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. 

Ross Stores Has Further To Run, But Not Much More

The U.S. economy remains in slow and unspectacular recovery mode, but this fact should not deter investors. Making money in the markets is not just about buying/selling stocks in line with the economy but, in my opinion, more about finding stocks that can surprise on the upside within an understanding of the future economic climate.

I think the off-price retailers are a good example of the sort of stock that has the potential to do well in this environment. In this article I’m going to focus on Ross Stores (NASDAQ: ROST). I will discuss its recent results and suggest some other names to look at.

Ross offers good value -- well, just about

I last looked at the stock in March in an article linked here. Since then the stock has done well, and I think it has a bit further to run. The recent rise is putting pressure on it to continue to outperform, but the good news is that current trading is pretty good.

As ever with Ross Stores it is worth noting that it tends to be conservative with its guidance. In the article linked above I referenced its guidance of 1-2% growth in comparable same store sales growth and suggested that it might beat that number. In the end the number came in at 3% for the quarter, and the guidance of 1-2% for the next quarter (and the full year) remains intact. Traffic was flat but an increase in the average basket size helped gross margins carry on their impressive performance.

Here is a table comparing its guidance with what it has reported:

As the notes in the graph suggest I think the market seems to expect Ross to beat its conservative same store sales guidance each time. If true, this could put pressure on the stock price should it fail to beat the range given for the next quarter. 

The 1-2% guidance is obviously something catching on in the industry because its rival TJX Companies (NYSE: TJX) tends to forecast in a similar manner.

What about the competition?

TJX is a useful company to compare and contrast with Ross because its same store sales came in at the top end of guidance with 2% growth; but the good news was that it guided towards 2-3% for the current quarter. The other interesting comparisons are that TJX is aggressively expanding into Europe and that it plans to launch an e-commerce initiative in the second half. By way of comparison Ross’ management declared that the economics of an e-commerce operation don’t ‘add up’ for the company. Will it work for TJX? And will either of these companies change their minds about e-commerce?

TJX’s home goods sales have been doing well while Ross had some disappointments last year and is somewhat playing catch-up. No matter, its management declared itself as ‘feeling good’ about the changes and said they were on track.

Another company worth watching in this context is J.C. Penney (NYSE: JCP). Frankly anyone would struggle to put this company’s difficulties as eloquently as Howard Davidowitz has done over the years. No prisoners taken when this guy gets fired up!

The good news is that the company has grasped the gauntlet and is starting to offer the kind of promotions that many think it needs to. Furthermore, it is pinning its hopes on expanding its home goods sales. Both of these activities will potentially increase competition for TJX and Ross, and investors need to watch events closely. The difficulty that J.C. Penney has is that it is exactly in the kind of mid-range retail space that this economy has ravaged.

Where next for Ross Stores?

In conclusion I think the stock has a bit more to run and I'm holding for now. Ross forecast EPS of $3.70-$3.81 for the full year, which puts it on a forward PE of around 17.2x as I write. In addition, this is a heavy investment year with a step-up in capital expenditures to around $670 million. The implied EPS growth rate of around 6.4% may not seem like much, but lets recall that last year's earnings contained a positive contribution of $0.10 from an extra week's sales. If you strip that out then the EPS guidance is for a more respectable 9.4% increase.

I think a target price of around $69 is reasonable given the risk of the extra capital expenditures (mainly to build out two new distribution centers), the possibility that J.C. Penney might get its act together and the chance that the market may be currently pricing the stock to keep beating its own guidance.

V.F.Corp Continues to Find Growth

V.F. Corp is one of those infuriating stocks that never seems to be cheap precisely when you want it to be. The latest set of results kept up its tradition of raising EPS guidance even if the revenue numbers were far from stellar. Indeed the key takeaway from these results was the margin improvements achieved within difficult end markets. This is one of the best run stocks in the retail sector, but it faces some headwinds in 2013. Is it good value right now?

V.F. Corp Prospects and Challenges

With its key brands of The North Face, Vans, and Timberland the company has benefited from the trend towards wearing outdoor sports clothing as a kind of fashion statement. I doubt that most people wearing mountaineering or hiking clothing have ever been on a climb or a trail. Moreover wearing Vans and listening to Sonic Youth doesn’t necessarily qualify you as bona fide skate boarder, but who cares as long as it adds to the bottom line of the company’s numbers.

In order to explain how Timberland makes money here is a breakdown of its segmental profits in Q1. The key brands are in the outdoor & action sports wear division.

Throughout 2013 the company is going to be faced with the following challenges

• Timberland’s has significant exposure to Europe and markets like Italy and Spain are some of its biggest existing markets. Fortunately, Vans and The North Face were ‘built out’ of Northern Europe.

• J.C. Penney is a key retail channel and in particular with Lee jeans and Vans. The difficulties with the department store and ongoing restructuring efforts could affect sales generation.

• It’s Chinese operations haven’t performing great and it is a key part of its international expansion plans

• In general the mid-market consumer is challenged in the current environment. It offers neither the income secure spending of the high end or the potential to benefit from trading down by the mass market.

Of course much of this known and the plan to deal with challenging markets is to expand its direct to consumer (DtC) sales via increasing the number of stores and investing in e-commerce facilities. Indeed DtC made up 21% of revenues in 2012 and are expected to rise to 23% in 2013.

What makes V.F. Corp different is that its diverse set of brands, channels and end-markets allow it to select areas in which to focus to generate growth through the cycle. Moreover its brands benefit from some secular fashion trends (as discussed above) whereas a company like The Gap $GPS is more exposed to general macro trends. Indeed, The Gap has had to completely restructure its business and separate its three brands (The Gap, Old Navy and Banana Republic) into three global entities. The idea being that this will create the ability to focus and innovate in order to drive growth. Note the difference here, The Gap is trying to innovate its brands to make the ‘cool’ while V.F. Corp is innovating in its sales channels. I’d argue that the latter is easier to do.

The J.C. Penney question is an uncertain one. The store has been hit hard by consumer spending changes and a misguided strategy of promising lower prices in general instead of the kind of discounting and promotional activity that the rest of the sector has been using. Whether the restructuring will work is open to question and it’s something to consider for V.F. Corp shareholders.

Q1 Performance

We can see how well V.F. Corp is run by looking at the profit margin movements in the quarter.

Margins were the real story this quarter because overall revenue growth was only up a paltry 2.2% and significantly below the 6% target for the full year. EPS was ahead of expectations and full year guidance was raised to $10.75 from $10.70 previously.

The standout performers in the quarter were the North Face and Vans which increased revenues 6% and 25% respectively. Moreover they achieved growth in the DtC channels of 25% and 20% respectively. As for the troubled region of Europe, The North Face recorded ‘modest’ growth while Vans rose an incredible 30%.

As discussed earlier the problematic brands in 2013 are likely to be Timberland and Jeanswear. Timberland revenues were up only 2% and flat in the Americas. Fortunately mid-teens increases in Asia managed to offset mid-single digit declines in Europe.

Where Next For V.F. Corp?

As I write the stock trades on 16.3x forward earnings. It is certainly not the cheapest stock out there and it has some headwinds to meet in 2013. With that said some of its brands are recording very strong growth and the DtC expansion is very impressive.

The problem with buying the stock up here is that I get the sense that all the positives are priced into it already and as good as the management are, the target of 6% growth for 2013 when only 2.2% was achieved for Q1, raises more questions than answers. Cautious investors will want to monitor events here and wait for a more favorable risk/return proposition.