Wednesday, June 13, 2012

The Best US Luxury Stock

The luxury goods sector is a great way to play some of the inequalities inherent in the current recovery. I take no pride in articulating that the rich have got richer, however, the focus here is with investment opportunities. It strikes me that there is somewhat of a bifurcation of prospects for retailers due to an uneven recovery.

At the lower end, we are seeing off-price clothing retailers like TJX companies, prospering as consumers retain cost saving behavior learned during the recession. Moreover, the lack of growth in average incomes is also playing to the lower end retailers. Any behavioral psychologist will tell you that it is much easier to sell a price differential as a discount rather than a surcharge. So, once consumers get used to lower prices, they want them to stay. Aside from the macro-economic metrics, current consumer psychology favors retailers like TJX too!

However, I want to focus on the high end.

Luxury Goods Retailers

The luxury goods sector pitch is well worn. It usually runs along the lines of emerging market growth creating a mass of new high income customers for Western luxury goods. It is a strong argument. At least, I hope so, because I happen to hold it.

However, I also happen to hold the view that China’s real estate market is slowing and, I reserve the right to be cautious on the growth prospects implied by the valuations of the China luxury plays such as Richemont, Tiffany’s $TIF LVMH, Coach $COH and Burberry.

Coach is a great company and, its management is excellent at managing costs (which includes shifting some production away from China) and, the brand has strong appeal in the Far East. However, any slowdown in the Far East, and Coach will suffer. In addition, companies like Tiffany, Coach and Burberry’s do a decent part of their business in Europe & the US from Asian shoppers on vacation. Its not something to worry about for now, but risk averse investors may shy away.

Running adjacent to the emerging market story is that of the ‘plutonomy’ economies of the Anglo-Saxon world. In other words, the US, UK and Canada are strikingly different in terms of wealth distribution than say, Japan and continental Europe. When growth and, ultimately wealth returns to these economies, the evidence is that it returns quicker and stronger. And to the already wealthy. 

Putting these two arguments together, suggests that US focused high end plays are the best option for a growth at reasonable price (GARP) investor. I will focus on Nordstrom $JWN but investors could just as easily look at Saks $SKS or Macy’s $M who have also been reporting strong sales growth recently.

Nordstrom’s End Markets

A quick look at the macro picture. These figures are taken from the Federal Reserve and are in $bn.

Although not clear in the graph, consumer credit is now on an upward trend. I've included real estate assets to demonstrate how they have been falling but, at the same time,US net household wealth (NHW) has increased. In my opinion, it is overall growth in NHW that is key to discretionary retail sales growth in the US. It took a dip in Q3 with the stock market, but the recent market move up (along with employment gains) should see better numbers ahead.

To demonstrate Nordstrom’s reliance on NHW.

Note how Nordstrom’s gross profits move closely with changes in US NHW. Also, note how well the company has done with expanding profits more than revenues in recent years.

Nordstrom in More Detail

This analysis is fine, but we need to look closer at Nordstrom and make sure the company is in place to benefit. I’ve made a few bullet points of what I think are the salient challenges and opportunities in future.
  • Expanding the roll out of Rack stores, Nordstrom’s reduced price stores
  • Expanding online presence, including integrating the Hautelook acquisition and, expanding on the Bonobos partnership
  • Taking advantage of increasing credit quality via Nordstrom Bank and its customer cards
Firstly, Nordstrom is not a company standing still. While the high end consumer has made a comeback, Nordstrom has been busy rolling out its chain of reduced price stores named ‘Nordstrom Rack’. In fact, 18 new Rack stores were opened in 2011 and, another 15 are planned for 2012.  The Rack business now accounts for over generated 21% total sales growth and generated $2bn of Nordstrom’s $10.9bn revenues. Management talked of same store sales expanding throughout 2011 for the Rack, indicating strong customer adoption.  Moreover, plans are afoot for significant investment in technology in these stores. For example, mobile point-of-sales devices will be added.

Secondly, alongside capital expenditures on the Rack, Nordstrom intends to expand its Web presence by building its IT infrastructure to enable increased e-commerce sales. In fact, the plan is to spend $140m on e-commerce capital expenditures, or 30% of the total for 2012.  All of which, will be integrated with tools to enable inventory management. A key issue when a company is aggressively expanding online sales.  The Hautelook (a flash sale retailer of luxury clothing) acquisition was a clear signal that Nordstrom are keen to grow online sales. Moreover, the Bonobos (a leading online clothing brand) partnership is similar sign of how important, management view Nordstrom’s online presence.

Thirdly, I think another area of growth for Nordstrom will come from the improving credit quality of US households. At the last results, Nordstrom reported bad debt reserves as a percentage of receivables at 5.5% from 6.9% last year. This boosts profits, but it also means that they environment is favorable for Nordstrom Bank to extend credit. 

You Can’t Please All of the People All of the Time

However, not all analysts are happy. Whilst expanding revenues via investing in direct sales growth is one thing, management also pointed out that high dollar growth in sales and EBIT would come as opposed to EBIT margin. Moreover, the increased capital expenditures are helping reduce 2012 forecast free cash flow to $400m from $432m in 2011. Consequently, they see a business with slowing EBIT margin growth and the execution risk of increased investment in e-commerce.

Frankly, I don’t share this attitude. I like the way that Nordstrom is exposed to favorable macro trends but, is also investing for growth in areas of the economy that retail is trending towards. Not enough companies have been investing for growth in this environment, so it is easy for analysts to see ‘risk’ after years of viewing companies generate growth via cost cuts. One key thing to look out for is that, this year, Nordstrom will be giving results with a breakdown of full-line, Rack and direct sales so investors will get a chance to see how the business is evolving. In conclusion, Nordstrom would be my pick of the luxury goods sector.

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