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Nordstrom, Inc. Investors Should Stay Patient

By Adam Levine-Weinberg – Updated Apr 13, 2017 at 1:28PM

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Nordstrom stock has performed poorly over the past two years, but investors shouldn't give up.

Nordstrom (JWN -11.75%) has been a frustrating stock for investors to own over the past few years. Shares remain far below the all-time high reached in early 2015, and earnings-per-share growth has disappeared.

Nevertheless, Nordstrom investors should stay patient. The company is reaching the end of a multiyear phase of heavy investment. These investments should start to pay off within a couple of years, which should help Nordstrom stock bounce back at long last.

Big investments

The department store sector has been crushed by Americans' evolving shopping habits in the past few years. Mall traffic has plunged. Instead, consumers are looking to get more bang for their buck and have a more convenient experience. E-commerce and off-price retailers have been the big winners from this shift.

What some investors don't realize is that Nordstrom was very proactive in responding to these trends. It has operated an off-price chain (Nordstrom Rack) for many years, and Nordstrom has doubled the Rack store count in the past five years. It also has a $2.5 billion full-price e-commerce operation. In recent years, Nordstrom has even waded into the online off-price business.

The exterior of a Nordstrom Rack store

Nordstrom has doubled the Nordstrom Rack store base in the past five years. Image source: Nordstrom.

Nordstrom has also pursued a few key opportunities to expand its full-line store base. The company has opened a handful of stores in Canada -- where mall traffic has held up better -- and it is preparing to open a flagship store in midtown Manhattan.

These moves have put Nordstrom in a good position to prosper going forward, but they have required heavy investments. Nordstrom's net capital expenditures have averaged about $800 million per year over the past four years.

Artificially depressed earnings

Nordstrom's growth investments have also put pressure on the company's profitability. First, heavy capital expenditures have gradually filtered through to Nordstrom's earnings results in the form of higher depreciation.

Second, a large proportion of the Nordstrom Rack store base is still maturing. As a result, sales per square foot slipped 8% at the Rack chain (from $552 to $507) between 2014 and 2016. This has temporarily reduced the chain's profitability. An inventory glut also caused problems in 2015 and the first half of 2016, but this issue has been resolved.

Third, several of the company's long-term growth initiatives haven't reached profitability yet. Nordstrom estimates that its off-price e-commerce operations, the Trunk Club personal stylist program and Nordstrom Canada, lost about $140 million in fiscal 2015 and $130 million in fiscal 2016.

Relief is in sight

Fortunately for Nordstrom shareholders, the company's investment cycle is finally starting to moderate. In 2017, the company expects capex to remain fairly elevated at $800 million. However, over the following four years, Nordstrom projects that capital spending will decline to an average of just $650 million annually.

Meanwhile, after more than doubling the Rack store base in the past five years, Nordstrom is slowing its pace of store openings. It's on pace to open about 18 new Nordstrom Racks this year, representing 8% year-over-year growth.

Finally, Nordstrom's e-commerce business is gradually reaching critical mass, leading to higher profitability.

As a result, Nordstrom is probably nearing an inflection point, after which earnings -- and especially cash flow -- will return to strong growth. There will still be some investments holding back Nordstrom's earnings in the next few years, such as pre-opening expenses for the Manhattan flagship store, which will open in late 2019. But on the whole, the earnings drag from Nordstrom's growth initiatives will moderate beginning in 2017.

Nordstrom stock currently trades at 16 times forward earnings, so it may not look especially cheap. However, as Nordstrom's recent investments pay off over the next few years, EPS should soar. This means there is a lot of upside for investors who remain patient.

Adam Levine-Weinberg owns shares of Nordstrom. The Motley Fool recommends Nordstrom. The Motley Fool has a disclosure policy.

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