Nordstrom Shows That Even The Best Can Struggle A Bit

By Stephen D. Simpson, CFA | August 19, 2013 AAA

It's hard to find new positive things to say about Nordstrom (NYSE:JWN). This high-end retailer has long stood out from the crowd with its sharp-eyed merchandising, high inventory turns, flexible operating model, and above-average returns on capital. Couple that with a still-growing Rack store concept and e-commerce opportunities, and it's hard to ever get too negative on this company. On the other hand, Nordstrom's excellence has been well-known for years and this second quarter shows that even well-run retailers can struggle to make headway in the face of a tougher consumer spending environment.

Margins Save The Day, But Sales Disappoint
Nordstrom reported overall revenue growth of over 6%, with 6.4% core net revenue growth. This growth was underpinned by 4.4% same-store sales growth, which sounds pretty good until you strip out the 250bp benefit gained from the Anniversary Sale and realize that the Street was expecting nearly 7% comp growth (6.7%, specifically). Sales were pretty soft at the core Nordstrom stores (down 0.7%), while the 37% growth in direct sales (e-commerce) boosted the overall result.

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Once again, though the company's flexible operating model helped rescue the results. Gross margin declined only modestly from the year-ago period (down 20bp), while operating income actually rose more than 15% on a nearly one point increase in margin.

Although sales clearly disappointed, management adapted pretty well – per-square foot inventory rose only about 2.6%, and it doesn't look like the sales slowdown is going to force margin-damaging markdowns.

Are Consumers Pulling Back?
It's hard to read the recent news in the apparel retail sector and come away feeling very good about the underlying conditions. Macy's (NYSE:M) saw comps down almost 1% for its second quarter, while American Eagle (NYSE:AEO) (admittedly not a comp to Nordstrom) plunged after lowering its second quarter outlook.

And yet, Tiffany (NYSE:TIF) sits near a 52-week high, as does Oxford Industries (NYSE:OXM), the manufacturer (and, increasingly, retailer) of popular lines like Tommy Bahama, LVMH (Nasdaq:LVMUY), and Kering (Nasdaq:PPRUY) (owner of Gucci), as some luxury goods companies are seeing demand improving.

It's a little challenging now to see where Nordstrom fits in. Saks (NYSE:SKS) hasn't reported second quarter earnings yet, and likewise neither has Hudson Bay Company (which will be acquiring Saks, and already owns Lord & Taylor). It's hard for me to say, then, whether Nordstrom is suffering from a lack of exposure outside the U.S. (as reviving European demand seems to be helping LVMH and Kering) and/or whether U.S. shoppers are shifting away from higher-end clothing in favor of other discretionary items.

The Bottom Line
The good news for patient shareholders is that one quarter, or even one year, of challenging growth at Nordstrom won't derail the company. Nordstrom has always been built around sustainable business practices, including controlled expansion into new markets. Moreover, while the company has seen free cash flow decline for three years (and estimates suggest that the streak will hit five years before reversing), building out the Rack store footprint should lead to leverageable long-term growth opportunities.

I'm looking for Nordstrom to produce 6% revenue growth over the next decade, or just slightly below its trailing decade's growth rate. I am looking for more free cash flow growth, though, as the company leverages that store base. From those growth rates, I see a fair value of around $60 today, which doesn't really tempt me to buy the shares, particularly when the outlook for consumer spending appears to be souring.

Disclosure – At the time of writing, the author did not own shares of any company mentioned in this article.

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