How Dillard's did it By Shelley DuBois

FORTUNE -- This could be the year for retail's big comeback. Retail companies, maimed during the crisis, are finally reporting balance sheets that contain glimmers of hope. Even some department stores -- a sector hit particularly hard by the recession -- have regained strength. Among them is an unlikely survivor:

Dillard's (DDS, Fortune 500), a historically unloved player in an unloved sector, reported a promising third quarter for 2010. Net income was $14.4 million, or 22 cents a share, up from the same period last year when the company reported a net income of $8 million, or 11 cents a share.For the 2010 fiscal year, Dillard's reported a net income of $69 million, up from a net loss of $241 for 2009. In a time when the trend seems to be retail losing market- and mind-share to online stores and smartphone-wielding comparison shoppers, that's a victory.

And it's not a fluke, says Bill Dreher, a research analyst with Deutsche Bank, and one of the two analysts that still regularly cover Dillard's since its perceived downward spiral began around 2007. But while Wall Street has mostly moved on, Dreher says, Dillard's launched a calculated effort to clean up the company. That, among other reasons, is why Dillard's landed on Fortune's 10 best performing stocks of 2010

Dillard's began shearing stores that didn't put up good sales numbers, tracking its inventory better and buying higher quality products, all before the recession. But that strategy was masked because consumers suddenly stopped buying, according to a Deutsche Bank analyst report published in 2009. Also, few knew about the Dillard's internal transformation because the company traditionally keeps its business plans in its vest pocket (as much as a public company can, anyway).

The challenge

All department stores will need to initiate changes like the ones that Dillard's made, says Dreher, to transform and survive. The sector as a whole has been frustrating for many investors. "Department store retailing was largely an art, managed by merchant princes," he says, who were less concerned with consumer spending research. But that's changing, "it's evolved into much more of a science based on hard facts."

Though they're evolving, department stores are still shackled to malls, which haven't grown in the past few years and probably won't in the near future. That's a problem for the sector because there's little that investors find less sexy than low growth rates now and no promise of an uptick on the horizon.

Other department stores have gotten around this problem by marketing outlets as clearance branches of the brand, while they actually operate as separate retail entities. Nordstrom Rack (JWN, Fortune 500) and Saks Off Fifth (SKS), for example, aren't shackled to malls like the bigger stores that carry the powerful names. These spin-off stores can leave the mall and enable the company to grow. Dillard's, on the other hand, didn't make that kinds of moves towards mobility.

Also, during the crisis, the store kept matters to itself. That's how it's traditionally operated, Dreher says, it still runs very much like family business. The CEO is William Dillard II, son of the founder of the department store, and several family members are high-level executives. The Dillard's management team doesn't generally hold earnings or investor calls, or offer much other management guidance. In fact, the company's secrecy around its management strategy is what both of Deustche Bank's most recent analyst reports listed as one of the stock's greatest risks.

In 2008, the store's close-lipped culture angered some activist investors who could only see sales numbers spiraling. Net income for the year was $53 million, down from $245 million in 2007, and would hit a net loss of $241 million in 2009 before climbing again.

In 2008, investors from Barrington Capital Group and Clinton Group wrote a letter to Dillard's demanding that management implement certain changes. And quietly, they did. But nobody knew about those changes until early 2009.

The comeback

Behind the scenes, Dillard's had started trimming down. Management cut 21 stores over the 2008 fiscal year and has continued to shed underperformers since. Dillard's also rediscovered itself. Previously, the Deutsche Bank report mentions, the company's sales strategy had been "stack it high, let it fly," but the cheap and plentiful sales model was flabby, and Dillard's decided, not the company's strong point.

Instead, Dillard's tried to move more towards a boutique feel, and position itself somewhere between Macy's (M, Fortune 500) and Bloomingdales instead of competing with discount outlets such as Kohl's (KSS, Fortune 500).

To stand out from the competition, Dillard's simplified its purchasing strategy by looking into fewer, but higher quality brands that resonated with its customers. Dillard's also communicated the change to its customers. Way back in 2006, it launched an ad campaign called "The Style of Your Life", which has started to take hold.

And while Dillard's will never have skyrocket growth, there's no reason why it can't keep profiting from tightening its assets and sales model. The company has more value stashed away in real estate. It owns 78% of its property, which Deutsche Bank says could ultimately be valuable for Dillard's, not now, but in the event that the credit and real estate market recover.

But the company's refreshed strategy to trim down and focus will probably generate more profit in the interim, Dreher says. It will be particularly effective soon if shoppers actually turn out this holiday season to buy clothes, which Dreher thinks they will.

"Earnings estimates have risen faster than the shares have, so they're still not expensive, it's still very buyable."

People still aren't paying much attention to the secretive store. In the short term, Dillard's could stay under the radar, secretly thriving in its stagnant department store spaces in a harsh retail market. To top of page