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Nordstrom, Inc. (NYSE:JWN)

F3Q08 Earnings Call

November 13, 2008 4:30 pm ET

Executives

Chris Holloway - Director, Investor Relations

Blake W. Nordstrom - President, Director

Michael G. Koppel - Chief Financial Officer, Executive Vice President

Erik B. Nordstrom - Executive Vice President, President - Stores, Director

Peter E. Nordstrom - Executive Vice President and President - Merchandising, Director

Analysts

Neely J.N. Tamminga - Piper Jaffray

Deborah Weinswig - Citigroup

Dana Cohen - Banc of America Securities

Lorraine Maikis - Merrill Lynch

Michelle Clark - Morgan Stanley

Richard Jaffe - Stifel Nicolaus

Operator

Hello and welcome to the Nordstrom third quarter 2008 conference call. At the request of Nordstrom, today’s conference call is being recorded. (Operator Instructions) I will now introduce Chris Holloway, Director of Investor Relations for Nordstrom. You may begin, sir.

Chris Holloway

Thank you. Good afternoon, everyone and thank you for joining us on the call. Today’s call will last approximately 30 minutes, which includes time for questions and answers. Before we begin, let me remind everyone that today’s discussion will contain forward-looking statements which are subject to risks and uncertainties that could cause the company’s actual results to differ materially from the expectations and assumptions discussed due to a variety of factors that affect the company, including the risks specified in the company’s most recently filed Form 10-K and Form 10-Q.

Here to discuss Nordstrom's strategy, third quarter performance, and business outlook are Blake Nordstrom, President of Nordstrom Inc.; and Mike Koppel, Executive Vice President and Chief Financial Officer. Also joining us for Q&A are Pete Nordstrom, President of Merchandising, and Erik Nordstrom, President of Stores. Blake is joining us from San Francisco and will begin the call. Blake.

Blake W. Nordstrom

Good afternoon and welcome, everyone. Today I would like to spend a few minutes sharing what we are hearing from our customers and what we are doing to better serve them in these challenging times. Mike will then review our most recent quarter and outline the steps we are taking to ensure that our business model, which is built on strong store productivity, a highly variable expense model, and a conservatively managed balance sheet remain strong.

We are in unprecedented times and customers are lacking confidence today. We saw this clearly in mid-September when the financial markets became extremely stressed. We are still focused on the same loyal Nordstrom core customer but many have different needs than they did last year. They are shopping less and are making more deliberate purchases. They still desire quality, fashion, and newness but value is more important than it has been in a number of years.

We believe that one of our strengths is our relatively broad appeal and the inclusive nature of our service experience and merchandise offering. Because of this, we can adapt to the evolving needs of customers without changing who we are. Let me give you a few examples of what we are doing to adapt and serve customers more effectively right now.

We are very focused on the balance of our inventory assortment. Our merchant teams have the tools and information to analyze our business category by category and to determine where the sweet spots are for price and value. By this we mean the price we own merchandise at versus the price sold. We are working hard to rebalance inventories to where the most demand exists. The sweet spot isn't necessarily about opening price points -- it’s about delivering quality, fashion, and newness but at the right price that creates a compelling value.

We are also working to sharpen prices across the store. In addition to what we can do with our own private label merchandise, our vendor partners are motivated to stimulate sales as well and we are passing those savings on to customers. For example, we have lowered average regular price by an average of 22% on over 800 styles. We have always maintained a robust regular price business and we want to make sure we have the right price on merchandise up-front, rather than take markdowns to clear merchandise. In many cases, this requires that we take lower mark-ups, which we have and will continue to do.

We believe that trust and confidence in pricing is critical to building long-term relationships with customers. One example of this commitment is our policy of never being undersold. We proactively monitor the market to make sure we have the best pricing on like items and we will also honor the price of the competitor if the customer brings it to our attention. This means it adds to our mark-downs but it is necessary to maintain our customers’ trust and loyalty.

We have made changes beyond merchandise, including our decision to aggressively use our Nordstrom rewards program to encourage customers to shop with us. On October 24th, we began offering double points and we will continue this offer through the end of the year. We held a triple rewards event in September to encourage shopping at the beginning of the fall season. Though the current financial crisis was just beginning, the response was very positive. Overall we believe our rewards program deepens the connection we have with our customers and adds significant value to their overall experience while allowing us to maintain the integrity of our pricing.

We are in a strong financial position and if we stay focused on the core aspects of our business -- people, product, value, and service -- we have a chance to enhance our reputation with customers. If we execute well, we believe we will gain market share in this environment and continue to position us well for the future.

Now I will turn the call over to Mike for a review of the third quarter and the actions we have taken to ensure the strength of our business model in this challenging economic cycle.

Michael G. Koppel

Thanks, Blake and good afternoon, everyone. Today I will review our third quarter results, provide an update on the company’s overall financial position, and share the steps we are taking to ensure that the company has positive free cash flow and a strong balance sheet through this difficult economic cycle. I will conclude with an update to our 2008 full-year outlook and then open the call up to your questions.

Third quarter earnings per diluted share were $0.33, a 51% decrease from $0.68 per share in the same period last year. We have a few non-comparable items that impact the comparison of our results. Remember last year’s third quarter results included a $0.09 gain from the sale of our Façonnable business. This year we have two non-comparable items that increased earnings per share by a total of $0.03. First, we have a $0.06 positive adjustment to income tax expense primarily driven by the closure of several tax years under audit. Second, we have a one-time adjustment to our sales return reserve that negatively impacted sales by $19 million and earnings per share by approximately $0.03. Our third quarter earnings outlook did not include these items because they were not part of our view of ongoing operations.

Total sales declined 8.4% to $1.8 billion and same-store sales declined 11.1%. Overall results in full-line stores continued to be challenging as same-store sales decreased 15.6% in the quarter. Our strongest relative regional performances in the full-line stores were in the northwest, South, and Midwest, and our best-performing merchandise divisions were cosmetics and junior women’s apparel.

Nordstrom Rack continued its positive sales growth, outperforming its off-price competition with the same-store sales increase of 3.6%. Sales for our direct segment, which includes our online business, increased 8.5%.

The combination of lower sales and higher mark-down rates resulted in our gross profit rate decreasing 332 basis points to 34.3%. Buy-in and occupancy costs are approximately one-third of the gross profit rate decline as these are relatively fixed costs. The remaining variance was driven by a decrease in merchandise margins as we responded to slower sales trends and the competitive environment with increased markdowns. We ended the quarter with inventory per square foot 3% below last year.

SG&A expenses increased $14 million to $567 million and our rate increased 336 basis points to 31.4%. We continue to be focused on rigorously controlling costs which offset $20 million in expenses from new stores and a $29 million increase in bad debt expense. During the quarter, we increased our bad debt reserve in anticipation of a weaker economy and higher unemployment rates. We ended the third quarter with a total delinquency rate of 3.2% and net charge-offs of 5.7%, which continue to be some of the lowest delinquency and write-off rates in the credit card industry.

Finance charges and other income increased $5 million, with 11% growth in receivables offsetting lower interest rates. Net interest expense of $33 million was $13 million higher than last year due to changes in our capital structure made in the fourth quarter of last year.

With the increased attention on the credit markets and company balance sheets, I wanted to spend a few minutes in discussing our overall financial position. We are currently at the peak seasonal borrowing period and ended the quarter with cash of $68 million and short-term borrowings of $252 million. Despite the strain in the credit markets, we recently increased our short-term borrowing capacity by $150 million. In total, we have $950 million of short-term borrowing capacity and expect borrowings to be minimal at year-end.

Looking at long-term debt, we have $250 million coming due in January 2009 and no additional maturities until a $350 million note expires in April of 2010.

We are monitoring the bond markets and believe we could access them today but the terms and rates are unattractive. If the bond markets continue to be challenging, we would expect to use free cash flow and a portion of our $950 million in short-term borrowing capacity to repay the $250 million note and we will continue to monitor the long-term debt markets.

In terms of total debt levels, we ended the third quarter with an adjusted debt-to-EBITDA ratio of 2.3 times, which is higher than our target of 2 times. This amount of leverage, while above our target, is relatively low for the industry and still supports our strong investment grade credit rating.

Overall, we remain well-positioned with industry-leading profitability margins, return on invested capital that continues to exceed our cost of capital, and a conservatively managed balance sheet.

These are unprecedented times, however, and we feel it is appropriate to take additional steps to ensure positive free cash flow and retain the company’s strong credit profile. First, we suspended our share repurchase program during the third quarter and may not resume the program until economic conditions improve. Second, we have reduced our net capital expenditures to approximately $350 million in 2009 from our plan of approximately $560 million. We had three full-line store projects originally scheduled to open in 2009 be delayed by developers and expect to experience more delays and changes to our new store opening plans. We now expect to relocate one full-line store and open three new full-line stores in 2009, and open four to five new full-line stores in 2010. This is reduced from the 12 new stores we originally planned to open over those two years.

In addition, we are taking a more conservative approach to remodels over the next two to three years. We typically undertake five to six major remodels a year in which we touch every part of the store. We will reduce major remodels to approximately two per year until economic conditions improve. We have not reduced maintenance capital expenditures, however, and we will continue to keep our stores well-maintained and a source of competitive differentiation.

Over the next five years, these changes will result in a CapEx plan of approximately $2.5 billion, which is down from the $3 billion plan we shared at this time last year. There may be additional changes to this plan due to either economic conditions or changes in the real estate development environment.

In addition to reductions in capital expenditures, we continue to focus on improving our profitability. Our variable expense model adjusts to slower sales trends but we have also been focused on finding additional efficiencies in other aspects of our business. The savings we will capture in 2008 will exceed $100 million and we are focused on capturing similar levels of profit opportunities in 2009. The changes I have outline today will enable the company to generate positive free cash flow in 2009 even if same-store sales are similar to 2008 levels.

Turning to our outlook for the remainder of 2008, we expect the current tough economic conditions to continue. Our fourth quarter plan assumes that same-store sales decrease 13% to 16%, yielding an earnings per share for the fourth quarter of $0.35 to $0.45.

In closing, we are focused on offering more compelling service, quality, fashion, and value to our customers and are taking steps to maximize cash flow and to preserve the company’s strong financial profile. We are in a strong position relative to the competition and are confident we have the flexibility to make additional adjustments to manage through this very difficult economic cycle.

Now I would like to turn it over to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question today is from Neely Tamminga from Piper Jaffray.

Neely J.N. Tamminga - Piper Jaffray

Good afternoon, gentlemen. Just two things here -- one is on your direct business. Can you talk about any potential trend you may be seeing in terms of returns? Can you actually track direct returns into the store? Are you seeing maybe a higher level of buyer’s remorse broadly? Is that something new this fall?

And then just a point of clarification -- the December 7 triple rewards that you guys have on deck, is that incremental over last year? Thanks.

Michael G. Koppel

First as far as the direct business, we do track all activities between both channels, direct and the stores, and know the return levels. I would say overall in the company both in the stores and direct, we have seen an increase in return levels.

In terms of the second part of your question on the triple rewards, first to clarify -- the double points that we added at the end of September through the end of the year, that is in addition over and above what we did last year but the event -- I’m sorry, end of October through the end of the year -- but the event that we are having, our normal events are comparable to last year.

Neely J.N. Tamminga - Piper Jaffray

The triple rewards, Mike?

Michael G. Koppel

Yes.

Neely J.N. Tamminga - Piper Jaffray

Okay, thanks.

Operator

Thank you. Our next question is from Deborah Weinswig from Citi.

Deborah Weinswig - Citigroup

Good evening. Actually following up with regard to the additional marketing events, how should we think about planning of the marketing calendar for 2009, especially in light of the fact that the competition has been so aggressive?

Erik B. Nordstrom

The changes that we have made so far has been with our rewards program. We have some enhanced -- that’s the triple rewards twice a year and those have been very successful for us. We’re in double points right now. That’s -- we are not planning on repeating that for next year but it is something that we can roll out pretty quickly if need be, and clearly these are uncertain times and we need to be responsive to what is going on and we will do that. But right now, the plans, the only additional marketing events we have are the two triple rewards points.

Deborah Weinswig - Citigroup

Okay, and then with regard to the specifics around the store openings in 2009 and 2010, should we assume that the 5 down to 3 and the 8 down to 4 to 5, how many of those stores have been kind of permanently put off versus just delayed into the out years?

Erik B. Nordstrom

We haven’t announced any of those yet but we are still in pretty constant conversations with our developers and as you can imagine, their plans are changing pretty rapidly so we don’t have anything to announce on that yet. We are confident that at least a number of stores will slide but it’s safe to assume that some of those, a portion of those will go away.

Blake W. Nordstrom

Deb, as we understand clearly exactly what is going to happen on a store-by-store basis, we will share that.

Deborah Weinswig - Citigroup

Okay, very helpful and then last question with regard to the significant out-performance of the Rack division, can you maybe go through some of the initiatives, et cetera, that are working there to drive that performance?

Peter E. Nordstrom

I’ll take that -- our focus for the last several years has really been trying to leverage the kind of brands that customers would expect to see in a full line store and offer it at a discounted environment, and we’ve got great vendor relationships, so we are able to get their distressed goods and sell it there on the racks. And when we made that transition to really the type of brands you would see in the full line stores is when our business really started to improve. So it’s driven largely by our ability to be able to buy these clearance distressed goods from the vendor directly, and then we also are trying to move merchandise through our full line stores as quickly as possible, and having to keep our inventories fresh in the full line, you know, they’ve got a good supply of goods coming from that channel as well.

Deborah Weinswig - Citigroup

Okay, great. Well, best of luck.

Operator

Thank you. Our next question is from Dana Cohen from Banc of America Securities.

Dana Cohen - Banc of America Securities

Just a couple of questions -- in terms of bringing down these prices through lower IMU, how do you convey that to the customer just to convey the value, which seems very different than the way you would normally convey it?

Second, can you just talk a little bit more in terms of any new information that you might have on the card as to whether you think you are adequately reserved at this point, and three if you could just talk a little bit more about the expense initiatives. Thanks.

Peter E. Nordstrom

So in terms of bringing the prices down and how we are communicating that, we have a few different ways. In some cases, the price has just been changed and our experience is the customers are smart, they are savvy, and they know what they are looking for and they can recognize a good value on a good item and we have been able to lower the mark-up on some items that were really outstanding sellers for us in the first place, and one of the examples, we have a [tissue eight] cashmere scarf, just as an example. It’s been a great ongoing item for us and we were able to significantly lower the mark-up on that and increase the value and it didn’t require a big campaign. I mean, it sold and the big part of that is our sales people recognize it as a good thing and as we like to call it, it’s a great conversation starter with the customers to say hey, did you know we had this. So we are trying to do it in the most organic ways possible.

There are some places where we have some black line prices and there is some signing that goes with that but most of it is making sure our sales people are well-informed as to what is going on to give them some great talking points to the customers.

Michael G. Koppel

I’ll take those other two questions. The first one on the card and how we feel about the reserve levels, we had booked additional levels to our reserve at the end of Q3 and in the guidance we share for Q4, it also contemplates increased levels as well. It’s very clear that we know over time that the write-offs trend pretty consistently with expectations over unemployment and based on some of the more recent news that we are reading like everybody else is, we felt it was appropriate to include in our Q4 outlook addition to that provision. So we continue to learn like everybody else but on a month-to-month, quarter-to-quarter basis, we believe we are reserved appropriately.

In terms of expenses, I will just frame the expense in the sense that if you look at where we finished and where we are going to finish in 2008, our sales per square foot is going to come down in roughly the $350 per square foot range, which is probably around where we were roughly 2004. What we have been trying to do as a company and overall is to right-size the business based on those levels of productivity. Ours is a model that is definitely driven by productivity on a sales per square foot basis and so we have been going back and adjusting our investments and our expenses to align with those levels of business and I think that’s been pretty consistent in 2008 and when we come in February to talk to you about our plans for 2009, we will share more specifics on that at that time.

Dana Cohen - Banc of America Securities

But you are talking $100 million at this point?

Michael G. Koppel

For 2008 -- and yes, once again for 2009.

Dana Cohen - Banc of America Securities

Okay, great. Thank you.

Operator

Thank you. Our next question is from Jennifer Black from Jennifer Black and Associates.

Jennifer Black - Jennifer Black & Associates

Good afternoon. I wondered if you could first talk about with business being tough, do you feel that your FTEs are in alignment with your business strategies? I know that you are working on your expenses but if you could elaborate, that would be great.

Erik B. Nordstrom

The quick answer is yes, our FTEs are aligned and really have been aligned all year. This has been a tough year but I think our expense management has been one of the positives and of our stores out there, our biggest grouping of employees are our sales people and our selling costs have been well-managed throughout this year and even as the top line has been very unstable, our stores have the discipline and the tools to adjust their staffing really naturally to the flow of business, so we are in good shape on FTEs.

Jennifer Black - Jennifer Black & Associates

Okay, great and then I wondered how you are ensuring your customer service will be at the top. I know that’s your number one goal. What kind of coaching are you giving your employees at this time?

Erik B. Nordstrom

I think that actually is a good follow-up to your first question because in having fewer FTEs, it’s really not -- I don’t think it’s so much an expense subject as a service subject. We rank all of our sales people based on their capabilities, their performance and we need to ensure we have our best people here as much as possible. We need to be an employer of choice for great sales people, the people that provide the best service to our customers.

So part of -- well, none of this is really positive -- part of the up-side of this we have -- we have better people in our stores and one of the positives, the productivity of our sales people is about even with what it was last year. Our average sales person is making about as much as they made last year and that’s important for us again to be an employer of choice for great sales people.

Jennifer Black - Jennifer Black & Associates

Okay, great. And then lastly, we’ve seen that bank cards are raising rates with delinquency rates going up. Will you be raising your rates on your credit cards? Can you just speak to that?

Michael G. Koppel

Well, as a matter of fact, we had a mailing that went out at the end of October that communicated to our card holders that we were raising the ATRs. That increase is effective November 15th and we should see that start to flow through to our results some time toward the middle of December and beyond.

Jennifer Black - Jennifer Black & Associates

Okay. Thank you very much and good luck.

Operator

Thank you. Our next question is from Lorraine Maikis from Merrill Lynch.

Lorraine Maikis - Merrill Lynch

Thank you. Good afternoon. Can you talk about inventory for a minute, how you are planning your ’09 receipts and also just touch on if there is any opportunity to adjust these levels to reflect the current environment?

Peter E. Nordstrom

We’ve really been working hard for the last couple of years to reconcile our inventory levels with our sales trends and we’ve got a pretty good process to be able to do that. When you have some precipitous drops like we had a couple of months back, it’s difficult to get caught up on that because a lot of what we are buying we are buying so far in advance but once things settle down, and at least they have settled down in terms of they are a little more consistent, we are able to manage that pretty well. I think that the challenge for us gets to be if we are running mid-teen type double-digit comps or worse, then you start to run into this place where we want to make sure we have at least a good minimum representation of merchandise on the floor, so we don’t just use the sales as an indicator of how much inventory we sell. We also have the ability to look at the units that we own and contrast that over previous years per square foot and everything, so we have some view around what a minimum standard would be and we are able to actually manage that by store and by department and we don’t do it perfectly but it is something that we are aware of and working on. So we think we’ve got a chance, much like Erik talked about with the variable expense manage around selling costs and with people, we got a chance to do that in inventory as well as long as we stay on top of it.

Lorraine Maikis - Merrill Lynch

But are you planning ’09 down at this point?

Peter E. Nordstrom

Yes.

Lorraine Maikis - Merrill Lynch

Okay, thanks.

Operator

Thank you. Our next question is from Michelle Clark from Morgan Stanley.

Michelle Clark - Morgan Stanley

Good afternoon. In the press release you detail for fiscal year 2008 outlook a finance charge increase of $30 million to $40 million. I was just wondering what your assumption is on net charge-offs and delinquency rates in the fourth quarter to get to that number.

Michael G. Koppel

We haven’t broken out specifically before what our assumptions are within that but what I alluded to earlier is that we had made adjustments -- we are going to make adjustments to our provision. We included it in the outlook and it is based on pretty much what we are reading in terms of unemployment expectation.

I will tell you a way to think about it is for every roughly 1% change in charge-offs that we book, it’s roughly $0.03 to $0.04 to the company, so that’s a way to think about it as you see us change it.

Chris Holloway

Just one clarifying point -- bad debt expense doesn’t hit that line item. It hits SG&A. The finance charge line item is just gross revenue.

Michelle Clark - Morgan Stanley

Got it. And then one last question -- any change in strategy? We had heard that you are pulling back on your receivables growth. Is there any truth to that?

Michael G. Koppel

Well, the story is that we continue to work to mitigate any additional risk that we don’t want to take on in that portfolio, so the answer is that we are monitoring on an account-by-account basis people’s credit history and their current experience as it relates to mortgage payments and other such liabilities, and as a result we are able to adjust how we assign risk to each individual account. So the answer is if it does result in some slowness of growth in more high-risk accounts, yes we are. But we are still committed to funding our continued loyal and good customers who are shopping with us, as well as those that maintain good credit scores.

Michelle Clark - Morgan Stanley

Great. Thank you.

Operator

Thank you. Our final question is from Richard Jaffe from Stifel Nicolaus.

Richard Jaffe - Stifel Nicolaus

Thanks very much, guys and I guess a question about comments you made with sharpening the prices, offering greater value to the consumer and I guess importantly, partnering with your vendors to make this possible -- one, work on shorter margins and two, I guess [had their co-operation] financially. Could you give us some sense of how that plays out in terms of what we should expect in reported gross margin or the merchandise component of that and how pervasive it will be throughout the store in terms of more value focus across the product line?

Peter E. Nordstrom

Virtually every department we have has some version of a value initiative that they’ve got in terms of whether it’s lowering the mark-up or work on the vendor, just lower the price. I mean, there’s no question that’s going to impact our margins to a certain point but the biggest thing is the deleverage we get from having the top line erode a lot, so I guess the question is for us is how do we want to do it. We think to maintain pricing integrity and have an honest relationship with the customer that way that we are better off trying to get the price right from the start, rather than try to have a kind of a sale, high/low thing going on and running extra promotions. Now, we have to respond competitively to what is going on out there and you guys obviously see what a lot of our competitors do with their price promotions and we are meeting those things but what we are choosing to do with the stuff that we have total control over is try to just create the price that it will sell at initially and so I think ultimately, we hope to mitigate some mark-down exposure but it is going to clearly show up in the mark-up, initial mark-up, so that would affect our margins.

Richard Jaffe - Stifel Nicolaus

Sure. Thank you.

Chris Holloway

We’d like to thank everyone for joining us today for our third quarter earnings call. As a reminder, a replay of this call will be available on the investor relations section of Nordstrom.com under webcasts. Thank you for your time and your interest in Nordstrom.

Operator

Thank you. That does conclude today’s conference. You may disconnect at this time.

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