DBI

Business Context and Reporting Period

Company: DSW Inc. (DSW), a leading U.S. specialty branded footwear retailer.

Reporting Period: Fiscal year ended February 2, 2008 (52 weeks).

Operations: DSW operates 259 company-owned stores in 37 states and 378 leased shoe departments for retailers including Stein Mart, Gordmans, and Filene's Basement. The company is a controlled subsidiary of Retail Ventures, Inc. (RVI), which owns approximately 63% of DSW's outstanding shares and 93.2% of the combined voting power.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 9.9% to $1.41 billion, driven by the opening of 37 new DSW stores and expansion of leased departments. However, comparable store sales declined 0.8%, marking the first decline in several years.
• Margin Compression: Gross margin decreased from 28.6% to 26.3%. This was primarily due to increased markdowns resulting from promotional activity and higher store occupancy expenses (rent and related charges).
• Profitability Decline: Operating profit fell 19.3% to $81.3 million, and net income dropped 17.9% to $53.8 million. The decline in operating profit was largely attributed to the decrease in gross profit.
• Expense Increases: Operating expenses rose to $288.8 million (20.5% of sales) from $265.6 million (20.7% of sales). Increases were driven by home office expenses, professional fees, and $6.0 million in start-up costs for the new e-commerce channel.
• Investment Liquidity: Due to auction failures in the market, $10.0 million of auction rate securities were reclassified from short-term to long-term investments as liquidity became uncertain.

Guidance, Outlook, and Risks

• Growth Strategy: Management plans to open at least 30 new stores annually from fiscal 2008 through 2010. Capital expenditures for fiscal 2008 are expected to be approximately $90 million.
• E-Commerce Launch: The company plans to launch an e-commerce business in the first half of fiscal 2008. $26.3 million has already been invested in capital for this initiative.
• Shared Services Risk: DSW relies on Retail Ventures (RVI) for key services (tax, finance, HR) under an agreement expiring at the end of fiscal 2008. RVI's recent disposition of an 81% interest in Value City may increase DSW's allocation of shared service expenses if Value City reduces operations.
• Legal Contingency: A putative class action lawsuit regarding a 2005 credit card data theft remains pending. The company has an accrued liability of $0.5 million, with potential exposure estimated between $6.5 million and $9.5 million.
• Market Risks: Risks include the inability to anticipate fashion trends, competition from department stores, and the potential impact of the PIES (Premium Income Exchangeable Securities) issued by RVI on DSW's stock price.

Investor Verification Checklist

• Comparable Store Sales Trend: Verify the sustainability of the -0.8% comparable store sales decline and the impact of increased markdowns on future gross margins.
• E-Commerce Execution: Monitor the launch of the e-commerce channel and its impact on cannibalizing existing store sales versus generating incremental revenue.
• Shared Services Allocation: Assess the financial impact of the Value City disposition on DSW's share of RVI's shared service costs.
• Auction Rate Securities: Review the liquidity status of the $13.7 million remaining investment in auction rate securities and potential impairment risks.
• Legal Exposure: Track developments in the 2005 data theft litigation to determine if the $0.5 million accrual is sufficient.