Narrow-Moat Nordstrom Faces Multiple Challenges, but Its Brand Advantage Provides Con
Narrow-Moat Nordstrom Faces Multiple Challenges, but Its Brand Advantage Provides Confidence
Business Strategy and Outlook | by David Swartz Updated Nov 28, 2022
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 the company was unprofitable in 2020 because of the COVID-19 crisis, its profitability returned in 2021, and we believe its brand intangible asset is intact. Despite a rocky couple of years, we believe Nordstrom’s full-price and Rack off-price stores have competitive advantages over other apparel retailers.
We believe Nordstrom is responding well to changes in its market. The company has about 100 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 250 stores) and significant e-commerce (42% of its sales in 2021). Still, the firm’s full-price business is vulnerable to weakening physical retail, and Rack competes with firms like no-moat Poshmark and narrow-moats TJX and Ross.
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 10% now) and greatly expand the number of items offered through partnerships (to 30% from 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. We forecast Nordstrom will consistently generate more than $1 billion in operating cash flow after 2022, achieve ROICs in the teens after 2023, and reach $16 billion in annual revenue in 2024. However, its recovery from the pandemic and economic distress has been rocky, and we think operating margins will fall marginally shy of 6% in the long run due to intense competition.
Economic Moat | by David Swartz Updated Nov 28, 2022
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 14% annually over the past 10 years despite disruption from the pandemic in 2021 and 2022. We forecast adjusted ROICs (including goodwill) to average 15% over the next decade. As we estimate Nordstrom’s weighted average cost of capital at 9%, we expect the firm to generate economic profits on an annual basis.
Nordstrom’s full-price, full-line stores generated $9.6 billion in 2021 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 100 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. Macy’s, for example, is in the process of closing about 125 stores. 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, went bankrupt in 2020) and Saks Fifth Avenue. As further support of the firm’s competitive edge, there are 13 million members (and growing) in Nordstrom’s loyalty club. These members generated about 67% of Nordstrom’s 2021 sales, up from 35% eight 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 North America. 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 nine of the 12 years since the 2009 recession. Meanwhile, Macy’s reported negative same-store sales at owned stores in five of the past seven years. Nordstrom’s full-price sales plummeted 30% in 2020 due to the COVID-19 outbreak and the closure of 16 stores, but rose 38% in 2021. 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. Nordstrom’s off-price business has grown from one clearance store in Seattle in 1973 to about 250 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. While the segment suffered a 35% sales decline in 2020 due to the virus, it achieved 41% sales growth in 2021 as the economy improved and its stores operated at full capacity. Apart from the pandemic, Rack has consistently reported positive annual sales growth, even during the 2008-09 recession. Nordstrom claims its off-price annual same-store sales growth has consistently exceeded that of a weighted-average peer group (includes Ross, TJ Maxx, Burlington) since 2013. Moreover, Rack’s sales per square foot (approximately $500 prepandemic) have exceeded those of the peer group. Although its recent results have been inconsistent, we believe Rack will outpace competitors on this metric as it has a smaller (only about 250 locations) and younger store base, allowing it to choose the best locations. Ross, for example, operates about 1,600 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 $6.1 billion in 2021 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, Nordstrom 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, which now generates more than $1.3 billion in annual sales. 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 42% of Nordstrom’s total net sales in 2021, and we anticipate they would account for about half of yearly sales by the end of this decade.
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% 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 Swartz Updated Nov 28, 2022
We are holding our per share fair value estimate on Nordstrom at $42. The company’s retail sales declined 3% in 2022’s third quarter, although this outperformed our negative 5% forecast. However, visibility on the holiday shopping season is low after relatively slow sales in early November and the prospect of widespread discounting in apparel retail. For 2022, we have marginally lowered our adjusted operating margin forecast to 4.3% from 4.4% and our adjusted EPS estimate to $2.45 from $2.55. In 2023, we forecast only a limited recovery, with 1% sales growth and $2.47 in EPS as we anticipate it will take some time for Nordstrom to implement some of its merchandising efforts, especially at Rack. Our valuation implies a fiscal 2023 price/earnings multiple of 17 and enterprise value/EBITDA multiple of about 7 on $1.35 billion in 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 margins to nearly 6% in the medium term.
Our model assumes full-price growth around 1.5% after 2023. While mall traffic may be declining, we think Nordstrom has a loyal customer base and strong e-commerce, which accounted for 42% of 2021 sales. Further, we forecast Nordstrom’s off-price sales growth at 3% after 2023.
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 $14.8 billion in 2021 to $18.6 billion in 2031, a modest compound average annual growth rate of 2.3%. 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 average of 32.5%.
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 bet heavily on two new territories, Canada and New York City. The firm has invested hundreds of millions of dollars in its properties in Manhattan, a market that already has many fashion retailers. We believe Nordstrom studied both the New York and Canadian markets extensively before entering and will earn good returns on investment.
Our upside fair value estimate is $66. In this case, Nordstrom’s total revenue rises 6.4% in 2022 after the 38% rise in 2021 as store traffic approaches normal levels and e-commerce remains robust. After 2023, its full-price stores achieve sales growth of 2.0% in our upside case. Full-price same-store sales may improve if e-commerce and its customer loyalty program continue to grow. Further, in this case, Nordstrom’s off-price segment reports yearly sales growth of 3.5% after 2022 as investments in digital capabilities and broader merchandising (more activewear, for example) attract consumers (especially those under 40). Our upside case assumes gross margins on net sales (excludes credit card operations) average 37.5% in the long term. While Nordstrom’s gross margins have recently been lower than this level, the company is changing its mix to sell higher-margin items, such as private-label apparel and activewear. Finally, our upside scenario case assumes SG&A margins settle at 30.5% as the Closer to You plan results in more efficient operations. This assumed SG&A margin is 150 basis points better than our base case.
Our downside fair value estimate is $19.50. In this scenario, full-price stores report sales growth of just 1% after 2023. This case assumes Nordstrom’s e-commerce does not make up for sales declines at full-price stores. Further, Nordstrom’s off-price segment reports sales growth of 2% in 2024-31 in our downside scenario, which is below historical norms. It is possible that Rack sales will underperform as the stores mature and competition from apparel discounters increases. Our downside case estimates Nordstrom’s gross margins on net sales of 34.5% in the long term. This scenario assumes no improvement in gross margins from Nordstrom’s plan to emphasize brands and categories with higher sales and gross margins and increase its private-label and shared offerings. Finally, our downside case forecasts SG&A as a percentage of revenue of 33.5% in the long run. In this case, despite its cost-cutting efforts, Nordstrom’s costs increase from elevated marketing, e-commerce fulfillment, and wages.
Risk and Uncertainty | by David Swartz Updated Nov 28, 2022
We assign a Very High Morningstar Uncertainty Rating to Nordstrom. Like all retailers, the company must manage a recovery from the COVID-19 crisis, which caused a sharp drop in 2020 sales. While U.S. stores are now operating normally, there are ongoing problems, including delayed shipping, factory shutdowns, and higher transportation and other costs. Moreover, inflation could damp consumer spending.
Nordstrom is exposed to weakness in U.S. physical retail. More than two dozen U.S. apparel retailers have gone bankrupt in the past few years, including direct competitors like Lord & Taylor, Neiman Marcus, and Barneys. While Nordstrom closed 16 of its stores in 2020, 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 (42% of 2021 sales) provides some shelter from weakness at physical retail. However, we believe that a 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.
Apparel and footwear account for more than 70% of Nordstrom’s sales. As China is the largest exporter of clothing, tariffs or trade restrictions on imports from the country could increase Nordstrom’s costs and reduce margins. We think it can shift some of its purchasing of third-party apparel and manufacturing of its own private-label apparel (roughly 10% of sales) to other countries if necessary.
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 Swartz Updated Nov 28, 2022
We assign a Standard capital allocation rating to Nordstrom. Members of the Nordstrom family own about 31% 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, has left the company and a search is on for her replacement. 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 October 2022 with $2.9 billion in debt, partially offset by nearly $300 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 debt/EBITDA will fall to 2.3 times by the end of 2022, 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 has resumed share repurchases and dividends in 2022 due to its cash generation (about $340 million in free cash flow to equity expected in 2022) and its debt reduction. Over the next decade, we expect it will repurchase about $300 million in shares per year and pay out about 25% of its earnings as dividends.
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