Off the Rack and Onto the Web: How Nordstrom is Reaping the Retail Space

Nordstrom (JWN -2.33%) is a familiar name in retail and has been in business for over a century, but being up to date is the only way to stay afloat in this competitive market. While sales growth has stalled out at most department stores in the past couple of years, that's not true at Nordstrom, where revenue continues to grow at a high-single-digit pace. So what is Nordstrom's secret to success?

The key may be its moves to branch out beyond the department store business that first brought it to fame. Big moves into e-commerce and off-price retailing are among the ways that Nordstrom is keeping up with the times -- allowing it to outperform its peers and serve up sizzling returns for investors. Tune in to hear the whole story.

A full transcript follows the video.

Sean O'Reilly: Nordstrom is making moves to be the best of breed in the retail business, on this consumer goods edition of Industry Focus.

Greetings, Fools! I am Sean O'Reilly joining you here from beautiful Alexandria, Virginia, at Fool headquarters. Joining me today is the incomparable Adam Levine-Weinberg, one of our writers. How's it going, Adam?

Adam Levine-Weinberg: I'm doing well. How are you?

O'Reilly: Not too shabby. You're out in Chicago, right?

Levine-Weinberg: That's correct.

O'Reilly: How are the Cubbies doing?

Levine-Weinberg: They're doing pretty well this year. It looks like they may have a playoff run in them.

O'Reilly: Yeah, if they were in any other division, they'd probably be No. 1, right?

Levine-Weinberg: Yeah.

O'Reilly: Sweet. For those of you that are just joining us, Adam and I were talking earlier about Nordstrom and how they're making major strides to have this awesome portfolio of businesses. It's been a great stock for the last five years, and I really want to talk about them to inform our listeners about them.

Adam, what is Nordstrom doing to separate itself from the pack?

Levine-Weinberg: A lot of the department stores have been under a lot of pressure in the past five years since the Great Recession. They haven't bounced back as well as some other industries. You look at Macy's (M -1.52%), which is one of the exceptions, and even Macy's is starting to run into some trouble growing its sales.

In the first half of 2015, its comparable-store sales declined. That's the sales in stores that were also opened the previous year.

O'Reilly: That was their saving grace because they seemed to be getting all those customers that weren't going to JCPenney (JCPN.Q) and Sears (SHLDQ).

Levine-Weinberg: Yeah. They've already knocked out a lot of competition so it's getting harder to keep finding new customers and keep customers coming back. Especially when there's lots of retailers out there trying to attract customers with great discounts. Even JCPenney is making an attempt at a comeback.

It's definitely getting harder for companies like Macy's. Macy's just cut its full-year guidance and it's expecting their total sales to decline about 1%.

O'Reilly: I was really surprised when I read that. How are things over at Nordstrom?

Levine-Weinberg: A day after Macy's reported, Nordstrom blew expectations out of the water. Their comparable-store sales were up 4.9% in the second quarter, and they raised their full-year guidance. Now they're expecting to have 3.5% to 4.5% comparable-sales growth, and total sales are expected to be up about 8.5% to 9.5%. They're almost at double-digit growth.

O'Reilly: That's white-hot. For our listeners that may or may not be familiar with Nordstrom's business model, how are they pulling this off?

Levine-Weinberg: I think one of the keys to Nordstrom's success in recent years -- especially what will be the key to its success going forward -- is its average of diversification. This is a company that's been around since 1901. They're more than 100 years old, but for the past several decades, they were really a full-line department store where they sold luxury goods in stores, mostly in malls, but sometimes in downtown locations within cities.

Those full-line stores are still a very important part of business as they make up more than half their sales. In addition to that, they have a thriving e-commerce business on Nordstrom.com. They've also begun opening up a chain of off-price stores called Nordstrom Rack, which has become incredibly successful.

A couple years ago, they actually surpassed the department stores in terms of the store counts. While Nordstrom's products are larger and they get more sales per store, there are actually more Nordstrom Racks out there than there are regular Nordstrom stores.

A few years ago, they bought a site called HauteLook, which is a flash sale, discount retail fashion site, and they used the technology from that to open up a NordstromRack.com site. It's an off-price version of their website. In addition to that, they announced that they wanted to expand into Canada a few years ago.

They opened their first store there almost a year ago in September. They opened a second store in Ottawa earlier this year. They've got a third store in Vancouver, which will be one of their flagships, and that's supposed to open next month. They have a few more stores planned there as well.

The last side of the business is another acquisition. About a year ago, they bought a company called Trunk Club, which is an Internet-based concierge service.

O'Reilly: Yeah, I see them on my Facebook News Feed.

Levine-Weinberg: They market heavily to guys in the business world trying to offer them the convenience of sending you clothes. You talk to a personal stylist, they'll send you a box of things they think you'll like, and you can keep what you like and send the rest back with free return shipping. Then as the personal stylist gets to know you better, they'll hopefully make better suggestions for what you could add to your wardrobe.

That's a business that only started about five years ago and it's grown like wildfire. Nordstrom bought them out for $250 million last year, and they expect that business to grow really quickly in the future.

O'Reilly: You're talking about all these new initiatives and opening. It sounds like the traditional stores aren't where the growth is.

Levine-Weinberg: That's completely true. If you look at 2014, the sales in Nordstrom's full-line stores actually declined by about 1%. It was because they closed a couple of stores and the comparable-store sales were pretty even with the year before. At the same time, you had the online sales at Nordstrom.com up 22% year over year.

Nordstrom Rack sales rose about 17% mostly because they've been adding more than two dozen stores every year. Their NordstromRack.com site got started up last year, which led to a growth of 22% in their off-price online sales. The other retail segment, including the Trunk Club acquisition as well as the new stores in Canada... their sales more than tripled. That was impressive because those two divisions only came into the picture in the second half of the year. They didn't even have a full year of sales.

Despite all this growth outside of Nordstrom full-line department stores, the full-line stores in the U.S. still represented about 58% of its total sales in 2014, but there's definitely a changing of the guard occurring gradually at Nordstrom.

O'Reilly: It's not hard to imagine a day when the traditional department stores make up a little less than half. When we get back from our break we'll be talking about Nordstrom as a business and the financial ramifications of its recent growth initiatives.

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If you're just joining us, I'm here with Adam Levine-Weinberg and we're talking about Nordstrom's latest growth initiatives and they're slowly diversifying away from their hardline department stores.

Adam, they're basically building a collection of a portfolio of billion-dollar businesses.

Levine-Weinberg: That's the way I see it. If you look at their newer business line, leaving out the traditional full-line department stores in the U.S., which are close to $8 billion now, Nordstrom.com's full-line website got $2 billion last year. Nordstrom Rack, which has been around a little longer and has been expanding very quickly, had sales at $3.2 billion last year.

You already have three distinct billion-dollar businesses at Nordstrom, and there's three newer areas, which are also definitely on their way there. If you look at their off-price website, NordstromRack.com and HauteLook, sales were about $360 million last year and grew 50% in the first half of 2015.

Last week, Nordstrom's management said they're on track for at least a half a billion dollars in sales on those off-price sites this year. With that level of growth, they're pretty certain to get up to a billion dollars in a few more years.

Canada is another area where Nordstrom has laid a clear target of reaching $1 billion in sales over time. They've got two stores open, the third one is opening in Vancouver next month, and then between late 2016 and early 2017, they're opening three stores in the Toronto area. That will already get them at least halfway there, I think. They plan to bring a Nordstrom Rack chain to Canada as well.

They'll probably add a few more full-line stores over the coming years as well. With a couple of really high profile locations in Canada, plus a handful of other full-line stores and Nordstrom Rack stores. That's definitely a $1 billion business in the making and should be there in six to eight years.

Finally, Trunk Club doubled their sales in 2014 to $100 million, and they expect to double their sales again in 2015, which would bring it up to about $200 million. Next month, they're going to be entering the women's business. Up until now, Trunk Club has been a men's-only business. That will more than double the opportunity because women's apparel is a larger business than men's apparel.

O'Reilly: Yeah. I'm surprised they didn't do that first.

Levine-Weinberg: I think it was a model that they wanted to try out in the men's business because in some ways it appealed to a lot of guys who don't have the patience to go shopping and deal with the mall. It's definitely a business that has a lot of potential for women's apparel as well.

As they continue to build awareness, and now that it's a part of Nordstrom, which is a giant fashion company, that will really help spread awareness and help grow the business faster in the future.

O'Reilly: Awesome. They're obviously growing like crazy, opening stores in Canada, you've got the Trunk Club. Are they making money doing all this? Growth is one thing, but bottom line is another thing.

Levine-Weinberg: You really have to distinguish between the short-term and the long-term impact when you think about how Nordstrom's growth is going to affect its earnings. If you only look at its earnings-per-share growth, it's actually slowed to a crawl in the last few years. Nordstrom earned $3.56 per share in 2012, and for 2015, they're showing an adjusting earning per share of $373.80. That's only a compound growth of 2% to 3% depending on where the earnings come out.

However, sales growth has remained strong and throughout that period, it's getting stronger now. The real problem is just having investments in this growth are holding back earnings per share at the moment.

As an example, Nordstrom has actually pulled out expansion into Canada, and the growth and acquisition of Trunk Club as well, as being businesses that are holding back earnings per share. They estimated the impact on their total profitability for this year at $38 million on their operating profits.

O'Reilly: At least, they pulled it out, though. Lesser companies might not.

Levine-Weinberg: Between Canada and Trunk Club, they're losing $38 million for interest and taxes this year. That's for a number of reasons. One example: Every time they open a new store in Canada, they hire all new department managers months in advance. That's about 30 of them.

They give them a three-month, all-expenses-paid trip to Seattle, where they go through an orientation at the company's headquarters and then work for a fair amount of time in a Nordstrom store alongside a Nordstrom department manager and learn their job from someone who is already an expert at it.

That's a very expensive acquisition because the store isn't open, they're not bringing any revenue, and yet they're paying all these managers' salaries and paying for them to come to Seattle. That's something that will be a great investment in terms of translating the legendary customer service that Nordstrom has in the U.S. over to Canada, but it does have its work term impact on profitability.

The thing to remember is, as these businesses grow and mature, those losses should turn into significant profits.

O'Reilly: Do you feel that Nordstrom is misunderstood in any way? It's got this valuation which is 19 times forward earnings, which is a premium in the market. It's losing money in this growth, but what should investors think? What do you think is going on?

Levine-Weinberg: I definitely think a lot of analysts and investors are skeptical about Nordstrom stocks because it has such a high valuation. Especially compared to retail peers, 19 times forward earnings is high for the market, but it's especially high compared to most other department stores.

As I said, Nordstrom isn't just a department store. It's diversifying into a lot of growth areas that have significant long-term potential, even if they're not producing much profit right now. By the early 2020s, I fully expect Nordstrom to have six distinct, billion-dollar businesses.

Just to recap, that's the U.S. department store business, the Nordstrom.com e-commerce business, NordstromRack.com off-price e-commerce business, you've got the Nordstrom Rack stores, and then on top of that, you have entry into Canada as your fifth business, and then Trunk Club as the sixth one.

You have all of these little companies within the company that are growing, and as they grow, they will become significantly more profitable. In the case of Canada and Trunk Club, they're hurting earnings right now, but within a few years, they should be contributing quite a bit to profitability.

Nordstrom has projected that they'll have at least $20 billion in sales by 2020. That estimate seems a bit conservative to me. It could be higher than that. By that point, I think the legacy business -- the U.S. department stores -- will only be about 40% to 45% of the total. Basically, between 2015 and 2020 all these other businesses are going to be growing at scale.

That will lead to sales growth and margin expansion which could drive many years back to back of low to mid-teens EPS growth, which will gradually close up that valuation at premium and should drive the stock higher as well.

As a concluding thought, if you look at Amazon (AMZN -1.64%), that's a company that's also growing really quickly. In fact, it's growing even faster at about 20% per year. It has a valuation of more than 100 times forward earnings, which shows that investors that understand with Amazon that it's a growth company, it's investing a lot of money in all these different initiatives, and over time not only will sales grow but its margins are going to expand. I think Nordstrom might be more like Amazon than a lot of investors realize.

O'Reilly: Especially if these online, Internet-based initiatives really start to pick up.

Levine-Weinberg: Yeah. As all of these new growth areas start to get to scale, they'll become much more powerful than they are today. That should have a big, positive impact on Nordstrom's companywide profitability.

O'Reilly: Awesome. Well, thank you for your thoughts, Adam. I can't wait to talk to you again.

Levine-Weinberg: Sounds great!

O'Reilly: Have a good one. If you are a loyal listener and have questions or comments, we would love to hear from you. Just email us at [email protected]. Again, that's [email protected].

As always, people on this program may have interests in the stocks that they talk about, and The Motley Fool may have formal recommendations for or against those stocks. So, don't buy or sell anything based solely on what you hear on this program. For Adam Levine-Weinberg, I'm Sean O'Reilly. Thanks for listening, and Fool on!