Going Private Possible for Nordstrom

We are not surprised by this news, as we have held that narrow-moat Nordstrom is better positioned than its no-moat peers, with a better-sized and -located store base (353 stores at the end of the first quarter versus Macy’s M 668), exposure to the growing off-price sector (about 30% of revenue is driven by Nordstrom Rack), curated offerings that differentiate it from e-commerce competitors, and reputation for customer experience excellence.

Therefore, we can understand how the family views the company as having underappreciated value in the market; we note that our $53 fair value estimate--based on the assumption for 3.6% average annual revenue growth over the next five years and adjusted operating margin remaining at 6%-7%--is still above the current price even after the stock's move. Furthermore, we think the family could use time outside public scrutiny to invest in growth areas like Nordstrom Rack and better position the full-line business.

Although no proposal has been made yet, the board of directors has formed a special committee consisting of the independent directors to act on behalf of the company and has retained a financial advisor and legal counsel. We believe these are the appropriate steps to protect shareholder interest. We are refraining from determining whether such a deal is favorable to shareholders as the family has not released any details regarding potential terms of a transaction. If necessary, though, we believe the balance sheet could support additional leverage, with current net debt sitting at about 1 times adjusted EBITDA. We continue to believe the market is undervaluing the business.

Investing for Success In our opinion, Nordstrom is one of the best operators in the department store space, having developed a differentiated curated product offering and managed store count and location to match its niche consumer base. The company has invested in advanced omnichannel capabilities and used an owned off-price channel to maintain full-priced sell-through at namesake stores, while catering to a younger customer base. Although investments have been high, with capital expenditure climbing from an average of 4% of sales in 2009-12 to more than 7% in 2015, we think store improvement, expansion, and IT spending has been wise and will begin to scale down (capital expenditure was already less than 6% of sales in 2016). We believe this economic profitability is sustainable.

We think the firm can achieve mid-single-digit revenue growth (albeit decelerating from the almost 6% last-three-year average) through further rollout of Nordstrom Rack stores, increasing from 215 in 2016 to just under 300 by 2021; new product lines, including Madewell and TopShop, at full-line stores; expansion of the rewards program, which boasts 4 times as many trips and 5 times as much spending, with about 45% of sales to loyalty customers; and e-commerce penetration increasing from about 22% in 2016 to 28% in 2021. We think the shift to the lower-margin e-commerce channel will pressure the margin, and we do not expect it to recover to its previous high levels. In the long term, we expect selling, general, and administrative expenses to scale, and we see expense-reduction programs adding additional upside through a focus on fulfillment, tech, and marketing expenses. However, we do not see this fully offsetting the shift to e-commerce.

Brand Has Significant Pricing Power We are maintaining our narrow moat rating, as we believe that investments in store expansion and e-commerce initiatives will continue to support Nordstrom's brand intangible asset, resulting in adjusted returns on invested capital north of its cost of capital. We expect adjusted ROIC to average in the high teens during the next five years, versus an 8% cost of capital assumption. We assign a moat rating of narrow instead of wide as we believe some of the company's consistently high returns on capital are because of its management, culture, merchandising, and systems. In our view, these are important value drivers, but are less strong and defensible than structural competitive advantages such as being the lowest-cost producer.

In our opinion, Nordstrom has built a brand worthy of significant pricing power through a best-in-class service model, localized curated product selection, and advanced omnichannel capabilities. Evidence of brand power is featured in Nordstrom’s 3% average annual comparable sales growth over the past five years versus Macy’s 1% comp sales growth and Kohl’s KSS 1% decline. This is despite continued overall U.S. department store retail market share declines (from 5.2% of retail sales in 2010 to 3.2% in 2016). We think much of this results from a curated and differentiated product selection, featuring partnerships such as TopShop and Madewell, as well as the dual full-price and off-price offering.

Most notably, Nordstrom has been able to maintain its price points and reputation for superior service and in-store experience despite its aggressive rollout of off-price Nordstrom Rack. Successful balance and differentiation of the two brands has enabled Nordstrom to take advantage of the high-growth off-price retail space without cannibalizing its core business. Nordstrom Rack is an important source of new customers, adding more than 5 million shoppers in 2015. We believe this channel has been a rich source of younger purchasers. It has also allowed Nordstrom to maintain industry-leading inventory turns (with about 73 days inventory in 2016, versus 116 days at Kohl’s and 126 days at Macy’s), which enables higher full-price selling at Nordstrom and higher conversion rates with the increased stream of new products. This inventory capability enhances the brand’s reputation as a cutting-edge source of new trends, in our opinion.

We think Nordstrom benefits from a singular positioning in the department-store space. Catering to a slightly wealthier clientele than Macy’s or Kohl’s, but below that of luxury retailers Neiman Marcus and Saks Fifth Avenue, Nordstrom is one of the few department stores offering affordable luxury. We think this space is defensible to new entrants, as negotiating power with suppliers and a plethora of data from a long history give the business a significant edge to localizing products to each market.

Apparel Retailing Is Volatile We see generally high levels of volatility in the apparel retailing space resulting from attempting to predict fashion trends, consumer confidence, and unemployment levels, as well as significant competition with few barriers to entry in both the brick-and-mortar and e-commerce channels. Mall traffic weakness could affect sales. Further, demand shifts to other categories like home, electronics, and experiential categories could further negatively affect demand. The combination of these factors could mean pricing pressure to match competitors' prices or clear excess inventory.

We see one of the biggest risks to the core business as maintaining mid- to high-teens returns on invested capital following a period of accelerated investing in new businesses, Canadian expansion, and IT. Although we believe Nordstrom has been sufficiently cautious entering Canada, with diligent market research and a plan for slow store growth, other retailers (most notably Target TGT) have had difficulty adapting to this market. We also acknowledge an inherent risk in balancing maximization of the high-growth Nordstrom Rack business without cannibalizing or lowering the brand equity of the full-line business. In our opinion, Nordstrom has been very successful at this, but this could change as more stores are added. We see fulfillment center investments and IT spending as necessary for adapting to consumer demand for quick shipping, omnichannel capabilities, and ease of mobile and e-commerce. However, failure to achieve suitable upside could result in declines in ROIC.