Friday, March 1, 2013

Nordstrom's Growth Strategy

Sometimes the best companies don’t necessarily make the best investments. I'm a big fan of Nordstrom (NYSE: JWN), and I really like the aggressive management initiatives taking place. The retailer deserves to be lauded for adjusting to the new retail reality. The increased roll-out of its reduced price stores (known as the Rack), its Canadian expansion and its notable investments in e-commerce (particularly mobile) capability are all signs that its management is on the ball. In this article I want to focus on its expansion program, because if you commit yourself to buying and holding Nordstrom for the next five years then you are going to witness a significant transformation in this company.

Nordstrom Equity Research

Readers may find it useful to look at a previous article that discusses how Nordstrom was achieving its ongoing initiatives. Now it’s time to look at the longer term objectives. In the conference call the company discussed its previously outlined five strategic goals for 2012. They are clearly aims that it is pursuing long term:

  • Invest in IT infrastructure to support e-commerce activities
  • Improvements in its online offering (particularly mobile): Indeed Nordstrom made two acquisitions in the online space and is now seeing 20% of its online volume come from mobile as opposed to only 4% in 2010.
  • Expand online products and try to adopt a customized approach to customers: This sort of thing will inevitably accrue out of the data analytics opportunities created by an increased online presence.
  • Invest in in-store mobile PoS devices in order to drive mobile adoption: Nordstrom now claims it gets over a hundred thousand unique visitors on an average day.
  • Invest in systems to assist inventory management: This is also necessary in order to deal with the changing nature of its sales channels.

In addition to these plans you can add the increase in Rack stores and international expansion, namely in Canada.

Nordstrom’s Capital Expenditure Plans

Of course, all of this expansion comes at a price, and there will be a noticeable ramp up in capital expenditures over the next five years with $3.7 billion planned to be spent over the period. I have interpolated historical figures to produce a rough approximation of what this will do to free cash flow over the next five years.

Readers should note that my definition of free cash flow (op cash flow minus CapEx) is different to the one that Nordstrom typically defines.

Note that operating cash flow hasn’t gone up much over the last three years and that the CapEx ramp is significant going forward. In fact, if you look at the average assumption for free cash flow for the next five years I have assumed $843 million or 6.4% of its current enterprise value. This is okay in the long term, but it will only be around 4% in a year’s time based on today’s share price of around $53.

The plan is to grow revenues in high single digits (I assumed 8%) and to achieve a return on capital in the mid-teens. This is fine, but I would note a few things that could be a cause for concern:

  1. EBIT margins are projected not to expand over ‘the next several years’ thanks to the investment program plus higher depreciation.
  2. Rack, direct (including online) and Canada are projected to generate the majority of sales within the next five years.

These issues are concerns because the younger consumer (a relatively higher part of the mix) may turn out to be lower margin for Nordstrom. Consider that online sales tend to be more price competitive. Furthermore, the Rack stores are discounted, and their growth may detract from the full price Nordstrom stores. In addition, this shift is somewhat of a change in sales approach, and this always brings about uncertainty.

A breakdown of how Nordstrom will allocate capital expenditures over the next few years.

The new stores are a mix of full price and Rack stores with relatively more spending intended for the latter.

Nordstrom and the Market

It is always interesting to compare Nordstrom with its peers and market trends. My view is that there is a real and sustainable shift to ‘trading down’ plus a heightened sense of price awareness in the US consumer. Both trends are being driven by the ease of comparing prices online, and clothing is not immune. TJX Companies (NYSE: TJX) and Ross Stores (NASDAQ: ROST) are off-price retailers and a good example of a stocks benefiting from the trading down effect. In addition, they both have growth prospects with expanding home ware sales. They also have moats because their merchandise is not generally available at the prices that they offer. Their success over the last few years rather suggests that Nordstrom’s plan to increase Rack stores is one of necessity rather than choice.

V.F. Corp (NYSE: VFC) is also expanding its online sales, but its growth prospects are mainly based on international expansion, particularly leveraging of its popular Vans and North Face brands. VFC is doing this because it can, but Nordstrom is restricting itself to Canadian expansion. In a sense this expresses the necessity for Nordstrom to make these investments because this is de-facto the best way to generate growth in a changing environment.

Is Nordstrom a Stock to Buy?

Essentially, your investment decision over Nordstrom relates to believing in its long term growth plan. I’m positive on their execution, but I also think some questions need to be asked over whether online and Rack expansion will detract from the value of its brand. Nordstrom’s reputation was built up over the quality of its customer service with its full price stores. Moreover, the prospect of cannibalization also exists, and it will be a while before the market can see the stock looking cheap on a superficial basis. One to monitor for now.

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