Last week, privately held Neiman Marcus reported surprisingly good sales results for the first quarter of its 2018 fiscal year. Unfortunately for the embattled luxury retailer's bondholders and private equity owners, the results didn't translate into stronger earnings.
Indeed, Neiman Marcus remains far behind larger rival Nordstrom (NYSE:JWN) in terms of profitability. Meanwhile, the company is struggling under a mountain of debt. Neiman Marcus' first-quarter performance shows that even if sales recover, the company has little chance of repaying its creditors in full.
Neiman Marcus has been floundering
Over the past two fiscal years, Neiman Marcus fell into a deep rut. A combination of falling mall traffic and operational missteps led to sharp declines in comparable-store sales. Comp sales declined 4.1% in fiscal 2016 and 5.2% in fiscal 2017.
As a result, profitability plunged. Adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) fell from $710.6 million in fiscal 2015 to $584.9 million in fiscal 2016 and just $433.8 million last year. This decline reduced its adjusted EBITDA margin to 9.2% in fiscal 2017 from nearly 14% two years earlier.
This level of profitability isn't enough to allow Neiman Marcus to meet its obligations while still investing in its business. Interest expense has reached roughly $300 million a year. Meanwhile, Neiman Marcus can't afford to back off on capital spending, especially for technology. (E-commerce now accounts for 32% of its revenue.) For comparison, Nordstrom plans to spend nearly $300 million annually on technology and fulfillment for the next few years.
A return to sales growth -- so what?
Neiman Marcus finally returned to sales growth last quarter, with comp sales up 4.2% year over year. Some of this increase can be attributed to an easy year-over-year comparison, as Neiman Marcus lost $55 million to $65 million of sales in the first half of fiscal 2017 to technology problems.
Nevertheless, this was a surprisingly strong sales result, given the trouble that even best-in-class retailers like Nordstrom have been having recently. Neiman Marcus' comp sales would have been even higher but for the negative impacts of Hurricane Harvey and Hurricane Irma. Gross margin also improved modestly compared with the same period a year ago.
However, this improvement didn't translate to a meaningful boost to the bottom line. Neiman Marcus' pre-tax loss narrowed slightly to $45.1 million from $46.8 million, and adjusted EBITDA inched up to $123.5 million from $122.9 million a year earlier. By contrast, Nordstrom posted a pre-tax profit of $180 million last quarter, despite turning in a much weaker sales performance.
Executives take home all of the extra profit
Higher incentive compensation was the cause of Neiman Marcus' disappointing first-quarter earnings. The strong sales performance triggered $9.9 million in cash bonuses and a $6.5 million accrual related to the company's long-term incentive program. If Neiman Marcus' financial performance continues at the recent trend, the company will face an ongoing headwind from incentive compensation throughout fiscal 2018, according to interim CFO Dale Stapleton.
During the Neiman Marcus earnings call, analysts repeatedly questioned management about this uptick in incentive compensation. Indeed, from the standpoint of creditors, it's rather obnoxious that virtually all of the benefit of Neiman Marcus' sales growth went to management.
Of course, it's important to reward employees when a business performs well. However, in this case, it seems as if the bar was set too low or the target bonuses are too big. The year-over-year increase in incentive compensation totaled 1.5% of Neiman Marcus' revenue, creating a virtually impossible hurdle to overcome. Even a strong sales increase this year wouldn't meaningfully improve the company's profitability.
Neiman Marcus doesn't have any debt maturing until 2020. However, that doesn't offer much comfort, given that the company seems to need massive sales growth to improve its earnings. There's no plausible way for Neiman Marcus to pay off or refinance the $2.9 billion it will owe, making an eventual bankruptcy filing or out-of-court debt restructuring inevitable.