Flipping My Stance on Nordstrom

 | Feb 17, 2012 | 9:30 AM EST
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Ever hear this catchy phrase from a Wall Street titan? "You have to stay nimble when investing." I sure have -- and, unfortunately, back in the day, I myself used such clichéd expressions in my equity research reports. In any case, to be nimble is to have a willingness to change direction on a particular stock call, and then to execute around your new perception. Allow me to demonstrate this process with Nordstrom (JWN).

Nordstrom was a name that did not tickle my fancy prior to earnings. Yes, its trends in comparable-store sales (comps) were quite healthy to end 2011, and the year was on the mark overall after the company raised full-year earnings guidance in its third-quarter report. Still, I was worried about profitability.

Nordstrom is investing rather aggressively in its namesake e-commerce platform, the still-fresh acquisition of Hautelook, as well as in the opening of new Rack stores. Further compounding the lack of visibility into Nordstrom's forward 12-month earnings stream were maneuvers to spur sales -- such strategies as free shipping for online orders, with some testing done on same-day delivery.

It appears all of these concerns rose to the surface in Nordstrom's fourth-quarter and initial fiscal year outlook. First, a strong holiday quarter comps bump of 7.1%, and a 35% direct-to-consumer gain, only yielded an earnings upside surprise of $0.01. What this says is that Nordstrom's actions toward driving sales are coming at the expense of profitability. Move 35% more stuff from an online portal that offers free shipping, and it could quickly take a bite out of overall gross profit margins.

Next, as seemingly robust as the top line was, I believe it lacked the complete "oomph" one would tend to associate with high-end consumption. The stock market has gone up in a straight line since the summer of 2011, consumer confidence has been on the mend and employment gains have intensified. Yet, Nordstrom only called out the South and Midwest as being top-performing regions, and it pointed to only three merchandise categories as notable areas of growth.

If all were fine and dandy on the upper end of retail, there really should have been a broader mix of categories, with an extra region tossed in. (Nordstrom generates a disproportionate amount of its sales from stores in the West.)

Finally, Nordstrom wound up issuing the earnings warning that I expected. I have been asked how I came to this conclusion ahead of time, so here is some insight.

1. I noted that the stock price showed short-term underperformance, relative to peers and broader equity indices.

2. I reviewed three quarters of management comments on the topic of expenses.

3. As always, I got a general feel for management itself -- because, in this case, management usually guides conservatively.

4. I always doubt Wall Street analysts, who tend to inflate earnings assumptions on companies it views favorably over the long term.

Yet, I've now shifted back into the buy camp for Nordstrom. Given my very recent pre-earnings bearishness, why now brown cow on the direction change? Well, I draw your attention back to the concept of staying nimble, when you come up with a new investment thesis that's supported by solid lines of reasoning.

Seeing Nordstrom Through a New Lens

The fiscal year guidance appropriately captures the margin concerns I had on the company. For one thing, the company's estimate on capital expenditure was lofty, as many of the e-commerce investments are capitalized and hit the profit and loss statement. Further, gross margin guidance signaled compression, and sufficient downside was offered by the comps growth outlook 4% to 6%. That all brings me to this question: Is this guidance conservative?

That could be the case, but in order to get to that conclusion one has to appreciate that Nordstrom's business is evolving. As a result, more attention should be assigned to margin potential on earnings before interest and taxes, instead of potential on gross margin.

Nordstrom has some impressive initiatives in place to facilitate EBIT margin upside:

  • further investment in mobile point-of-sale devices and Nordstrom-specific apps for handheld devices
  • an attack on the high-end discount channel through a flurry of Rack store openings
  • enhancements to the rewards program, which deepens the relationship with customers
  • investments in planning and allocation tools,which helps to bring goods to the floor quicker -- which is very important when dealing with picky higher end shoppers

Nordstrom, as I see it, is doing things that its competitors aren't, and the speed with which which it's implementing initiatives should lead to market share gains in short order.

If push came to shove, I'd say Macy's (M) -- trading at 10x forward earnings, sporting a 2.3% dividend yield and having two years of positive news at its back -- has the advantage over Nordstrom. However, I don't believe it would be completely off-base to include Nordstrom on your shopping list.

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