Times for Dillard's Grow Even Tougher With Talk of Ouster

by Mark Friedman  on Monday, Nov. 3, 2008 12:00 am  

An Oct. 24 letter by Dillard's activist shareholders demanding the removal of CEO William Dillard II comes at a bad time for the Little Rock retailer.

Dillard's Inc. had been trying to deal with the shrapnel from the exploding economy when it took yet another hit this week.

This shot, however, was sniper fire targeting the company's management: Activist shareholders took public their campaign to oust CEO William Dillard II and his family from the Little Rock retail chain that Dillard's late father founded in 1938.

Here's a rundown of what the company faced last month alone:

  • On Oct. 8, Dillard's (NYSE: DDS) released its September same-store sales numbers, a key indicator of a store's health. Same-store sales were off 12 percent from the same month in 2007 (which were off 7 percent from September 2006).
  • Dillard's stock was dropped from the Standard & Poor's 500 Index on Oct. 16, and by Oct. 27 the stock was trading as low as $3.10, its lowest price in more than 20 years.
  • On the same day, activist shareholders released a letter to the three independent directors elected by Dillard family members demanding a management change, citing the "atrocious" performance of the company during the past decade.
  • And particularly ominous was the part of the letter that seemed to contain a threat that the directors might be sued for breach of fiduciary duty if they allow the management team to stay in place.

(Click here to see a depiction of Dillard's stock performace since Dec. 2006. Click here for a timeline of events since William Dillard II took over the company in 1998.)

As if those problems weren't enough, the company is closing more and more stores in the face of a particularly grim Christmas forecast. Department stores are expected to see 1.7 percent sales growth for the season, which would be the sector's worst performance since 2002.

"Everything is bad in the department store sector," said Howard Davidowitz of Davidowitz & Associates Inc. of New York, a national retail consulting and investment banking firm. "Now Dillard's was bad when other people were good. Now when things are bad, [Dillard's] is worse."

He expects the company "to do terrible" this holiday season.

Frustration Mounts
Activist shareholder James Mitarotonda is frustrated by Dillard's performance and lack of action by the board, which is controlled by the Dillard family under a dual stock arrangement. Class A stock is traded on the New York Stock Exchange, but the Class B shares - owned almost exclusively by Dillard family members - have the right to choose eight of the 12 corporate directors.

Four of those eight seats are held by Dillard family members: brothers William II, Alex and Mike Dillard and their sister, Drue Corbusier. A fifth is held by Dillard's CFO James Freeman.

The three remaining Class B directors are Warren Stephens, CEO of Stephens Inc. of Little Rock, Peter R. Johnson of San Francisco and Robert C. Connor of Dallas.

It was to Stephens, Johnson and Connor that Mitarotonda, chairman and CEO of Barington Capital Group LP of New York, and George Hall, chairman and CEO of the Clinton Group Inc. of New York, sent a letter demanding a change of management.

Barington and Clinton represent a group of investors that owns more than 5 percent of the outstanding Class A common stock of Dillard's and that successfully agitated for representation on the board of directors. Dillard's avoided a proxy fight by letting the hedge fund investors pick four new directors to represent the Class A shareholders. They were approved during the May shareholders' meeting.

To make room for the new Class A directors, Johnson and Connor - who had been Class A representatives - were selected by the Dillard family to replace departing Class B directors.

If the four new Class A directors could persuade the three independent Class B directors to join them, the coalition would have the votes to oust the Dillard family managers.

But those independent Class B directors have rejected the request to replace Dillard as CEO.

"We believe our management team has an appropriate strategy" for dealing with the current economic conditions, the three Class B directors said in a statement Thursday.

Still, Mitarotonda and Hall's letter reminded the independent Class B directors that they have a fiduciary duty to all the shareholders, not just the Dillard's family.

"Unfortunately, it seems as if our very serious concerns as shareholders have been ignored as you have permitted the status quo to continue under your stewardship," the letter said. "It is our strong belief that any further delay or indecision on your part would be completely unacceptable, and we expect you to address these pressing matters at once."

A Barington Capital spokesman declined to comment on the letter or the company's plans.

Trying to wrest control from the Dillard family will be difficult, said Charles M. Elson, who was nominated by the hedge funds earlier this year to be on the Dillard's board but then had his name withdrawn. He declined to say why his name was taken off the slate of nominees.

"The family controls the business," said Elson, who is a director of the John L. Weinberg Center for Corporate Governance at the University of Delaware. His field of expertise includes corporations, securities regulation and corporate governance.

But he did agree with Mitarotonda and Hall that the independent Class B directors' loyalties should be to the company and both classes of shareholders, not to the Dillard family.

It wouldn't surprise some people if Mitarotonda filed a lawsuit against the Class B independent directors.

"Mitarotonda, he's not shy about launching a lawsuit or defending himself against a lawsuit," said Ron Orol, who has written about Mitarotonda in his book "Extreme Value Hedging: How Hedge Fund Managers Are Taking on the World."

He said Mitarotonda has filed lawsuits against other companies.

"So he'd be willing to go through [a lawsuit] ... if he thought there was some justifiable reason for it," Orol said.

Dillard's Responds

Dillard's spokeswoman Julie Bull issued a rare statement this week after Mitarotonda and Hall's letter was filed with the Securities & Exchange Commission.

While not addressing the allegations in the letter, Bull said the company was committed to improving shareholder value.

"Our efforts to improve our merchandise mix, to close underperforming stores and to reduce capital and operating expenses are ongoing as we weather the most challenging economic time in modern history," Bull said in the statement. "We believe the best way to serve the long-term interests of all shareholders is to concentrate our efforts on running our business conservatively and on navigating the near-term economic uncertainty while focusing on the important upcoming holiday selling season."

In a statement issued Friday that was designed to highlight financial strengths, Dillard's said it maintains a $1.2 billion revolving credit facility with JP Morgan Chase. Dillard's said the agreement ends near the end of 2012.

"There are not financial covenants under this facility provided availability exceeds $100 million," the statement said. "Even at peak working capital requirements in late November, availability should well exceed $500 million."

And the company said after it pays a debt of $100 million, which comes due on Nov. 15, total maturities of long-term debt over the next two years are less than $26 million.

But the statement didn't address the company's performance over the past 10 years.

The company's plans include closing more underperforming stores. At the first of the year, Dillard's listed just three stores that were closing in 2008. As of last week, that number had grown to 20. Dillard's said it expects more store closures in 2009.

"Management has become increasingly aggressive in closing underperforming stores and while this is a newer initiative it appears to be gaining momentum," Deutsche Bank analyst Bill Dreher Jr. wrote in an Aug. 27 research report.

Dillard's, unlike many department stores, owns about 75 percent of its more than 300 stores, which gives the company a significant real estate value. Dreher estimated that value as ranging from $2.3 billion to $5.2 billion.

And that should put Dillard's stock trading in the range of $25 to $55, he wrote.

Dreher kept his neutral "hold" rating on Dillard's stock.

"On paper there is no fundamental reason why Dillard's could not show dramatic improvement in their operations," he said.

Shareholders Voice Outrage

The letter to the independent Class B directors includes the same kind of blunt language that has been a hallmark of public communications from Barington Capital and the Clinton Group.

"The performance of the Company over the past ten years has been atrocious," Mitarotonda and Hall said in their letter. "Since Mr. Dillard was appointed CEO in May 1998, the Company's market capitalization has plummeted from over $4.36 billion to less than $246 million as of the close of business [Oct. 24]."

Mitarotonda has been attacking Dillard's poor performance since mid-2007, but even the injection of new blood on the board hasn't stopped the steady flow of bad news.

On July 26, Dillard's was featured as one of the worst-performing stocks on the S&P 500 in the last 10 years, according to a report by Elizabeth Harrow, an analyst and financial writer in the research department at Schaeffer's Investment Research.

"As a mid-market department store, Dillard's ... was in the wrong place at the wrong time when a slowdown in spending spread across the U.S.," Harrow wrote.

And since the shareholders' meeting, Dillard's stock price has continued to crumble. On May 6, the stock closed at $20.84. Last week it had rallied to just under $5.

The bargain price in October didn't go unnoticed by Dillard's executives.

On Oct. 23, William Dillard II and Alex Dillard each bought 100,000 shares at $3.93. And Dillard's CFO Freeman bought 200,000 shares at $3.90.

Brad Martin, one of the new Class A directors, bought 20,000 shares at $3.95 on Oct. 23 and 30,000 shares at $4.88 on Oct. 28.

Ouster Wanted

Mitarotonda and Hall, who had been urging the directors privately to replace the Dillard family managers, took their campaign public on Oct. 27.

They released a letter that urged the three independent Class B directors to start looking immediately for a CEO to replace William Dillard II. And the other members of the Dillard family - brothers Alex and Mike and sisters Drue Corbusier and Denise Mahaffy - should follow him out the door, the letter said.

The Dillard family "is overpaid and under-qualified for the positions they hold and can be readily replaced with more talented retailers," Mitarotonda and Hall said in the letter.

The three Class B shareholders responded Thursday by taking issue with the criticism of the Dillard family's compensation.

"While these shareholders have on occasion made helpful suggestions, in this instance they have, among other things, questioned management compensation."

The Class B board members pointed to a study that said Dillard's CEO total compensation was well below the median in its peer group in 2007. And a 2008 report showed that the company paid less compensation to its top officers than the median compensation for 39 similarly sized companies.

Mitarotonda and Hall also were unhappy with the response they received when they recommended on Sept. 25 that a special committee be formed to buy back the Dillard family's Class B shares. The family sent back word that it wasn't selling, the letter said.

Pete Hastings, senior vice president at Morgan Keegan & Co., said he didn't think the Dillard family would hand over control of the company.

"I would imagine that they would try and defend their position pretty vigorously," Hastings said. "Whether or nor they deserve to remain in place is a separate question."

At some point, however, the company's performance will reach a level that concerns even the Dillard family, said Elson, the former nominee to the board.

"In the end, the performance does matter," Elson said.

Until that happens, the activist shareholders bought into Dillard's fully aware of the dual-class stock structure.

"Which is a good reason why you shouldn't buy dual-class stock companies," he said. "You always end up in this situation."


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