Nordstrom's Shrinking Margins Spell Trouble For The Stock

Jun. 25, 2015 9:57 AM ETNordstrom, Inc. (JWN)2 Comments

Summary

  • JWN has shown great progress in growing the top line.
  • But margins continue to shrink as pricing is weak and costs are out of control.
  • I think the stock should trade for 14 times earnings, or $58.

High end retailer Nordstrom (NYSE:JWN) has seen its stock well off of its highs set earlier this year. The company has enjoyed a premium valuation and a strong uptrend since the stock took off from the $60 area early last year but at least for the moment, it appears that uptrend may be coming to an end. Back in January I said the stock looked expensive at $78 but of course, it subsequently rose to more than $82 before pulling back. With shares now below $76 but rallying, is now the time to jump into JWN or is there potentially more selling ahead? In this article I'll take a fresh look at JWN's valuation to see if I still think the stock is expensive.

To do this I'll use a DCF-type model you can read more about here. The model uses several inputs including earnings estimates, which I've borrowed from Yahoo!, dividends, which I've set to grow at 8% annually, and a discount rate, which I've set at the 5 year Treasury rate plus a risk premium of 7%.

2014

2015

2016

2017

2018

2019

2020

Earnings Forecast

Prior Year earnings per share

$3.72

$3.75

$4.14

$4.44

$4.77

$5.11

x(1+Forecasted earnings growth)

0.80%

10.40%

7.30%

7.30%

7.30%

7.30%

=Forecasted earnings per share

$3.75

$4.14

$4.44

$4.77

$5.11

$5.49

Equity Book Value Forecasts

Equity book value at beginning of year

$11.96

$14.23

$16.77

$19.49

$22.39

$25.49

Earnings per share

$3.75

$4.14

$4.44

$4.77

$5.11

$5.49

-Dividends per share

$1.48

$1.60

$1.73

$1.86

$2.01

$2.17

=Equity book value at EOY

$11.96

$14.23

$16.77

$19.49

$22.39

$25.49

$28.80

Abnormal earnings

Equity book value at begin of year

$11.96

$14.23

$16.77

$19.49

$22.39

$25.49

x Equity cost of capital

8.67%

8.67%

8.67%

8.67%

8.67%

8.67%

8.67%

=Normal earnings

$1.04

$1.23

$1.45

$1.69

$1.94

$2.21

Forecasted EPS

$3.75

$4.14

$4.44

$4.77

$5.11

$5.49

-Normal earnings

$1.04

$1.23

$1.45

$1.69

$1.94

$2.21

=Abnormal earnings

$2.71

$2.91

$2.99

$3.08

$3.17

$3.28

Valuation

Future abnormal earnings

$2.71

$2.91

$2.99

$3.08

$3.17

$3.28

x discount factor(0.0867)

0.920

0.847

0.779

0.717

0.660

0.607

=Abnormal earnings disc to present

$2.50

$2.46

$2.33

$2.21

$2.09

$1.99

Abnormal earnings in year +6

$3.28

Assumed long-term growth rate

3.00%

Value of terminal year

$57.81

Estimated share price

Sum of discounted AE over horizon

$11.59

+PV of terminal year AE

$35.10

=PV of all AE

$46.69

+Current equity book value

$11.96

=Estimated current share price

$58.65

We can see the model is still very bearish with the fair value coming in at $59, a long way down from the current $75 price tag of shares. That would imply we've still got some selling to do but let's take a look at the fundamentals to see if they agree.

The two things I built my bearish case upon in January were JWN's contracting revenue growth and margins. Obviously revenue growth and margins are everything in retail as growth or contraction in those numbers has an outsized effect on earnings growth potential. JWN's recent history suggested to me that its earnings multiple was unjustified and thus, the stock looked expensive.

If we fast forward to today we've received more information on each of these metrics and we'll start with revenue growth. Nordstrom reported earnings in May and on the revenue front, things are looking up. Total revenue growth came in at just under 10% which is better than JWN's recent history growing the top line. The number was helped by online sales' strong growth and by a robust 4.4% comp sales increase. That was surely a great comp number and it has helped fuel investor optimism regarding JWN. For the year JWN suggested total revenue growth of 7% to 9%, below the level of Q1 but still decent growth that would be roughly comparable to last year's number.

With online sales booming and the popularity of the Nordstrom Rack concept in concert with strong comp sales at existing stores, it would seem JWN's revenue outlook has improved since I last looked in January. To its credit, it seems JWN has taken care of one of the reasons why I thought the stock was expensive.

On the margin side, however, it appears there is still much work to be done. The way that I like to look at a retailer's operating profits is to simply compare gross margins to the company's SG&A costs. These two numbers contain the vast majority of the costs of running a retail operating (people and product) and thus, give us a clear picture of operating profit trends. I've charted the spread between these two numbers for Nordstrom for the past decade below.

We can see that after margins were crimped during the recession - a condition virtually every retailer experienced - pricing power took over as sales rebounded until 2010. After that time, however, JWN has struggled with operating margins. In recent years both ends of the spread - gross margins and SG&A - have moved unfavorably. That has conspired to shrink the spread over time as each value slowly erodes the company's profitability.

In fact, we saw this trend continue in Q1 as gross margins were essentially flat but SG&A moved up significantly to further erode the company's operating margins. It appears investors are focused solely on Nordstrom's ability to grow the top line at the expense of margins but that is a dangerous game to play.

The problem I have with Nordstrom's valuation - 18.3 times forward earnings - is that its growth rate doesn't come close to justifying it. I'll concede that JWN's revenue growth has reignited and that will certainly be a huge positive going forward but JWN's expenses are out of control. The company's operating margins are average at best and continue to fall each year as SG&A rises and gross margins are flat to down. This is not a sustainable cycle for any company and if JWN is to grow into its valuation, it will have to find a way to boost margins and/or shrink SG&A's share of revenue.

I haven't seen anything but more losses in margins from Nordstrom so for that reason, I'm sticking with my bearish call. Revenue growth is one piece of the puzzle but JWN has shown zero ability to control costs and that will keep a lid on EPS growth going forward. I think investors are enamored with Rack's growth potential and that's fine but if it is at the expense of profits, the cost is too high. I still think JWN should trade for more like 14 times earnings which would see the stock around $58, right where the model projected its current fair value. JWN's margins simply don't justify a premium multiple and at some point, the situation has to be rectified.

This article was written by

Josh Arnold profile picture
22K Followers
Author of Timely Trader
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I've been covering financial markets for ten years, using a combination of technical and fundamental analysis to identify potential winners (and losers) early, particularly when it comes to growth stocks.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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