Shares of Nordstrom (NYSE:JWN) soared 15% last Friday, reaching an all-time high above $70. Clearly, investors liked the upscale clothing retailer's first-quarter earnings, in which earnings per share of $0.72 exceeded the guidance range of $0.60-$0.70. Many investors were also intrigued by the company's stated interest in selling its credit card receivables, which could free up cash for higher share buybacks.
Nordstrom's strength goes far beyond a single "good quarter." The company is investing heavily in growth initiatives, which should enable it to achieve a long-term high single-digit revenue increase rate. This will help Nordstrom produce double-digit EPS growth in the long run, sending the stock to $100 by 2017 -- and then higher.
Margins: Falling now, but rising in the long run
Even after the recent rally, Nordstrom shares trade for about 18 times earnings. That's relatively close to the average for the market as a whole. At first glance, that might seem fair considering that the company is projecting low-to-mid single-digit EPS growth this year.
However, Nordstrom's short-term margin trajectory and its long-term margin trajectory are not the same. In early 2013, CFO Michael Koppel told investors not to expect any earnings before interest and taxes, or EBIT, margin expansion in the next few years.
So far, that prediction has been accurate. Last year, the EBIT margin for Nordstrom's retail business -- thus excluding credit card revenue -- contracted from 8.7% to 8.4%. Nordstrom's current guidance for fiscal 2014 calls for its EBIT margin to decline by another 0.5 percentage points.
For most companies, falling margins are a sign of trouble. By contrast, Nordstrom's margins are falling because the company is investing heavily in growth. This includes doubling the Nordstrom Rack store base, entering Canada, and laying the foundation for future growth in e-commerce.
Nordstrom's growth timeline
These investments will start to pay off in a big way over the next two to three years, helping margins rebound to historical levels by 2017 or so.
In 2012, Nordstrom announced plans to more than double the number of Nordstrom Rack stores to about 230 by the end of 2016. Opening new locations causes short-term losses as new staff must be trained and rent paid for the period before the store opens. It then takes two to three years for a new store to "mature" and reach peak profitability.
With 25 to 30 new Rack stores opening each year, at any given time Nordstrom is incurring pre-opening expenses for a large number of locations. It also has dozens of stores that are still maturing. By 2017, that will start to turn, and the base of mature Rack stores will be larger than the number of new openings and maturing locations.
Nordstrom is also investing heavily in Canada. The company will open its first store in Canada in September, and it plans to open five more stores in the next three years. That is approximately one every six months.
Nordstrom is incurring significant launch-related costs in Canada despite not having any stores open there yet. For example, department managers are being hired six months in advance of the store opening and brought to Seattle for an intensive training program. In total, Nordstrom expects a pretax loss of $35 million in Canada this year.
By 2017, the initial group of six stores will be open. The last few will still be ramping up from a sales perspective, but by that point Nordstrom Canada should be profitable, removing a major margin headwind. In the long run, Nordstrom could be more profitable per square foot in Canada than it is in the U.S., as its six store locations will be in some of the most productive malls in North America.
Lastly, Nordstrom is spending more than $1 billion on technology. Much of that investment is directed at boosting the company's e-commerce and "omnichannel" capabilities. This has already paid off in the form of strong online sales growth. Last quarter, direct sales rose 33%. Over time, this will allow Nordstrom to leverage its technology investments, boosting profit margin.
Earnings growth will accelerate
In 2014, Nordstrom's investments in growing the Nordstrom Rack store base, entering Canada, and strengthening e-commerce are producing sales increases but not earnings growth. In fact, Nordstrom would be making more money today if it were not investing so heavily in growth.
However, these growth investments will produce solid returns by 2017. While I expect Nordstrom to continue investing in growth beyond then, there will be more of a balance between investments that are paying off and those that are still in the early stages.
The result will be substantial earnings growth over the next three years. The biggest gains will be weighted toward the end of that period, with earnings momentum continuing through the close of the decade. The combination of strong earnings growth and associated multiple expansion should propel Nordstrom stock to $100 by 2017, with plenty of long-term upside beyond that level.
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Adam Levine-Weinberg owns shares of Nordstrom. The Motley Fool has no position in any of the stocks mentioned. 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.