Why Luxurious Can Be Profitable

Investors were not enamored with Nordstrom's  (NYSE: JWN  ) results. After the company reported fourth-quarter earnings at the end of February, the stock was down as much as 2% before it recovered to close off 0.3%. This is a key period for the upscale retailer since it includes the holidays.

The company could have performed better, certainly. However, investors can find plenty of positive items in the company's transitional period as Nordstrom battles fellow retailers such as Macy's (NYSE: M  ) and Kohl's (NYSE: KSS  ) . Nordstrom is making investments that seem likely to pay off down the road, and it already offers sterling customer service. The combination may very well pay off for patient investors willing to look past a couple of bumpy quarters.

The glass is half full
Same-store sales, which are comprised of its full-line and direct businesses, were up a respectable 2.2%. The latter, which is its e-commerce platform, continued to do well, with a 30% top-line increase. Its off-price concept, Nordstrom Rack, also grew at a nice pace, with a same-store sales increase of 3.6% and total sales rising 10.2% to $71 million as Nordstrom continued to add new stores. The company's fiscal year had an extra week compared to 2012, skewing results, but same-store sales takes out the additional time.

The quarter did have some disappointments. Its full-line stores same-store sales fell 3.3%. The gross margin fell by 55 basis points, to 37.2%, as the retailer had to discount merchandise during the holidays to clear the shelves. However, the company also expanded the pace of store openings at Rack, increasing the occupancy costs and helping dent the margins. All told, diluted earnings per share were down 2.1% to $1.37.

However, the results show the company's investments are paying off, with two of its major initiatives, Direct and Rack, showing nice growth. Despite these commitments, Nordstrom continues to generate a prodigious amount of free cash. For all of 2013, it was $517 million. Granted, this was down 13.4% from the prior year, but this was due to a significant 56.5% bump in capital expenditures to $803 million. Nordstrom's operating cash flow grew 18.9% to $1.3 billion.

Looking ahead, management expects a decent 2% to 4% same-store sales increase this year. The company's guidance is for diluted earnings per share to be in a range of $3.75 to $3.90. . Although this is a modest 1% to 5% increase year over year, next year's bottom line will be suppressed as the company expands into Canada, a third major growth initiative. This will raise expenses as Nordstrom builds its presence and takes on the associated infrastructure and pre-opening costs. This is a new area for the company, and it will take time to establish the brand, but it has a successful blueprint to follow.

Competitive advantages
Nordstrom has a nice weapon at its disposal as it expands its concepts and geographic presence. It has established its reputation for incredible customer service. The retailer also has a Nordstrom Rewards loyalty program, which ties in to credit card business. Granted, this is not a new concept in retail, but the company has been successful in using it to expand its customer base and strengthen existing relationships. Last year, more than 1 million accounts were open.

Macy's fourth-quarter earnings per share were helped by cost-cutting and share buybacks. Diluted earnings were $2.16 a share, an 18% increase from a year ago. Although the top line was hurt by the addition of an extra week in the 2012 period, selling, general, and administrative expenditures declined by 70 basis points to 25% of sales. Buybacks added $0.13, according to my calculations, since the diluted share count fell by more than 24 million to 375.1 million.

The retailer is pinning its growth on a localization strategy, along with selling in more than one channel and strong customer service. In this age of technology, it makes sense since shoppers prefer to shop online at home and via mobile devices while being able to pick up at a nearby store, although this is not a unique strategy among retailers. Nordstrom already offers world-class customer service that is ingrained in the employees.

Meanwhile, results at Kohl's were not too exciting. Fourth-quarter diluted earnings per share were down 6% to $1.56. This comes about despite 13 million fewer shares. Granted, the year-ago period included an extra week, which added $0.06. Still, share net would have been down 2.5% when the additional days are excluded from that year's results. This year's results do not seem likely to pick up, either.

Management's guidance calls for diluted earnings of $4.05 to $4.45 compared to $4.05 in 2013. However, it will not come from stellar top-line growth since it expects sales to increase 0.5% to 2.5%, with same-store sales ranging from flat to a 2% rise. Since Kohl's operates 1,158 stores in 49 states, it would appear to have the market covered, making it hard to imagine how domestic growth will increase.

Foolish final thoughts
It is not easy to be patient, but often that leads to big investment gains. Besides, this is not a complete turnaround, just a matter of waiting for its initiatives to pay off. Shareholders can comfort themselves with the 2.1% dividend yield. Despite increased investments, Nordstrom has continued to return cash to shareholders via share buybacks and dividends. Recently, the board increased dividends by 10%, to a $0.33 quarterly rate. This continues a string of raises that goes back to 2006.

Trading at 16 times earnings, investors may not find this luxury retailer in the bargain bin for long.

Can Nordstrom take over retail?
To learn about two retailers with especially good prospects, take a look at The Motley Fool's special free report: "The Death of Wal-Mart: The Real Cash Kings Changing the Face of Retail." In it, you'll see how these two cash kings are able to consistently outperform and how they're planning to ride the waves of retail's changing tide. You can access it by clicking here.


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