Retailers and department stores have long been the target of activist investors, and at least one has finally succumbed to the pressure. Dillard's (NYSE:DDS) recently announced that it reached an agreement with its dissident shareholders whereby four new directors will be installed on the board to implement the activists' agenda.

The result is a clear template for other activist investors hoping to turnaround similar retailers like Target (NYSE:TGT), Sears (Nasdaq:SHLD) and others.

Introducing the Activists
Barington Capital and the Clinton Group own a combined 5.4% of Dillard's and both believe that the company is worth substantially more than its current stock price. The Hedge Funds believe the problems the company is facing with same-store-sales growth, declining margins, and an ailing stock price can be solved with a simple two-step plan that can be quickly implemented and put into action. (To profit by following the lead of some of Wall Street's most ruthless investors, check out Activist Hedge Funds.)

Step 1: Reduce Costs and Enhance Revenue
The first step is to boost the bottom line for long-term growth. Dillard's operating free cash flow margin is 2.4% for the trailing twelve months versus 7.7% for its peers, which means shareholders could realize enormous upside if margins can be improved to match the standard. The activists recommended a number of solutions to reduce costs, including improved sourcing, rationalizing of SG&A expenses and the lowering of capital expenditures. These efforts would result in an immediate improvement to the retailer's bottom line through cost reductions. (To learn how to take a deeper look at a company's profitability, read The Bottom Line On Margins.)

Meanwhile, improvements can also be made in inventory management and merchandising that can drive customer traffic and enhance margins. The activists believe that an aggressive re-merchandising effort that includes adding new vendors and updated private-label and in-house collections could both improve its value proposition and enhance its profit margins. Moreover, adding more image and lifestyle campaigns to its brand marketing could add excitement and newness to Dillard's shopping experience and attract new customers to its stores. Combined, these translate into higher revenues and margins.

Step 2: Unlock Value Via Real Estate
The next step is to unlock value in its real estate and leverage it to increase the stock's multiple. Dillard's owns about 75% of its store portfolio, which is comprised of about 42 million square feet of real estate. The value of this real estate is currently understated at around $32.50 per share, with many analysts pegging the value closer to $59 per share. With Dillard's trading at just $22 per share, there is clearly some value that could be unlocked.

In fact, Deutsche Bank (NYSE:DB) noted that "actions taken to unlock the company's real estate value would be positive for the shares, as the NAV for Dillard's [is] greater than the value based solely on operating fundamentals." This value can be unlocked through a combination of property conversions into better uses, the closure of underperforming stores, and most importantly, sale and leaseback transactions that can bring immediate value back to the company. (For further reading on unlocking the value of real estate, check out Investing In Real Estate and Smart Real Estate Transactions.)

Conclusion
The leaseback income from these operations can help improve Dillard's bottom line while the extra cash could be put towards a share buyback or special dividend to unlock value. The activists then just have to wait for the net income to increase from the long-term improvements and the multiple to increase through the buybacks and dividends. And that's how the activists plan on making money in the retail sector!

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