Narrow-Moat Nordstrom Is Struggling, but Its Brand Advantage Provides Confidence in a
Narrow-Moat Nordstrom Is Struggling, but Its Brand Advantage Provides Confidence in a Turnaround
Senior Equity Analyst
Business Strategy and Outlook| by David SwartzUpdated Jun 27, 2023
Nordstrom continues to be a top operator in the competitive U.S. apparel market. The firm has, in our view, cultivated a loyal customer base on its reputation for differentiated products and service and has built a narrow moat based on an intangible brand asset. While its recovery from the pandemic has been rocky, its profitability has returned, and we believe its brand intangible asset is intact.
We believe Nordstrom is responding well to changes in its market. The company has about 94 full-price stores, with nearly all of them in desirable Class A malls (sales per square foot above $500) or major urban centers. We view this as an advantage, as some lower-tier malls are unlikely to survive. Moreover, Nordstrom has a presence in discount retail with Rack (about 245 stores) and significant e-commerce (38% of its sales in 2022). Still, the firm’s full-price business is vulnerable to weakening physical retail and competition from key brands’ direct-to-consumer efforts, while Rack competes with firms like no-moat Poshmark, narrow-moat TJX, narrow-moat Ross, and many others.
Nordstrom unveiled a new strategic plan, Closer to You, in early 2021 that emphasizes e-commerce, growth in key cities (through Local and other initiatives), and a broader off-price offering. Among the merchandising changes, Nordstrom intends to increase its private-label sales (to 20% of sales from about 10% now) and greatly expand the number of items offered through partnerships (to 30% from about 5% now). The firm set medium-term targets of annual revenue of $16 billion-$18 billion, operating margins above 6%, annual operating cash flow of more than $1 billion, and returns on invested capital in the low teens. Nordstrom’s recent struggles to manage through industry turmoil and exit from Canada have put these goals in doubt, but we forecast it will consistently generate more than $1 billion per year in operating cash flow, achieve ROICs in the teens after 2024, and reach $16 billion in annual revenue in 2028. However, we anticipate operating margins will top out at just over 6% in the long run due to intense competition.
Economic Moat| by David SwartzUpdated Jun 27, 2023
We maintain a narrow moat rating on Nordstrom based on the company's intangible brand asset. In a difficult environment for fashion retailers, Nordstrom maintains successful full-price, off-price, and e-commerce channels. The full-price Nordstrom stores (two third of sales) maintain premium pricing over other mall-based department stores through differentiated product and a reputation for excellent customer service. The Nordstrom Rack stores (one third of sales) compete in the fast-growing discount fashion space and outperform many other outlet chains. Both full-price and Rack are supported by e-commerce that has made Nordstrom one of the largest online apparel retailers in the U.S. As evidence of its competitive edge, adjusted returns on invested capital (including goodwill) have averaged 12% annually over the past 10 years despite disruption from the pandemic. We forecast adjusted ROICs (including goodwill) to average 15.5% over the next decade, nicely above our 9.5% weighted average cost of capital estimate.
Nordstrom’s full-price, full-line stores generated $10.3 billion in 2022 net sales, making the company one of the largest upscale fashion retailers in the U.S. Nordstrom’s full-price stores are known for providing quality customer service and access to some brands not available at most department and mass market retailers. The full-price stores carry luxury fashion brands like Fendi, Gucci, and Prada, private-label brands from the Nordstrom Product Group, and mass-market brands like Nike and Levi’s. Nordstrom operates about 94 full-price stores, which we view as a manageable size. Some department store chains, such as no-moat Macy’s, J.C. Penney, and no-moat Kohl’s, have much larger footprints and are downsizing. Nordstrom’s full-price stores serve customers who tend to be more affluent than those of other department stores, such as Macy’s and Kohl’s, but somewhat less affluent than those of smaller competitors Neiman Marcus (which, like J.C. Penney, filed for bankruptcy in 2020) and Saks Fifth Avenue. As further support of the firm’s competitive edge, there are approximately 15 million members in Nordstrom’s loyalty club. These members generated about two thirds of Nordstrom’s sales, up from 35% nine years ago. We believe Nordstrom’s full-price stores serve a loyal customer base, providing support for our narrow moat rating based on the company’s brand intangible asset.
We believe Nordstrom’s full-price stores have held up well in the difficult and competitive business of mall-based retail. Unlike many competing department stores, such as Macy’s, Belk, Dillard’s, and J.C. Penney, Nordstrom is not dealing with large numbers of stores in struggling malls in second-tier markets. Approximately 95% of its full-price stores are in malls rated A (malls with annual sales per square foot of $500 or more) or better, and Nordstrom operates full-price stores in each of the top 20 consumer markets in the U.S. Moreover, more than 60% of its sales are generated in the top 10 markets. Nordstrom has reported positive same-store sales growth at its full-price stores in 10 of the 13 years since the 2009 recession. Meanwhile, Macy’s reported negative same-store sales at owned stores in five of the past eight years. Nordstrom’s full-price sales plummeted 30% in 2020 due to the COVID-19 outbreak and the closure of 16 stores, but rose above 2019’s level in 2022. Although its full-price sales are likely to decline in 2023 due to the closure of its six stores of this type in Canada, we forecast 1.5% annual sales growth for the segment in the long term on the strength of its Manhattan flagship women's store (opened in October 2019), e-commerce, and very limited store base growth. We believe Nordstrom’s presence in many of America’s leading upscale malls allows it to outperform other department stores and contributes to its narrow moat.
Nordstrom has a strong presence in the discount apparel market through its Rack stores. The firm’s off-price business has grown from one clearance store in Seattle in 1973 to about 245 stores today. We do not think Nordstrom’s off-price business hurts its full-price business as Rack attracts a somewhat younger (average age under 40), less affluent customer than the full-price stores. Nordstrom claims that Rack is the company’s number one source of new customers and that one third of off-price customers become full-price customers over time. Further, the company reports customers who shop at both full-price and off-price stores spend 4 times as much as customers who only shop at one or the other. Nordstrom uses Rack to sell lower-priced items of popular brands, to sell private-label apparel, and to clear merchandise from full-price stores (about 10% of merchandise sold).
Nordstrom’s off-price business has a been a major source of the company’s growth. Between 2014 and 2019, its yearly off-price sales grew to $5.2 billion from $3.6 billion. While the segment suffered a 35% sales decline in 2020 due to the pandemic and its recovery has been slow, Rack has typically reported positive annual sales growth, even during the 2008-09 recession. Prior to the pandemic, Nordstrom claimed its off-price annual same-store sales growth consistently exceeded that of a weighted-average peer group (includes Ross, TJ Maxx, Burlington). Moreover, Rack’s sales per square foot (approximately $500 prepandemic) have exceeded those of the peer group. Despite the inconsistent recent results, we believe Rack will outpace competitors on this metric as it has a smaller (only about 245 locations) and younger store base, allowing it to choose the best locations for new stores (20 expected in 2023). Ross, for example, operates about 1,700 stores, most of which opened before 2010. We believe Nordstrom Rack has staked out a strong position in discount fashion retail and contributes to our narrow moat rating.
While concerns surrounding online adoption throughout the industry abound, we believe Nordstrom’s e-commerce capabilities surpass those of many competitors and support its brand power. The company’s main site, Nordstrom.com, was launched in 1998 and was integrated into the rest of the business from the beginning. In contrast, many competitors outsourced their online businesses to third parties or operated them separately from their physical stores until a few years ago. Nordstrom’s investments in e-commerce have allowed it to introduce online capabilities earlier than others. The firm, for example, offered free shipping and online returns in 2011, well before these practices were standard in the industry. Nordstrom has become one of the leading e-commerce companies in the U.S. Its digital sales increased to approximately $5.7 billion in 2022 from $3.5 billion in 2016.
Nordstrom’s success in e-commerce brings both costs and benefits. The company does not believe e-commerce hurts its profitability as it claims its contribution margins from Nordstrom.com sales are like those of sales through its physical stores. Nordstrom’s results, however, suggest e-commerce entails extra costs as reported SG&A as a percentage of sales has been rising as e-commerce has grown. We do not think the lower labor and sales costs of e-commerce fully mitigate the impact of higher shipping, distribution, and service costs. On the other hand, Nordstrom believes e-commerce is additive to the business, claiming that customers who shop at both its physical stores and its online sites spend five times as much as those who only shop at one or the other. Further, the company claims customers who buy online and pick up in store spend twice as much as other customers. We think Nordstrom’s major e-commerce presence contributes to its brand intangible asset and narrow moat.
Nordstrom supports its off-price business with a solid e-commerce offering. In 2011, Nordstrom acquired a flash sales site called HauteLook for total consideration of $270 million (roughly double its sales at the time). In 2014, it launched Nordstromrack.com as a separate shop but on the same platform as HauteLook. Later, it eliminated the HauteLook brand to focus on Nordstromrack.com. As with the Nordstrom.com site, the firm believes the online presence is additive to its off-price segment. It claims customers who shop at both Rack stores and online (approximately 10% of the total) spend 55%-70% more than customers who shop at only one or the other. Overall, digital sales represented 38% of Nordstrom’s total net sales in 2022, and we forecast they will account for close to 50% of annual sales in 10 years.
We believe the strength of Nordstrom’s brand allows for a narrow moat but does not produce a wide moat, as we lack confidence that the firm will generate ROICs above WACC over the next two decades. While we believe Nordstrom is dealing with threats to the traditional retail business better than most, it is still subject to competitive pressures from e-commerce companies (like wide-moat Amazon, no-moat Poshmark, and narrow-moat eBay), discount fashion chains (like TJX and Ross Stores), other department stores, small-format fashion stores, and huge numbers of outlet stores. Moreover, the future of mall retailing in the U.S. is difficult to project, and Nordstrom has a major mall presence. We do not think Nordstrom’s single moat source is enough to support a wide moat rating. Further, we do not expect it can expand margins enough to achieve a second moat source based on cost advantage. Two of its competitors, TJX and Ross, have a narrow moat rating based on both cost advantages and intangible brand assets. Both firms routinely purchase large amounts of clothing from vendors at steep discounts and achieve double-digit operating margins versus about 5%-6% (normalized) for Nordstrom.
We do not believe Nordstrom has a moat based on any other factors besides its brand intangible asset. It has no production cost advantage as it sources its apparel from many of the same manufacturers as other fashion retailers. We do not believe it has the power to negotiate lower prices from producers. Nordstrom does not have a moat based on efficient scale, either, as its distribution system is like that of competitors. There is no network effect in the fashion retailing business, and switching costs are nonexistent.
Fair Value and Profit Drivers| by David SwartzUpdated Jun 27, 2023
We are holding our per-share fair value estimate for Nordstrom at $40. The firm closed its 13 stores in Canada in 2023’s first quarter and recognized $309 million in wind-down expenses. However, its 1.6% adjusted operating margin was not as bad as the 0.2% that we had forecast. Moreover, it reiterated its full-year guidance, including $1.80-$2.20 in adjusted EPS (excluding the special charge). Thus, we forecast an operating margin of 3.8% (unchanged) and $2.02 in adjusted EPS (up $0.08) for 2023. Including the charge, we forecast $0.68 in EPS (up from $0.44). On an adjusted basis, our valuation implies a fiscal 2023 price/earnings multiple of 20 and enterprise value/EBITDA multiple of about 7 times on $1.2 billion in projected adjusted EBITDA.
Despite its problems, we believe Nordstrom is recovering from the COVID-19 crisis and its Closer to You strategy is beginning to take shape. Among the initiatives under this plan, the company is increasing the amount of private-label and partnered merchandise that it sells, cutting costs, improving its Rack selection, and boosting its online offerings. We believe these initiatives are poised to lift operating margins to nearly 6% in the medium term.
Our model assumes full-price growth around 1.5% in the long run. While mall traffic may be declining, we think Nordstrom has a loyal customer base and strong e-commerce, which accounted for 38% of 2022 sales. Further, we forecast Nordstrom’s long-term off-price sales growth at 3%.
We think Nordstrom’s Closer to You plan and recent large investments to build out its e-commerce platform and network of stores should lead to continued sales and profit gains over time. We forecast total revenue increases from $15.5 billion in 2022 to $17.6 billion in 2032, a modest compound average annual growth rate of 1.2%. Our forecast assumes gross margins on net sales (excludes credit card revenue) average 36% over the next 10 years, slightly above the average of the five years before the pandemic. Our model also anticipates SG&A as a percentage of revenue stabilizes around 32% over the next decade, better than its five-year historical average of 34.7% due to cost cuts and higher sales.
Our estimates could be a risk if the U.S. (contrary to our forecast) enters a major recession in 2023. Nordstrom suffered in the 2008-09 recession, as it experienced same-store sales declines at its full-price stores of negative 12.4% in 2008 and negative 7.2% in 2009.
Nordstrom has invested hundreds of millions of dollars in its properties in Manhattan, a market that already has many fashion retailers. Unfortunately, Nordstrom’s entry into the market was almost immediately impacted by the pandemic. Our estimates assume the firm can ultimately succeed there.
Risk and Uncertainty| by David SwartzUpdated Jun 27, 2023
We assign a Very High Morningstar Uncertainty Rating to Nordstrom. The company has struggled to recover from the COVID-19 crisis, which caused a sharp drop in sales in 2020. While U.S. stores are now operating normally, there are ongoing problems, including inconsistent shipping, sporadic factory shutdowns, and higher transportation and other costs. Moreover, inflation has dampened consumer spending on apparel.
Nordstrom is exposed to weakness in U.S. physical retail. More than two dozen U.S. apparel retailers have filed for bankruptcy in the past few years, including direct competitors like Lord & Taylor, Neiman Marcus, and Barneys. While Nordstrom closed 16 of its stores in 2020 and then exited Canada in early 2023, we think it is in better shape than some mall retailers as 95% of its full-price stores are in Class A (greater than $500 in sales per square foot) malls. Also, Nordstrom’s significant e-commerce business (38% of 2022 sales) provides some shelter from weakness at physical retail. However, we believe that our Very High Uncertainty Rating is warranted as Nordstrom’s generational investments and Closer to You plans have yet to translate into strong sales growth or improved profit margins.
Nordstrom’s long-term debt of just under $3 billion limits its financial flexibility, although we believe its debt is manageable as near-term maturities are limited.
Apparel and footwear account for more than 70% of Nordstrom’s sales. As China is the world’s largest exporter of clothing, tariffs or other protectionist measures on imports from the country could increase Nordstrom’s costs and reduce margins.
We do not believe Nordstrom faces material environmental, social, and governance risks. However, like most firms in the apparel retail industry, it is subject to controversies related to the treatment of workers in its supply chain and the large environmental cost of clothing production.
Capital Allocation| by David SwartzUpdated Jun 27, 2023
We assign a Standard capital allocation rating to Nordstrom. Members of the Nordstrom family own about 30% of the outstanding stock and manage the company as well. We view Nordstrom’s status as a family run firm as mostly favorable to investors as we think it is managed with a long-term view. The company has, for example, made large investments in e-commerce and Rack that have transformed it in a positive way.
Nordstrom's chief financial officer of five years, Anne Bramman left the company in late 2022. In May 2023, experienced financial executive Cathy Smith was named to the position. Given the influence of the Nordstrom family, we do not expect this change to impact the firm's capital allocation plans or our rating.
Nordstrom closed fiscal 2023’s first quarter with $2.9 billion in debt, partially offset by nearly $600 million in cash. In 2021, it issued $675 million in new bonds to pay down the $600 million in high-interest (8.75%) debt that it raised during the pandemic, helping to reduce its annual interest expense. As we expect net debt/EBITDA will fall to below 2 times by the end of 2024, we believe its debt is manageable.
Capital expenditures were elevated for many years as Nordstrom built its Manhattan flagship and invested in digital capabilities. Between 2013 and 2019, its annual capital expenditures averaged about 6% of revenue. Now that its largest investments are complete, however, we forecast yearly capital expenditures at less than 4% of revenue over the next decade.
Although Nordstrom suspended dividends and share repurchases during the pandemic, we think it has a good record of returning cash to shareholders. The company has reduced its share count by more than 30% since 2007 and paid out about 42% of earnings as dividends over the 10 years before the crisis. Nordstrom resumed share repurchases and dividends in 2022 due to its cash generation ($473 million in free cash flow to equity in 2022) and its debt reduction. We forecast the firm’s long-term dividend payout ratio at 25%-30%. However, we anticipate little or no further buyback activity until 2025 as Nordstrom concentrates on improving its execution.