We believe Nordstrom JWN continues to be a top operator in the competitive U.S. apparel market. It has cultivated a loyal customer base through its reputation for differentiated products and service and has built a narrow economic moat based on an intangible brand asset, in our view. While no-moat Macy’s M and other department store competitors have suffered declining sales, Nordstrom increased revenue from about $10 billion to $16 billion between 2010 and 2018. Nordstrom’s full-price and Rack (off-price) stores consistently reported positive same-store sales growth over this period. We forecast same-store sales growth of 1% and 3% for Nordstrom’s full- and off-price segments, respectively, over the next 10 years.
We believe Nordstrom is responding well to changes in its market. The company has about 140 full-price stores, nearly all of them in desirable Class A malls (sales per square foot above $500). Still, Nordstrom’s full-price business is vulnerable to weakening physical retail. Online apparel sales as a percentage of total U.S. apparel sales have more than doubled since 2010 to more than 20%, while discount retailers have continued to open stores (for example, narrow-moat Ross ROST has opened more than 500 stores since 2010). NPD estimated off-price sales represented 75% of apparel transactions in 2016. Rack has been part of this trend, as sales for this segment have nearly doubled since 2012 to $5 billion.
Nordstrom has spent heavily on what it calls “generational investments.” This plan, which includes expansions in e-commerce and new territories (Canada, New York City), has lowered EBIT by approximately $600 million over the past four years, with consolidated operating margins eroding from more than 10% five years ago to just 6% presently. Nordstrom expects the generational investments to produce positive EBIT by 2022, suggesting that they may produce more than half of the company’s EBIT growth over the next four years. We view the plan as promising but unproven, with our forecast calling for about 50 basis points of operating margin improvement over the next decade.
Brand Intangible Asset Is Sole Moat Source We maintain a narrow moat rating on Nordstrom based on its 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 thirds of sales) maintain premium pricing over other mall-based department stores through differentiated products 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 stores are supported by online businesses that have made Nordstrom one of the 10 largest e-commerce retailers in the United States. As evidence of its competitive edge, adjusted returns on invested capital (including goodwill) have averaged 19% annually over the past five years, and we forecast the company can generate ROIC above weighted average cost of capital over the next 10 years, supporting our narrow moat rating. We estimate Nordstrom's WACC at 8% and forecast its adjusted ROIC will average 17% over the next decade.
Nordstrom’s full-price, full-line stores generate more than $10 billion in annual 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. The company operates 140 full-price stores, 122 of which operate under the Nordstrom nameplate. Some department store chains, such as Macy’s (690 full-line stores), J.C. Penney JCP (852 stores), and Kohl’s KSS (1,158 stores), have much larger footprints and may need to close hundreds of stores. Nordstrom’s full-price stores serve customers that tend to be more affluent than those of other department stores, such as no-moat Macy’s and Kohl’s, but somewhat less affluent than those of smaller competitors Neiman Marcus and Saks Fifth Avenue. Nordstrom estimates that its full-price business increased its share of the North American apparel and footwear market from 2.5% to 2.7% over the past four years, even as the U.S. Department of Commerce reports department store sales as a percentage of total retail sales have been declining since at least 2005. As further support of the company’s competitive edge, there are more than 10.5 million members (and growing) in Nordstrom’s loyalty club. These members generate 55% of Nordstrom sales, up from 35% five 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 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 reported positive same-store sales growth at its full-price stores in seven of the eight years since the 2009 recession, posting an average same-store sales figure of 4% over the period. For comparison, narrow-moat competitors Ross and TJX TJX also reported average same-store sales of 4% over the period. Meanwhile, no-moat Macy’s reported negative same-store sales at owned stores in 2015 (negative 3.1%), 2016 (negative 3.6%), and 2017 (negative 2.2%). We forecast Nordstrom will report annual full-price same-store sales growth of 2.0% or better over the next 10 years. Further, we forecast Nordstrom’s full-price sales will increase from $10.6 billion in 2019 to $12.5 billion in 2025, in contrast to a few of its peers, which are being plagued by declining sales. 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 Nordstrom Rack stores. Nordstrom’s off-price business has grown from one clearance store in Seattle in 1973 to 240 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 apparel of popular brands, sell private-label apparel, and clear merchandise from full-price stores (about 10% of merchandise sold).
Nordstrom’s off-price business has a been a major source of growth. Rack has consistently reported positive annual same-store sales growth, even during the 2008-09 recession, posting an average same-store sales result of 4.7% over the past 12 years. Rack’s average same-store sales numbers over the period were roughly 1 percentage point better than those of (much larger) competitors Ross and TJX. Rack grew from $1.1 billion in sales in 2007 to more than $5 billion in sales in 2018. Over 2012-17, Rack experienced a 13.1% compound annual growth rate in sales (versus 1% for the overall North American apparel and footwear market) and nearly doubled its market share from 0.7% to 1.3%. Nordstrom claims its off-price annual same-store sales growth exceeded that of a weighted average peer group (includes Ross, T.J.Maxx, and Burlington Coat Factory) in every quarter from 2013 to 2017. Moreover, Nordstrom claims sales per square foot (approximately $500) at Rack stores is roughly double that of the peer group. We believe Rack can continue to outpace competitors on this metric as it has a smaller and younger store base, allowing it to choose the best locations. Ross, for example, operates more than 1,600 stores, most of which opened before 2010. As evidence of Nordstrom’s solid location choices, Rack has maintained its sales per square foot levels despite more than tripling its store base since 2009. We believe Nordstrom Rack has staked out a strong position in discount fashion retail and that it contributes to our narrow moat rating on Nordstrom.
E-Commerce Has Costs and Benefits 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. For years, many competitors outsourced their online businesses to third parties or operated them separately from their physical stores. Nordstrom's investments in e-commerce have allowed it to introduce online capabilities earlier than others. Nordstrom, for example, offered free shipping and online returns in 2011, well before these practices were standard in the industry. We estimate Nordstrom invested approximately $1.2 billion in capital expenditures in its online business over the past five years (nearly 2% of total sales). Nordstrom has become one of the leading e-commerce companies in the U.S. In a 2017 eMarketer survey of the 50 largest U.S. retailers, it ranked seventh in terms of e-commerce sales. Moreover, Nordstrom's e-commerce sales as a percentage of total revenue of 21.8% were larger than that of many competing department stores, such as Kohl's, Macy's, Hudson's Bay, and J.C. Penney, all of which reported e-commerce sales as a percentage of total revenue below 18%.
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 selling, general, and administrative expense 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 5 times as much as customers 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 sale site, 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. The two shops form an online off-price business that generated approximately $1 billion in sales in 2018. As with the main Nordstrom.com site, Nordstrom 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. Online off-price sales grew at a compound annual growth rate of 30% from 2012 to 2017. Online sales as a percentage of total off-price sales have grown from 0% at the beginning of the decade to nearly 20% today. Overall, digital sales represented 30% of Nordstrom’s total net sales in the first nine months of 2018. We do not see this percentage going much higher as Nordstrom continues to open Rack stores and some full-price stores, suggesting a continued commitment to its physical retail base.
We view the good margins at Nordstrom as evidence of a narrow moat. The company realized an average annual operating margin of 9.2% over the past 10 years, approximately 140 basis points better than that of Macy’s. Nordstrom achieved this result even as its operating margins have been recently depressed by large investments in new stores and online capabilities. We believe its operating margins will stabilize at 6.5% over the next 10 years.
We believe the strength of Nordstrom’s brand allows for a narrow moat but does not produce a wide moat, as we lack confidence it 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 AMZN and narrow-moat eBay EBAY), discount fashion chains (like TJX and Ross), 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. Nordstrom has already shown some signs of weakness from competitive pressures. While its adjusted ROIC including goodwill remains comfortably above its WACC, it has dropped from 24% to 18% over the past seven years. 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, are rated narrow moat based on both cost advantages and intangible brand assets. Both companies, unlike Nordstrom, routinely purchase large amounts of clothing from vendors at steep discounts. As evidence of their differentiated business models, TJX and Ross report operating margins in the double digits and adjusted ROICs above 20%, well above Nordstrom’s forecast operating margins of 7% and adjusted ROICs (including goodwill) of 17%.
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.
Mall Presence Could Be a Risk We assign a high fair value uncertainty rating to Nordstrom. The company is exposed to weakness in U.S. physical retail. The U.S., by some measures, has roughly 5 times as much retail space per capita as such nations as the United Kingdom, France, and Japan, suggesting many retail stores in the U.S. are unneeded and will be closed. Many Nordstrom full-price stores anchor large shopping malls, some of which have suffered customer traffic declines due to heavy competition. As evidence of the turmoil, two department store chains, Bon-Ton and Sears, filed for bankruptcy in 2018. Further, other chains, including Macy's, J.C. Penney, and Lord & Taylor, are closing stores or downsizing existing stores. Nordstrom is in better shape than some mall retailers, though, as 95% of its full-price stores are in Class A malls. Also, Nordstrom's significant e-commerce business provides some shelter from weakness at physical retail. We believe, however, that a high uncertainty rating is warranted as Nordstrom's generational investments plan has yet to translate into strong sales growth. The company reported same-store sales growth of just 0.3% at its full-price stores for the holiday 2018 period. While Nordstrom's e-commerce and off-price businesses (same-store sales of 3.9% for holiday 2018) continue to perform well, they may bring lower profit margins. Nordstrom's operating margins have dropped by more than 400 basis points over the past five years, and we do not expect them to rise materially.
Nordstrom could suffer if there is a full-blown trade war with China. Clothing (including shoes) composes more than 75% of Nordstrom’s sales. Tariffs or trade restrictions on imports from China 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 (11% of sales) from China to other countries if necessary.
We expect Nordstrom to generate significant cash flow that it can return to shareholders. We expect the company will generate $3.5 billion in free cash flow over 2019-23, an average of about $700 million per year. Nordstrom has been a consistent buyer of its own stock. It repurchased about $300 million in stock in 2016 but paused repurchase activity in mid-2017 while the Nordstrom family attempted a takeover. Nordstrom resumed repurchases after the family’s offer was rejected by the board. The company authorized a new $1.5 billion repurchase program in August 2018, and we forecast stock repurchases of about $400 million per year over the next five years. We also expect Nordstrom will pay out about 40% of its earnings as dividends.