Deciding whether or not to invest in a high-end clothing retailer like Nordstrom (NYSE:JWN) used to be easy. In the past, it boiled down to your view on the environment for higher-income consumer spending. Although that argument is still applicable, it's far from the full picture now. Nordstrom is undergoing some fundamental changes in its business, and Foolish investors need to consider what this company will look like in a few years.
Nordstrom adjusts to a changing environment
The retailer is best known for its full-line stores. However, its investment plans for the next five years involve shifting sales toward its other sales channels. The idea is to move toward the kind of growth trends that seem to have categorized the US consumer since the recession.
For example, off-price retailers like TJX Companies (NYSE:TJX) and Ross Stores have been flourishing, while mid-market department stores like J.C. Penney are struggling. In response to these trends, Nordstrom is investing in its off-price concept, known as the Rack. Nordstrom is also imitating clothing companies such as VF Corp (NYSE:VFC) and Coach, which are investing significantly in their online strategies.
Unfortunately, Nordstrom is having some teething problems. Its third-quarter results were a disappointment, with its full-line stores delivering a same-store sales decline of 4.2%. Moreover, it lowered its full-year earnings per share guidance to $3.60-$3.70 from a previous estimate of $3.65-$3.80. The question is if Nordstrom's investment plans are making it lose its focus on its core business.
Nordstrom's growth plan
Nordstrom's plan involves ramping up capital expenditures to $3.7 billion over the next five years in a way that changes the way it does business.
Key parts of the plan include:
- Expansion of its Rack outlets (20% of total sales) to at least 230 from 127 today
- Invest in IT infrastructure initiatives in order to expand its e-commerce sales, and increase stock keeping units, or SKUs, in its online offerings
- A combination of investment in Canada and its US flagship stores, such as the store in Manhattan
Nordstrom and the retail environment
In order to illustrate the importance of the plan, here is a breakout of Nordstrom's same-store sales data. Note that the direct division includes Nordstrom's own online sales (11% of total sales) plus sales from Haute Look (2% of total sales), an off-price online company it bought in 2011. The numerically aware will have calculated that Nordstrom's full-line stores currently contribute 67% of total sales.
Clearly the biggest issue is with Nordstrom's full-line sales. It is true that Nordstrom's anniversary sale took place in the second quarter -- last year it was across the second and third quarters -- so its third quarter numbers were expected to look weak. However, Nordstrom's full-line sales have been weak for four quarters now.
When pushed on the issue in its conference call, management stated
We don't believe it's attributable to any one factor. That said, we know customers respond to freshness and fashion, and we're working to provide that, combined with ongoing efforts to enhance the store environment and overall execution.
This sort of performance and commentary captures the problem facing many retailers in this environment. If you are not a differentiated specialty store, then consumers want discounts to buy from you. On the other hand, if you discount too much then consumers will lower their perception of the value of your higher ticket items.
In this scenario a clothing company like VF, which owns Vans, The North Face, and Timberland, can do well because its outdoor action clothing lines are differentiated. It's also growing its online business. VF has a lot of upside potential, particularly if winter is cold this year. VF's main strength is the ability to invest adapt to changing market conditions because it has a diverse set of brands. In addition, its relatively low penetration in emerging markets (particularly with its jeanswear) means it should be able to generate growth through expansion alone.
Meanwhile, off-price retailer TJX has been raising guidance throughout 2013, and it continues to benefit from consumers seeking discounted prices. In fact, TJX just beat analyst expectations with its third quarter results, and raised its long-term estimates for its store expansion program.
What's next for Nordstrom?
Nordstrom's strategy is to try and retain premium pricing in its full-line stores while growing its off-price business through Rack expansion. Unfortunately, it looks like its core full-price store growth is weakening, even while direct and Rack sales are expanding.
In a sense, Nordstrom's management should be commended for aggressively making the changes necessary to navigate its way through changing end markets. However, the expansion plan contains execution risk and will eat into cash flow in future. Cautious investors will want to see a turnaround in Nordstrom's core full-price stores before buying in.
Lee Samaha owns shares of The TJX Companies. The Motley Fool recommends Coach. The Motley Fool owns shares of Coach. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.