Nordstrom's Growth Strategy

Investors in upscale retailer Nordstrom  have enjoyed a spectacular week with the stock rising nearly 15% after its recent results. The market took heart from Nordstrom's overall trading performance and the announcement that it is seeking a partner for its credit card receivables. It appears that all is going well for Nordstrom, but how do the results tie in with its long-term strategic plans? This is an important question, because Nordstrom will look like a different business in a few years' time.

Nordstrom's long-term plans
The retail sector has been bedeviled with some unusual conditions because of the protracted and moderate nature of the recovery. The bottom end has continued to struggle, while the high end has done relatively better. Meanwhile, the mid-range department stores have suffered as middle-class shoppers traded down with their lack of exposure to the higher-end shopper. Anyone who doubts these trends need only take a look at how J.C. Penney  has suffered in recent years. J.C. Penney's investment proposition now relies solely on the successful execution of its turnaround strategy. 

Nordstrom's full-line stores sit somewhat in between the mid and high range, and the environment has necessitated a significant restructuring of its growth priorities. The good news is that -- unlike J.C.Penney-- Nordstrom has been investing early and aggressively.

Indeed, a breakout of its same-store sales growth reveals how Nordstrom is evolving.


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Nordstrom's Long Term Growth Plan

Deciding whether or not to invest in a high-end clothing retailer like Nordstrom   used to be easy. In the past, it boiled down to your view on the environment for higher-income consumer spending. Although that argument is still applicable, it's far from the full picture now. Nordstrom is undergoing some fundamental changes in its business, and Foolish investors need to consider what this company will look like in a few years.

 

Nordstrom adjusts to a changing environmentThe retailer is best known for its full-line stores. However, its investment plans for the next five years involve shifting sales toward its other sales channels. The idea is to move toward the kind of growth trends that seem to have categorized the US consumer since the recession.

 

For example, off-price retailers like TJX Companies   and Ross Stores have been flourishing, while mid-market department stores like J.C. Penney are struggling. In response to these trends, Nordstrom is investing in its off-price concept, known as the Rack. Nordstrom is also imitating clothing companies such as VF Corp   and Coach, which are investing significantly in their online strategies.

 

Unfortunately, Nordstrom is having some teething problems. Its third-quarter results were a disappointment, with its full-line stores delivering a same-store sales decline of 4.2%. Moreover, it lowered its full-year earnings per share guidance to $3.60-$3.70 from a previous estimate of $3.65-$3.80. The question is if Nordstrom's investment plans are making it lose its focus on its core business.

 

Nordstrom's growth plan
Nordstrom's plan involves ramping up capital expenditures to $3.7 billion over the next five years in a way that changes the way it does business.

 

Source: company presentations

 

Key parts of the plan include:

• Expansion of its Rack outlets (20% of total sales) to at least 230 from 127 today

•  Invest in IT infrastructure initiatives in order to expand its e-commerce sales, and increase stock keeping units, or SKUs, in its online offerings

• A combination of investment in Canada and its US flagship stores, such as the store in Manhattan

Nordstrom and the retail environmentIn order to illustrate the importance of the plan, here is a breakout of Nordstrom's same-store sales data. Note that the direct division includes Nordstrom's own online sales (11% of total sales) plus sales from Haute Look (2% of total sales), an off-price online company it bought in 2011. The numerically aware will have calculated that Nordstrom's full-line stores currently contribute 67% of total sales.

 

Source: company presentations

 

Clearly the biggest issue is with Nordstrom's full-line sales. It is true that Nordstrom's anniversary sale took place in the second quarter -- last year it was across the second and third quarters -- so its third quarter numbers were expected to look weak. However, Nordstrom's full-line sales have been weak for four quarters now.

When pushed on the issue in its conference call, management stated

We don't believe it's attributable to any one factor. That said, we know customers respond to freshness and fashion, and we're working to provide that, combined with ongoing efforts to enhance the store environment and overall execution.

This sort of performance and commentary captures the problem facing many retailers in this environment. If you are not a differentiated specialty store, then consumers want discounts to buy from you. On the other hand, if you discount too much then consumers will lower their perception of the value of your higher ticket items.

 

In this scenario a clothing company like VF, which owns Vans, The North Face, and Timberland, can do well because its outdoor action clothing lines are differentiated. It's also growing its online business. VF has a lot of upside potential, particularly if winter is cold this year. VF's main strength is the ability to invest adapt to changing market conditions because it has a diverse set of brands. In addition, its relatively low penetration in emerging markets (particularly with its jeanswear) means it should be able to generate growth through expansion alone.

 

Meanwhile, off-price retailer TJX has been raising guidance throughout 2013, and it continues to benefit from consumers seeking discounted prices. In fact, TJX just beat analyst expectations with its third quarter results, and raised its long-term estimates for its store expansion program.

What's next for Nordstrom?Nordstrom's strategy is to try and retain premium pricing in its full-line stores while growing its off-price business through Rack expansion. Unfortunately, it looks like its core full-price store growth is weakening, even while direct and Rack sales are expanding.

 

In a sense, Nordstrom's management should be commended for aggressively making the changes necessary to navigate its way through changing end markets. However, the expansion plan contains execution risk and will eat into cash flow in future. Cautious investors will want to see a turnaround in Nordstrom's core full-price stores before buying in. 

Why TJX Companies Remains Good Value

The retail sector has been one of the hardest to call in recent years. The bifurcation in prospects between the haves and have-nots in the U.S. has created an atypical situation within the sector. Whereas in previous recoveries, the general drift is upwards across the board, this recovery has seen a strengthening at the high end and a general movement towards ‘trading down’ in the mid range. Within these shifting sands, one island of retail has offered strong prospects.

Specifically, the off-price retailers have demonstrated continued strength and The TJX Companies’  latest results are confirming this trend.

TJX Companies reports sales growth at the high end

Earlier in May TJX Companies had reported same-store sales growth of 2% in the quarter and declared that its same-store sales in April came in at the high end of guidance at 8%. This positive trend appears to be in place as the company declared that its May sales were off to a ‘strong start.’

As ever with TJX Companies, it is worth noting that its guidance tends to be conservative. I discussed this issue at more length in an article linked here. In rote like fashion, its management tends to guide towards 0%-2% in same-store sales growth. However, they came in at 2% for this quarter and the guidance was 2%-3% for Q2. All of this makes it rather surprising that it kept its full year guidance at 1%-2%. Upside to come?

I’ve broken out the revenue trends within its segments.

And in order to see how TJX makes its money, here is a breakdown of its segmental profit for the quarter.

Clearly, it is still largely a story of Marmaxx (T.J. Maxx and Marshalls) and its prospects are largely guided by the retail movement towards trading down. TJX is not alone in this. Indeed, Ross Stores has benefited from exactly the same trends. Furthermore a retailer like Nordstrom is expanding its lower priced Rack stores in order to react to the new retail reality. I’ll come back to these companies in a moment, but for now I want to look at some of the interesting other growth drivers that TJX has going for it.

TJX Companies’ other growth prospects

While the reliance on Marmaxx is well understood, TJX has some interesting growth drivers going forward

• Europe presents significant growth prospects. The competition in the off-price market is a lot less and Europe’s economic difficulties are creating growth opportunities. The U.K. has long been a strong market for TJX, but Germany was cited as doing ‘very well’ with the potential to expand to 350 stores from 50 at present.

• Home goods in the U.S. have the potential to grow in line with the recovery in the housing market. Its segmental margins increased 120 bps in the quarter and the opportunity to cross sell home goods to its clothing customers is significant. It is the right category at the right time.

• TJX also has growth opportunities from expanding its appeal to male and youth customers

• It is launching a large scale e-commerce initiative in the second half of 2013, of which it claims to have made minimal assumptions within its growth projections.

Many of these plans have things in common with other companies in the retail sector. For example Coach  is trying to deal with the problem of rivals like Michael Kors encroaching on its affordable luxury market by focusing on non-core categories for its growth. In particular, its initiatives in footwear, apparel, and men’s categories are a recognition that retail outlets need to be innovative in developing new revenue streams. In common with TJX Companies' plans to target men, Coach is trying to tap into the growing market for male fashion and grooming.

Similarly, Nordstrom’s collection of growth plans center on expanding its e-commerce, in-store mobile point of sale devices, and Rack stores; all of which requires significant capital expenditures (around $3.7 billion) over the next five years. It is an ambitious plan and adjusting to the new retail environment is the right thing to do, but investors need to be confident in its execution.

Where next for TJX Companies?

The stock has had a nice run and I note some profit taking after the results. I like the stock and have a target price in the mid $50’s. Analysts expect double-digit earnings growth for the next couple of years and I like its long-term earnings prospects from the growth drivers discussed above.

A forward PE of around 18x may appear expensive, but it has converted over 140% of its earnings into operating cash flow on average for the last three years. Its business model is cash generative and it has good growth prospects. If it can generate another $2 billion in free cash flow this year, this would put it on a forward free cash flow yield (as I write) of 5.4%. That’s good value for its long-term prospects.