Nordstrom Inc. is trading with one of the lowest P/E’s in retail (11.5x consensus).  Using reasonable assumptions, its shares should be worth closer to $70-$80 per share (~2x the current share price) given the company’s low concept penetration, high business quality, accelerating new store growth, aggressive share repurchases, earnings growth potential and industry leading economics--ROA of 14%, ROIC of 20% and ROE of 28% (all the more impressive given the fact that JWN owns 70% of its real estate).

Nordstrom Inc. is one of the nation’s largest upscale apparel and shoe retailers.  The company sells clothes, shoes and accessories through 101 Nordstrom stores and ~50 outlet/clearance stores (Nordstron Rack) in 27 states.  The company also sells online and via catalog. The Nordstrom family owns about 20% of the company’s stock (economic and voting) and closely supervises the chain (Blake Nordstrom, a 4^th generation descendant of John Nordstrom, who started the company back in 1901 is the current president and four other family members hold senior management positions).

JWN has made tremendous strides over the last several years, particularly after a 4 year stint (beginning in 1995) of outside “professional management”  that was brought in to help run the company, which resulted in slumping sales and profitability far below industry averages. In 2000, the outside management members were ousted and the Nordstrom family was back in charge, with 4^th generation Blake Nordstrom appointed as President and Bruce Nordstrom (Blake’s father) came out of retirement to take on the Chairman’s role.  The Nordstroms’ led a dramatic turnaround of the company and beginning in 2002, invested heavily in IT to develop a perpetual inventory  system that has enabled merchant teams (which became more decentralized) to more accurately forecast sales trends and to better track/plan store level inventory and expenses.  In 2004, JWN also put into place a new POS system that includes a tool called Personal Book, which allows salespeople to tailor service to the needs of each customer by organizing and tracking customer preferences, purchases, and contact information.  The result has been a dramatic improvement in sales productivity and profitability.  Sales per square foot has grown to over $400 currently vs. $317 in 2002, and over the same timeframe, comps have been positive, ranging from 4%-8% (will likely be around 4% for FY07), EBITDA margins have expanded to around 14% from 7.4% and return on invested capital increased to ~20%  from 7%.

JWN’s equity price, similar to several other retailers, is down 27% YTD and began to slide in late September (when it was around $51/share—was at a high of nearly $60 in February) due to economic/recession fears, above-plan inventories at the start of the fall selling season, and warm weather in September which dampened apparel sales.  The company successfully worked through the excess inventory by taking additional markdowns during the 3Q.    3Q07 results actually ended up being better than expected,  with comps up 2.2%, gross margins down only 40 bps on the markdowns, and SG&A as a percent of sales actually decreasing 70 bps (to 28.7%).  After inventory per square foot growth of 7% during 2Q, Nordstrom was able to ratchet this down to 2% in the 3Q (below comp store sales growth).  EPS for the Q ended up at $0.59, above the revised guidance of around $0.50 and 13.5% ahead of last year.  This is actually a pretty good achievement given the inventory issues going into the Q and further provides evidence that JWN is a far better managed company today as a result of the IT, inventory management and merchandising improvements over the past 4 years.  In November, comps rebounded to a strong 8.7% (2x expectations), as weather shifted in its favor (stronger sales of warmer clothing), the company benefited from a calendar shift (extra week in the measurement period) and enjoyed very strong sales (far above the average 9% comp) in designer merchandise across all categories, particularly in women’s shoes and accessories.  Because of the calendar shift, Dec. comps will be down ~4-5%, with a flat comp expected for all of 4Q (which has one less week vs. last year).  Since the 3Q and November sales results, the stock bounced fro $31 to $36, but it still represents good long-term value.

Now that JWN has enjoyed success in its inventory/merchandising execution, management feels that it can now focus on more rapid expansion for what is really an under-penetrated concept catering to customers with average incomes above $100k per year (above Macy’s/Bloomingdale, JCP, Sears Dillards $45k-80k) but below Saks, Neiman Marcus, and Barneys ($200+k).  As one of the major purveyors of “affordable luxury”, JWN distinguishes itself from the rest of the department store fray by emphasizing high quality, differentiated merchandise, personalized customer service, and a consistent upscale shopping experience across the entire store base.  Anyone who has shopped at a Nordstrom realizes that the experience is truly a cut above shopping at Macy’s or even the average Bloomingdale's both in terms of merchandise quality and customer service (which is right on par with the likes of Saks, Neiman, and Barneys).  In addition to expanding retail square footage, JWN plans to drive sales growth by continuing to focus on three key initiatives:  1) developing targeted merchandising strategies in women’s apparel; 2) enhance the women’s designer business-- i.e. carry more upscale items similar to Saks and Neiman, particularly in apparel and accessories (the latter has performed tremendously well this year with strong double digit comps that appear to be accelerating in 3^rd and 4^th quarters); 3) creating a more integrated, consistent merchandise offering across the full line stores and direct sales (internet/catalog) channels.

Investment Positives:

JWN’s renowned service is a competitive advantage: JWN has developed a reputation for some of the best customer service in the retail industry, with an almost legendary easy-return policy (customer returning automobile tires and getting his money back—which according to John Nordstrom, is actually true), personal touches such as thank-you notes from employees, employees cheering customers on the opening day of new stores, and pleasant shopping atmospheres complete with live piano music, restaurants, espresso bars and some stores even featuring day spas.  Other retailers routinely cite Nordstrom as being among the best of breed in customer service.

JWN has plenty of growth potential:  With only 101 full line and 50 Nordstrom Rack stores in 27 states (West Coast, Mid-Atlantic, South and Midwest).  This is a relatively small footprint compared with other department stores.  Now that JWN has improved its profitability though its IT/JIT initiatives, the company feels it has the platform to meaningfully accelerate growth and intends to spend nearly $3BN over the next 5 years to open approximately 28 full line stores and 12-15 Rack stores and remodel nearly 70 of its existing stores.  Three years ago, the company identified 50 target markets it would like to be in, and thus far, approximately only 10 of those markets have been opened/scheduled.  These expansion plans will result in “built in” growth of square footage to the tune of ~5% per year over the next 5 years (vs. ~2% historically), which can be completely funded with internal cash flow generation.   Assuming that comps average 2%-3% per annum over the next 5 years (below 5-yr average), JWN should enjoy top line growth of 7%-8% per year, which on stable/improving margins, would be leveraged to low-mid teens digit earnings growth (and mid-teems w/share repurchases).

Cost structure as an advantage and management expects further improvement:  In contrast to much of the retail/department store sector (save for the high end), JWN has a relatively more variable cost structure because its salespeople’s compensation is 100% based on commissions.  Approximately 30% of total costs comprise of SG&A expense, and about 45% of SG&A is  represented by sales commissions.  Couple this with COGS ex depreciation and occupancy costs comprising 60% of the cost structure, and you have a cost structure that is approximately 70% variable--of course not all of COGS is truly ‘variable’ because if sales slow down, the company will have to take more markdowns which will eat into gross margins.  Notwithstanding this, JWN does enjoy a more variable cost structure vs. most of its retail peers which should help the company better weather a potential recession.   Also strides in systems-driven inventory management improvements and better fashion merchandising has enabled JWN to expand gross margins and better leverage SG&A.  On a low single-digit comp, management believes that margins can continue to expand (albeit at a more modest pace vs. historically), with a long-term goal of getting SG&A as a % of total sales to low 26% range (from ~27% currently) and continued modest improvement in gross margins (~25-50 bps over next few years).

Accelerating share repurchases: JWN recently raised debt (net $700MM) to conduct an accelerated share repurchase program.  In 2006, the board authorized a $1.5BN share repurchase program (~$7500MM has been repurchased to date under the program) and in Nov. 2007, the board further expanded the program by an additional $1BN to be completed by the year-end 2009.  JWN has plenty of balance sheet capacity to conduct these share repurchases (debt/EBITDA is ~ 2.0x) and after 2009, it should have the ability to conduct further repurchases of $700MM-$800MM per annum by modestly increasing debt (but maintaining current  2.0x debt/EBITDA level) for total share repurchase of  approximately $3.5-$4BN over the next 5 years).  With a market cap of $8.35BN, $4BN of share repurchases would take out 48% of the market cap at today’s prices.  Moreover, given the Nordstrom family’s ownership of the stock (at 20%), share repurchases as a % of outstanding float is very high nearly 60%),which at least from a technical basis, should help support the share price over time (albeit this plays a minor role in my thesis).

 

Valuation:

 

Fwd. P/E (FY09)

Earnings growth Past 5 Years

Earnings Growth Next  5 Yrs

ROIC Run-Rate

ROE Run-Rate

Source of earnings growth and ROIC/ROE Estimates:  Value Line

JWN is trading at a meaningful discount to other retailers, some of which will be more susceptible to variations in the economic cycle given their focus on moderate-income consumers (ie. Kohl’s, Macy’s, Sears, Bon-Ton, JC Penney) and nearly all of which have lower long-term revenue/earnings growth prospects, ROIC, and ROE.  JWN’s ROIC is particularly impressive given that it owns 70% of its retail square footage and it maintains its credit card receivables securitization program on balance sheet (net investment of ~430MM on total receivables of $1.6BN backing $1.2BN in secured debt).  Against the average of the comps, JWN is trading among the cheapest with a P/E of 11.5 of FY08 consensus earnings (6x turns below the group average), yet with earnings growth, ROIC, and ROE far higher vs. the rest of the comps and with one of the strongest balance sheets in the industry (rated A-/Baa1, highest among all dept. stores and 4^th highest among all US rated retailers  with TGT, WMT, and COST being higher)

JWN is also trading cheap to its long-term (15 year)  historical forward P/E of approximately 17.0-17.5.

Also underpinning the valuation is the company’s real estate ownership, where it owns 70% of its retail square footage.  Looking at the cities in which the stores are located as well as the malls/shopping areas  (all prime, upscale shopping destinations), you can safely assume a valuation of $200/sq ft for owned retail selling space (14.6mm sq. feet) and $100/sq ft for the 6 owned distribution centers (~1mm sq feet ) for a total owned R/E value of ~$3BN.  Given that most of JWN’s leased stores have been built prior to 2000 (many from the 1970s and 1980s) and many of which are under long term leases, you can reasonably assume a fair market re-rental rate of $2-4 per square foot (ie. the leases psf that JWN pays can likely be re-leased at $2- $4 psf more and likely higher) at a 7% cap rate equates to another $200-$400MM of below market lease real estate value for a total R/E value of~ $3.4MM.  Total R/E value makes up about 41% of JWN’s current market cap and 33% of EV.

Looking 5 years out, you can see the limited downside (and vast potential upside)  when you consider that of the current $8.35BN market cap, $4.0BN may be ‘taken out’ through repurchases (assuming current stock prices), real estate value will have increased (through new store openings) by $1.1BN+, and  you would be effectively owning a company (assuming today’s stock price ) with a market cap of $4.35BN, which owns ~ $4.5BN worth of real estate, and generated after-tax earnings of over $1BN by 2012).  Of course not all share repurchases will be executed at today’s market prices, however it illustrates that the current share price level relative to the cash flow generating ability and projected real estate value makes little sense.

Projections/DCF analysis:

Below are the assumptions for how I get to an intrinsic value per share of $75-$80+.

Revenue growth:  5% square footage growth for next 5 years + average comp of 2% per year (much lower vs. past 5 years of mid-high single digits) for total average revenue growth of 7%.  All square footage growth can be internally funded with cash flow.

Margins: No improvement in gross margins (management assumes modest improvement over time), remaining at about 41% of sales.  SG&A margins expected to improve to 26% by 2012 from ~27% currently (in line w/ mgmt’ projections) as larger store base will result in better leverageing fixed expenses (particularly in Corp, G&A, overhead, distribution). 

Interest rates & Taxes:  Similar to historical levels.

Share repurchases of $750-$800MM per year at assumed prices of $40-$60 per share over next 5 years.  Share repurchases assumed to be funded with debt (beyond 2009) so as to maintain the company’s debt/EBITDA ratio at 2.0x

Result:  EPS grows from approximately $2.96 per share in FY08 to $5.25/share in 2012. Applying a 17.0x multiple (avg. 15 year historical multiple of JWNs earnings, and in line/below other comparable growth retailers seen today) on $5.25 of earnings = $90 per share.  Discounting this at 10% yields a valuation of $76/share.  Assuming a 9% discount rate (not unreasonable given that JWN’s 30 year bonds trade at a yield of  7% + 200 bps = 9%) = $80/share.

Assume the above, with a 15x terminal multiple (same as long-term S&P 500 multiple, even  hough JWN’s top line growth will likely exceed that of the S&P given the relative under-penetration of the concept) at a 10% discount rate, intrinsic value/share = $69.

Sensitivities & Upside/Downside analysis:

1) Greater comp growth:  Assumed long-term comp store growth of 4% , which is lower vs. recent history of mid-high single digits and higher vs. original assumption of 2% combined w/ planned 5% square footage growth = $85 at 10% discount rate.

2)  Recession case:  With strong evidence that we may be headed into a recession in FY08-FY09, JWN would unlikely be completely immune despite its focus on higher  income customers who theoretically would feel less pinched by a recession in comparison to the customer bases of JWN’s other retail peers.  There is the counter-argument, however that since JWN focuses more on “affordable luxury” vs. the higher-end luxury chains Saks, Neiman, and Barney’s (incomes over $200-$250k), it will still be susceptible to a cash-strapped (and less wealthy with the popping of the R/E bubble) customer. 

While recessions don’t last forever (and JWN has survived many of them) if sales/margins become more strained, earnings/cash flow will be lower and the company will likely repurchase fewer shares, all of whichwhich will affect intrinsic value (particularly the ‘near term’ cash flows discounted to the present).  For companies like JWN who have solid balance sheets, are able to properly manage inventories, and continue to expand market share during a downturn may actually emerge from a recession even stronger.  Nonetheless, it is still worthwhile to look downside 2 year “recession case” on the intrinsic value calculation with the following  assumptions:

 

--Comps decline by 2% in FY08 and 4% in 09 for 2 year comp decline of 6% (worst comps JWN has had in past recession was down ~3%).  Company still has enough internally generated funds to expand its square footage by at least 4% per year  (vs. 5% initially assumed), which would effectively offset the negative comps (ie. overall sales revenue would be flat).

--Gross margins contract by 100- 200 bps on heavier discounting (worse than prior downturns)

--SG&A as % of sales remain flat as 45% of SG&A expense are salespeople commissions.

--Inventory days on hand increase by 8% as sales slow (reduces operating and free cash flow).

--SG&A margins stay the same at ~27% as 45% of  SG&A expense consists of sales commissions

--Income generated from the credit card portfolio currently $250MM per year) is reduced to by 50% over a 2 yr time frame because of charge-offs (pretty draconian assumption as JWN has never witnessed such charge-offs in prior downturns).

-- Beginning in 2010, prior assumptions regarding the company’s top line growth growth, margin expansion, share repurchase activity, and leverage remain intact.

 

Result:  EPS in 2008 declines by 25% to $2.30/are, FY09 EPS goes down to $2.25/share and recovers to $4.50/share in 2012.  Applying a 10% discount rate with a terminal multiple (2012) of 17, yields a price of $65/share (nearly 2x the current price). 

 

 

Risks:

 

--Consumer led recession could stall top line growth, reducing cash flow and amount for share repurchases.

--Real-estate wealth effect may have disproportionately boosted sales of “affordable luxury” items—however, the sale of branded items in all categories (an initiative that JWN has been expanding) has never been stronger (as seen in the 3Q results), and JWN’s move to carry more designer/branded items should capitalize on long-term trends of higher income consumers moving up the quality spectrum.

--Exposure to Nordstrom card and Co-branded VISA card receivables quality.  Company as recently seen an increase in delinquency rates, which are currently 2.4% and above the ~2% long-term average.  Nonetheless, this is still below the rates seen in the rest of the industry currently and are also consistent with the rates that JWN experienced prior to the bankruptcy law change in 2005.  Management has expressed confidence in the quality of the portfolio, as over 90% of JWN credit card spending is done by prime or super-prime customers.  Also, ~50% of the credit card portfolio pays in full every month, as customers mostly use Nordstrom card for convenience and benefits (i.e. the fashion rewards program).  The credit card receivables are secured by debt and are well capitalized on a stand-alone basis  ($430MM equity cushion on $1.6BN in receivables or 25%) and historically during past recessions, the portfolio has far outperformed industry averages considering the prime/super prime nature of the customer base.