Nordstrom Investors Shouldn't Sell Yet

Nordstrom (NYSE: JWN  ) lost the support of one of Wall Street's top investment banks this week, as analysts at Goldman Sachs cut the retailer's rating to hold. Stephen Grambling and his analyst team argue that after Nordstrom's recent stock run, there isn't much upside left.

JWN Chart

Nordstrom 1-Year Stock Chart, data by YCharts.

However, Nordstrom's strong growth profile compared to other department stores such as Macy's (NYSE: M  ) justifies its higher-than-average earnings multiple. Indeed, I continue to believe that Nordstrom stock has a clear path to $100 by 2017, which would represent nearly 50% share price appreciation. That's reason enough to hold on to the stock.

Macy's vs. Nordstrom
Today, most department stores are retrenching and looking to e-commerce for sales growth. For example, earlier this year, Macy's announced plans to close five stores. Macy's still plans to open a few stores in the coming years, but its square footage will remain stable or shrink slightly.

If anything, Macy's is shrinking its retail footprint.

By contrast, Nordstrom is seeking growth both in-store and online. Nordstrom is nearing the middle of a four-year campaign to double its Nordstrom Rack off-price store count. It is also entering the Canadian market, with plans to open six stores in the next three years. As a result of its growth initiatives, Nordstrom's selling square footage has been increasing about 4% annually.

The divergent strategies of Macy's and Nordstrom can be seen in their revenue growth over the last five years. Over that period of time, Nordstrom's revenue has grown more than 50%, whereas Macy's revenue has increased only 17%.

JWN Revenue (TTM) Chart

Nordstrom vs. Macy's 5-Year Revenue Chart, data by YCharts.

Short term vs. long term
Nordstrom and Macy's are both great companies, but for investors with a long-term focus, the advantage goes to Nordstrom. That's true despite the fact that Nordstrom has a higher earnings multiple than Macy's.

JWN PE Ratio (TTM) Chart

Nordstrom vs. Macy's P/E ratio, data by YCharts.

From an investing perspective, a key difference in terms of evaluating the two companies is capital allocation. Macy's has been spending the vast majority of its free cash flow on share buybacks, and it repurchased $1.6 billion of stock last year. These share buybacks immediately boost Macy's EPS.

By contrast, Nordstrom has been reinvesting heavily in its business, limiting the free cash flow available for dividends and buybacks. Investments in IT infrastructure and new store openings do not immediately boost EPS. In fact, new store openings initially reduce EPS, because it takes two to three years for a new store to build its customer base and mature.

For example, Nordstrom has projected that its new Canadian operations will lose money for several years until the company gains enough scale in the market. This year, the pre-tax loss in Canada is expected to be around $35 million.

Nordstrom's growth investments are depressing EPS today, but will lead to strong long-term growth.

Thus, Nordstrom's true long-term earnings potential is being masked by the size of its current growth investments. Its current growth spurt is likely to slow down around 2017. That will allow Nordstrom's profit margin to recover toward the end of the decade, driving superior EPS growth.

Foolish conclusion
Nordstrom shares may not seem like a bargain today -- the stock trades for 18 times trailing EPS and about 16 times 2015 earnings estimates. That's pricier than other top department store stocks like Macy's.

However, long-term Nordstrom investors will reap the benefit of the company's heavy growth investments in the future. As Nordstrom exits its current phase of rapid growth in the 2017-2018 time frame, margins should recover. Nordstrom will then have significantly higher revenue than today along with a higher profit margin -- leading to strong share price appreciation.

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