DBI

Business Context and Reporting Period

Company: DSW Inc. (Note: Metadata listed "Designer Brands Inc.", but the filing is for DSW Inc., a subsidiary of Retail Ventures, Inc.)
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: November 3, 2007 (Nine months ended November 3, 2007 vs. October 28, 2006)
Business Overview: DSW is a leading U.S. specialty branded footwear retailer operating 250 stores in 36 states and leased departments in other retailers (Stein Mart, Gordmans, Filene's Basement). The company is a controlled subsidiary of Retail Ventures, Inc. (RVI), which owns approximately 63% of DSW's outstanding shares.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 10.6% ($35.2M) for the quarter and 13.0% ($123.1M) for the nine months, driven by the net addition of 35 DSW stores and 121 leased departments. However, comparable store sales declined 3.0% in the quarter and 0.5% for the nine months due to lower customer traffic.
• Margin Compression: Gross margin decreased to 29.0% (quarter) and 27.7% (nine months) from 29.7% and 29.2% respectively. This was primarily due to increased store occupancy expenses and higher markdown rates from promotional activity.
• Operating Expenses: Operating expenses decreased 2.2% in the quarter but increased 8.0% for the nine months. The nine-month increase was driven by new store openings, e-commerce start-up costs ($4.0M), and home office personnel expenses, partially offset by a reversal of bonus accruals ($8.7M).
• Profitability: Net income rose 40.2% in the quarter and 7.9% for the nine months. Operating profit margin improved to 9.5% in the quarter but declined slightly to 7.5% for the nine months.
• Liquidity: Cash and equivalents decreased from $73.2M to $46.4M. Net cash provided by operating activities dropped significantly to $38.9M from $67.3M in the prior year, largely due to a $37.2M increase in inventory levels.

Outlook, Risks, and Contingencies

• Guidance & Strategy: Management plans to open at least 35 new stores in fiscal 2007 and expects capital expenditures of approximately $100M for the year. The company is launching an e-commerce channel, incurring significant start-up costs.
• Legal Contingency (Data Theft): Regarding a 2005 credit card data theft involving 1.4 million cards, the company estimates potential exposure between $6.5M and $9.5M. A $6.5M charge was accrued in 2005; the remaining accrual balance as of November 3, 2007, was $0.5M.
• Risk Factors:
  • Parent Company Strategy: Retail Ventures (RVI) is exploring strategic alternatives for its Value City operations (sale or discontinuance). If Value City ceases operations, DSW's allocation of shared service expenses may increase materially, negatively impacting financial performance.
  • Seasonality: Sales are typically higher in spring and early fall; the company does not historically see a large holiday surge in Q4.
  • Inventory Risk: Significant markdowns and inventory valuation judgments impact gross profit.
• Debt & Liquidity: DSW maintains a $150M secured revolving credit facility with no borrowings outstanding. $137M was available as of November 3, 2007. The company has no long-term debt.

Investor Verification Checklist

• Comparable Store Sales: Verify the sustainability of the 3.0% decline in comparable store sales and the impact of declining customer traffic on future revenue.
• Margin Trends: Monitor the impact of increased store occupancy costs and markdown rates on gross margins, which have compressed year-over-year.
• Value City Exposure: Assess the potential financial impact of Retail Ventures' strategic review of Value City on DSW's shared service expense allocations.
• Capital Allocation: Review the burn rate associated with the new e-commerce channel and the $100M capital expenditure plan for fiscal 2007.
• Inventory Levels: Analyze the $37.2M increase in inventory and its effect on working capital and future cash flow.