DBI

Business Context and Reporting Period

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

Reporting Period: Fiscal year ended January 28, 2006 (52 weeks).

Operations: DSW operates 199 company-owned stores in 32 states and 238 leased shoe departments within other retailers (Stein Mart, Gordmans, Frugal Fannie's, and Filene's Basement). The company offers brand-name and designer footwear and accessories.

Corporate Status: DSW completed its Initial Public Offering (IPO) in July 2005. Retail Ventures, Inc. (RVI) remains the controlling shareholder, owning approximately 63.1% of outstanding shares and 93.2% of voting power.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 19.0% ($183.0 million) driven by a 5.4% increase in comparable store sales and the addition of 29 new DSW stores and 12 new leased departments.
• Profitability: Operating profit increased 25.0% to $70.1 million. However, gross margin declined 50 basis points to 27.6% due to increased markdowns as the company executed planned clearance rotations.
• One-Time Charges: Results included a $6.5 million pre-tax charge (approx. $3.9 million after-tax) related to a reserve for estimated losses from a credit card data theft incident in March 2005.
• Liquidity: Cash and equivalents surged to $124.8 million from $8.3 million, primarily due to IPO proceeds of $285.8 million used to repay intercompany debt and fund operations.
• Debt Reduction: The company repaid all long-term obligations outstanding at the end of fiscal 2004. As of January 28, 2006, DSW had no long-term debt, though it maintains a $150 million secured revolving credit facility with $136.4 million available.

Guidance, Outlook, and Risks

Outlook and Strategy

• Expansion Plan: DSW plans to open approximately 30 new stores annually from fiscal 2006 through fiscal 2010. As of March 31, 2006, leases were signed for 21 additional stores.
• Capital Allocation: Future earnings are expected to be retained to fund expansion; no cash dividends are anticipated in the foreseeable future.
• Merchandising: Focus remains on driving sales through enhanced merchandising, vendor relationships, and the "Reward Your Style" loyalty program (6.8 million members).

Risks and Contingencies

• Data Security Breach: A theft of credit card information involving 1.4 million cards occurred in March 2005. The company estimates potential exposure between $6.5 million and $9.5 million. A $6.5 million reserve was accrued, with $4.8 million remaining as of period end. The company entered a consent order with the FTC requiring a comprehensive security program.
• Vendor Concentration: Three key vendors accounted for approximately 22% of net sales in fiscal 2005.
• Related Party Dependence: DSW relies on Retail Ventures for shared services (IT, tax, legal, etc.) under an agreement expiring in fiscal 2007. RVI controls 93.2% of voting power.
• Expansion Risks: Rapid store opening could strain resources, and new stores may not achieve profitability as quickly as anticipated.

Investor Verification Checklist

• Reserve Adequacy: Verify if the $4.8 million remaining reserve for the data breach is sufficient given ongoing legal proceedings and potential insurance recoveries.
• Comparable Store Sales: Monitor the sustainability of the 5.4% comparable store sales growth, particularly in the women's and athletic categories which drove the increase.
• Margin Pressure: Assess the impact of increased markdowns on future gross margins and the effectiveness of the clearance strategy.
• Related Party Transactions: Review the terms of the Shared Services Agreement with Retail Ventures to ensure costs are allocated fairly and competitively.
• Capital Expenditures: Confirm that the planned $1.4 million average investment per new store remains accurate as expansion accelerates to 30 stores per year.