DBI

Business Context and Reporting Period

Company: DSW Inc. (Ticker: DSW)
Filing Type: Form 10-K (Annual Report)
Period Ended: February 3, 2007 (Fiscal Year 2006, 53 weeks)
Business Overview: DSW is a leading U.S. specialty branded footwear retailer operating 223 stores in 35 states. The company operates two segments: DSW stores and leased shoe departments (supplying Stein Mart, Gordmans, Frugal Fannie's, and Filene's Basement). DSW is a controlled subsidiary of Retail Ventures, Inc. (RVI), which owns approximately 63% of outstanding shares and 93.2% of voting power.

Key Financial Metrics

Note: Fiscal 2006 included an extra week compared to Fiscal 2005.

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 11.8% ($135.0 million) driven by the 53rd week, 29 new DSW stores, and 122 new leased shoe department locations. Comparable store sales grew 2.5%.
• Profitability Expansion: Operating profit increased 43.7% ($30.6 million). Gross margin improved 100 basis points to 28.6% due to increased initial markups and reduced warehouse expenses (1.1% of sales vs. 1.4% prior year).
• Expense Management: Operating expenses as a percentage of sales decreased to 20.7% from 21.5%. This was aided by a $7.1 million favorable variance in the loyalty program and the absence of the $6.5 million credit card theft charge incurred in the prior year.
• Interest Income: The company shifted from net interest expense ($7.5 million) in 2005 to net interest income ($6.9 million) in 2006, utilizing IPO proceeds and operating cash flows for investments.

Guidance, Outlook, and Risks

Management Commentary & Outlook

• Growth Strategy: Plans to open at least 30 new stores annually from fiscal 2007 through 2010. Long-term potential estimated at over 400 stores.
• Capital Expenditures: Expected to spend up to $80 million in fiscal 2007 on new stores, remodels, information systems, and e-commerce development.
• Liquidity: The company maintains a $150 million secured revolving credit facility (expires July 2010) with no outstanding borrowings as of period end. Management expects to fund operations and expansion via cash flows and existing cash balances.

Risks and Contingencies

• Legal Proceedings: Ongoing litigation related to a 2005 credit card data theft. The company has accrued $3.2 million (down from $6.5 million initial accrual) with a potential exposure range of $6.5 million to $9.5 million.
• Related Party Dependence: Significant reliance on Retail Ventures (RVI) for shared services (tax, HR, IT) and Schottenstein Stores Corporation (SSC) for real estate leases. RVI controls 93.2% of voting power.
• Vendor Concentration: Three key vendors accounted for approximately 22% of net sales in fiscal 2006.
• Expansion Risks: Aggressive store opening plans could strain resources, and new stores may cannibalize existing sales or fail to meet profitability targets.

Investor Verification Checklist

• Comparable Sales Sustainability: Verify if the 2.5% comparable store sales growth can be maintained given the deceleration from 5.4% in the prior year.
• Legal Reserve Adequacy: Monitor the $3.2 million accrual for the credit card theft litigation against the stated potential exposure of up to $9.5 million.
• Related Party Transactions: Review the terms of the Shared Services Agreement with RVI and lease agreements with SSC affiliates to ensure arm's-length pricing.
• Capital Allocation: Assess the return on investment for the planned $80 million capital expenditure budget, particularly regarding e-commerce and new store openings.
• Inventory Valuation: Confirm inventory reserves ($21.2 million) are sufficient given the retail inventory method and markdown policies.