Investors in upscale retailer Nordstrom (JWN -1.35%) have enjoyed a spectacular week with the stock rising nearly 15% after its recent results. The market took heart from Nordstrom's overall trading performance and the announcement that it is seeking a partner for its credit card receivables. It appears that all is going well for Nordstrom, but how do the results tie in with its long-term strategic plans? This is an important question, because Nordstrom will look like a different business in a few years' time.
Nordstrom's long-term plans
The retail sector has been bedeviled with some unusual conditions because of the protracted and moderate nature of the recovery. The bottom end has continued to struggle, while the high end has done relatively better. Meanwhile, the mid-range department stores have suffered as middle-class shoppers traded down with their lack of exposure to the higher-end shopper. Anyone who doubts these trends need only take a look at how J.C. Penney (JCPN.Q) has suffered in recent years. J.C. Penney's investment proposition now relies solely on the successful execution of its turnaround strategy.
Nordstrom's full-line stores sit somewhat in between the mid and high range, and the environment has necessitated a significant restructuring of its growth priorities. The good news is that -- unlike J.C.Penney-- Nordstrom has been investing early and aggressively.
Indeed, a breakout of its same-store sales growth reveals how Nordstrom is evolving.
Source: Nordstrom Presentations
The market got excited by the total comparable-sales increase of 3.9%. However, as the chart demonstrates, it's a tale of declines at Nordstrom's full-line stores (down 1.9% on a comparable basis) being more than offset by increases at its discount store, Nordstrom Rack, and its direct sales and online operations.
Dealing with reality
The chart above illustrates the reality in the retail marketplace. Simply put, consumers have become accustomed to seeking out bargains, and Nordstrom is finding it hard to generate sales growth with its full-line stores. In response, the company plans to make $3.9 billion in capital expenditures (mainly in Nordstrom Rack and IT infrastructure to support Nordstrom's online activities) in the next few years in order to generate "high single-digit sales growth and mid-teens ROIC".
Nordstrom isn't quite there yet, because its current forecast for 2014 sales growth is just 5.5%-7.5% and it has a return on invested capital, or ROIC, of 13.3% over the last four quarters. In fact, its ROIC actually declined from 14% in the same period of last year, but it's understandable if the investments it's making in new Nordstrom Rack stores and e-commerce will take a little time to generate returns.
A look at Nordstrom's net sales by channel demonstrates the shift in revenue toward Nordstrom Rack and its online and direct sales channels.
Source: Nordstrom Presentations
Moreover, a look at its sales per square foot demonstrates the greater profitability of its Nordstrom Rack stores, although -- just as with the full-line stores -- their sales per square foot declined in 2013.
Source: Nordstrom Presentations
Meanwhile, total sales per square foot are rising due to the success of its online and direct-selling operations.
Will Nordstrom's strategy work?
All told, the strategy makes perfect sense and is a realistic realignment of where Nordstrom can generate profit growth going forward. The recent results were merely an extenuation of ongoing trends and highlight the shifts taking place in the business. Retailers like J.C.Penney are being forced to undergo radical structural transformations, but Nordstrom already has the growth platforms (Nordstrom Rack, direct, and online) on which it can invest.
Moreover, the announcement that Nordstrom is seeking a partner for its credit-receivables business was warmly received, because it helps to de-risk the company from an activity that many feel is non-core. It will also allow Nordstrom greater financial flexibility for accelerating investment in its growth program. The market reacted the most to this news, because even though the company beat earnings estimates in the quarter Nordstrom left its full-year sales and EPS guidance unchanged.
How to evaluate Nordstrom
This question is not as easy as it might seem to answer. For example, the capital-expenditure program will affect free cash flow, and the investment program and increased depreciation will affect earnings. Under these circumstances, I would argue that enterprise value, or EV, to revenue would probably be the best valuation method for Nordstrom.
JWN EV to Revenues (Forward 1y) data by YCharts
The chart indicates that Nordstrom is trading toward the high end of its EV/Revenue band for the last few years.
Where next for Nordstrom?
On a valuation basis, the stock is not looking particularly cheap right now. In addition, the decline at its full-line stores continues in terms of sales per square foot and same-store sales. Moreover, it's also not clear if Nordstrom Rack is somewhat cannibalizing growth at the full-line stores.
All of this suggests a note of caution over the stock. Nordstrom's growth strategy is the right one and it's working in terms of generating top-line sales growth, but the market seems to have priced in success here. Any disappointment with Nordstrom Rack's growth and the market will be quick to punish the stock.
