At first glance, Nordstrom's (JWN 4.95%) recently released first-quarter earnings report might seem to show that the company's growing focus on off-price retail is working. After all, the company reported an 8.7% jump in its total off-price sales last quarter on a 2.3% comp sales increase.
On the one hand, these results show that Nordstrom's aggressive expansion of the Rack chain and its quick push into off-price e-commerce are driving growth. On the other hand, this growth may be coming at the expense of profitability.
Rapid e-commerce growth is hurting margins at Nordstrom Rack. Image source: Nordstrom.
By contrast, off-price market leader TJX Companies (TJX 0.45%) has shown in recent years that pursuing growth in a measured fashion can lead to better results. Nordstrom would do well to heed that lesson going forward.
Growth without comp sales increases
Nordstrom's off-price revenue is still growing quickly. However, for more than two years, this growth has been driven entirely by adding new stores and increasing e-commerce sales. Last quarter, comp sales declined 0.9% year over year at its existing Nordstrom Rack stores. In fiscal 2016, Nordstrom Rack posted a meager comp sales increase of 0.2%, and in 2015 its comp sales fell by 1.0%.
A portion of this weak brick-and-mortar comp sales performance can be attributed to rapid store growth. As the Nordstrom Rack chain expands, the company sometimes opens new locations near existing ones, cannibalizing some sales from those stores.
That said, a bigger drag on in-store sales is coming from Nordstrom's focus on building up its off-price e-commerce business. The Nordstromrack.com site has driven explosive revenue growth since launching just three years ago. In fiscal 2016, Nordstrom's off-price e-commerce revenue totaled $700 million, up from $360 million two years earlier. That's already more than 15% of Nordstrom's total off-price revenue.
This shift is bad for earnings
Sales per square foot have been falling at Nordstrom Rack. Image source: Nordstrom.
To the extent that Nordstrom's online off-price growth is cannibalizing sales from physical stores, it is hurting profits significantly. Nordstrom Rack's sales per square foot fell to $507 last year from $552 just two years earlier, and is poised to fall further in 2017. Lower sales productivity reduces profitability because fixed costs are spread over less revenue.
Meanwhile, e-commerce has very high variable costs. As a result, Nordstrom's off-price e-commerce business lost money in its first few years of operation and is still barely breaking even.
The rapid growth of Nordstrom's off-price e-commerce business is also creating inventory management problems. Most customers who want to return an item bought via Nordstrom's online off-price channels will do so at a physical Nordstrom Rack store. The rising volume of returns at Nordstrom Rack led to inventory imbalances last quarter, reducing the company's gross margin.
There is another way
Nordstrom executives have been open about the challenges of managing the shift from in-store sales to e-commerce. However, their attitude has been that Nordstrom must adapt to its customers' changing shopping habits.
TJX has shown that this isn't entirely true. Rather than just reacting to customers' changing shopping habits, TJX has also tried to proactively shape customers' behavior.
Most notably, it has adopted a cautious approach to e-commerce. Management has explicitly stated that the goal is to avoid cannibalization of TJX's lucrative brick-and-mortar business. Thus, while the company launched a T.J. Maxx e-commerce site several years ago, its popular Marshalls and HomeGoods brands still have no e-commerce presence. (Their websites just have store locators and show a selection of items that may be available in stores.)
This strategy has paid off in a big way. E-commerce still accounts for just 1% of TJX's revenue. Meanwhile, its brick-and-mortar business has posted back-to-back 5% comp sales increases for the past two fiscal years, with a stellar 14% segment margin in the domestic market.
Time to learn from the best
On Nordstrom's recent earnings call, company co-president Blake Nordstrom enthusiastically stated that Nordstrom's off-price e-commerce operations are set to reach $1 billion in annual revenue faster than any other part of its business.
This may not be something to cheer about. To be fair, as the off-price e-commerce business matures, it should become solidly profitable. But it will probably never have the margin potential of the Nordstrom Rack brick-and-mortar chain. All the while, it is cannibalizing sales from Nordstrom Rack and thereby undermining the profitability of those stores.
TJX has shown decisively that off-price retailers need not rely on e-commerce to drive growth. A more thoughtful e-commerce strategy aimed at driving most business to brick-and-mortar stores might lead to slightly slower growth but much higher profitability for Nordstrom.
