns.

Realizing that it needed to streamline its business to survive, DSW abandoned struggling subsidiaries like its e-commerce site EBuys and the footwear chain Gordmans. It also shuttered Canadian shoe retailer Town Shoes' namesake brand, but retained the subsidiary's Shoe Company and Shoe Warehouse banners.

DSW also realized that it needed to give shoppers more reasons to visit its stores. It renovated its locations, expanded its selections of shoes, and even tested out shoe repair, manicure, and pedicure services at several locations. It expanded its e-commerce ecosystem and loyalty program, which surpassed 25 million members earlier this year.

All these improvements enabled DSW to generate its strongest comps growth in seven years over the past two quarters. Meanwhile, its gross margins expanded as its comps rose, indicating that DSW wasn't leaning heavily on markdowns or new store openings to boost sales. Its rising operating margins indicate that DSW is keeping the costs of its streamlining and expansion efforts under control.

Q4 2017

Q1 2018

Q2 2018

Q3 2018

Comps growth

1.3%

2.2%

9.7%

7.3%

Gross margin

26.5%

28.9%

32.1%

32.6%

Operating margin

4.7%

5.4%

3.1%

6.4%

DSW's comps growth and margins remain higher than those of most of its competitors. Foot Locker (NYSE: FL), for example, posted just 2.9% comps growth last quarter, with a gross margin of 31.6%. Analysts expect Foot Locker's revenue and earnings to rise 1% and 10% this year, respectively, which is much weaker than DSW's full-year guidance.

Is DSW an undervalued income stock?

DSW didn't raise its dividend between 2015 and 2017, but it raised its quarterly payout from $0.20 to $0.25 per share earlier this year. Its adjusted EPS forecast of $1.70 to $1.85 this year should easily cover that dividend with a payout ratio of just over 50%, leaving it plenty of room for future hikes. Foot Locker pays a lower forward dividend yield of 2.6%, but it's raised that dividend annually for seven straight years.

Analysts expect DSW's annual earnings to grow at an average rate of 7% over the next five years. This gives it a 5-year PEG ratio of 2.1, compared to Foot Locker's PEG ratio of 1.0. Since a PEG ratio under 1 is considered "undervalued", DSW's stock can't be considered cheap relative to its growth potential.

DSW's stock isn't expensive, it pays a decent dividend, and its turnaround should continue throughout 2019. However, I don't think it can be considered an "undervalued" dividend stock unless its valuation contracts further and it raises its dividend on a more consistent basis.

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Leo Sun has no position in any of the stocks mentioned. The Motley Fool recommends DSW. The Motley Fool has a disclosure policy.