Department store operators Nordstrom (NYSE: JWN ) and Dillard's (NYSE: DDS ) both beat Wall Street's expectations when they reported earnings last Thursday. As a result of their solid performances, shares of both companies rose by about 15% on Friday.
Nordstrom and Dillard's both compete in the mid-high range of the department store market, and both companies' stocks have performed well in the five years since the Great Recession. However, the similarities end there.
Dillard's has adopted a strategy oriented around minimizing investment and spending every dollar available on buybacks to reduce its share count and boost earnings per share. On the other hand, Nordstrom is investing heavily in growth initiatives. In the long run, Nordstrom's strategy is likely to deliver the best returns for shareholders.
The Dillard's buyback frenzy
Dillard's earned $112 million last quarter and generated free cash flow of $139 million. It spent $66 million of that total on share buybacks. This was actually a fairly modest level of capital return relative to Dillard's earnings and cash flow compared to its recent track record.
In the company's 2013 annual report, Dillard's boasted that it had returned more than $1.7 billion to shareholders in the last five years through buybacks and dividends. During that same period of time, Dillard's total net income was just $1.37 billion.
Dillard's thus managed to return more cash to shareholders in the last five years than it earned under GAAP accounting rules. It did this by minimizing capital expenditures. Between 2009 and 2013, Dillard's closed 21 stores, while it only opened two stores. (Dillard's does plan to open two new stores this year, though.)
By minimizing new store openings, and closing underperforming stores rather than investing in them to try to improve sales trends, Dillard's has kept capex far below its annual depreciation and amortization expense of more than $250 million. Last year, Dillard's spent just $95 million on capex, and it expects to spend $150 million this year.
Dillard's strategy of minimizing investment and returning all available cash to shareholders worked well when its stock was trading at a very cheap valuation. By repurchasing shares at a discount, Dillard's was able to reduce its share count by more than 40% in less than five years.
Today, Dillard's shares trade for about 14 times expected current-year earnings. Even if Dillard's continues to direct all of its free cash flow to share repurchases, it won't be able to buy back nearly as many shares as it could a few years ago. Since Dillard's is not growing organically, this means that EPS growth will slow down -- barring a collapse in the stock price.
Investing for long-term growth
In terms of capital allocation, Nordstrom is the polar opposite of Dillard's. Whereas Dillard's spent $95 million on capex last year, Nordstrom -- which is twice the size of Dillard's by sales -- spent $714 million on capex in FY13. This year, Nordstrom plans to increase capex to at least $840 million.
This high level of investment is no fluke. Nordstrom expects to spend $3.9 billion on capex in the next five years. This will allow it to keep its existing stores looking spiffy, add new full-line and Nordstrom Rack stores, and grow its online sales. In fact, Nordstrom plans to spend $1.2 billion on technology alone in the next five years.
One tangible result of this heavy investment in technology is the recent launch of the first-ever e-commerce site for Nordstrom Rack. Nordstrom already had an off-price e-commerce offering through its HauteLook flash sale subsidiary. The launch of nordstromrack.com will broaden Nordstrom's off-price assortments, boosting its e-commerce momentum.
Growth at the right price
The differing strategies of Dillard's and Nordstrom can be seen in their dramatically different revenue growth rates. Last quarter, merchandise sales at Dillard's rose just a fraction of 1%. Meanwhile, Nordstrom's net sales grew 6.8% last quarter.
As Nordstrom's online sales become a larger proportion of total sales, the company's bold technology investments should pay off in the form of even faster revenue growth. Nordstrom is also in the early stages of a push to more than double the Nordstrom Rack store base by the end of 2016. Lastly, Nordstrom is opening its first store in Canada in September, with five more store openings planned within the next three years.
Nordstrom is investing heavily in growth, and it has enough runway to maintain a high-single-digit revenue growth rate for many years to come. This should also translate to solid long-term earnings growth, particularly when its current round of growth investments start to pay off.
By contrast, Dillard's doesn't really have a plan to grow earnings. It has done an admirable job of boosting its profit margin in the past few years, but there's not much room left for further improvements there. Dillard's can only offer to put its cash flow toward more share buybacks, and thereby grow EPS. In the long run, Nordstrom's growth-oriented strategy is likely to generate the best results for investors.
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