After consumer confidence and retail sales rebounded in April, Wall Street has turned bullish on U.S. retail stocks. Despite weaker-than-expected earnings from Wal-Mart Stores, Inc. (NYSE:WMT) earlier this month, many investors still believe that upscale department stores, such as Nordstrom, Inc. (NYSE:JWN), Dillard’s, Inc. (NYSE:DDS) and Macy’s, Inc. (NYSE:M) will continue growing as they bleed their lower-end peers J.C. Penney Company, Inc. (NYSE:JCP) and Sears Holdings Corporation (NASDAQ:SHLD) dry.
Although Wall Street had high expectations for Nordstrom, Inc. (NYSE:JWN), the Seattle-based company disappointed investors by missing first quarter estimates on both its top and bottom lines. Nordstrom’s shares slid 4% after it reported earnings on May 16. This also followed a solid earnings beat from Macy’s, Inc. (NYSE:M) on May 15, which caused investors to wonder if the growth trajectories of these two upscale retailers were diverging.
A first quarter divergence
For its first quarter, Nordstrom, Inc. (NYSE:JWN) earned $0.73 per share, a 4.3% increase from the prior year quarter that missed the consensus estimate by three cents. By comparison, Macy’s earned $0.55 per share, up 28% from the prior year quarter and topping Wall Street expectations by two cents.
Sales growth painted a similar picture. Nordstrom, Inc. (NYSE:JWN)’s revenue rose 4.7% year-on-year to $2.75 billion but came up short of the $2.81 billion that analysts had expected. Same-store sales rose 2.7%. Meanwhile, Macy’s reported revenue growth of 4% to $6.39 billion, slightly ahead of the consensus forecast of $6.38 billion. Same-store sales rose 3.8%.
In short, Nordstrom, Inc. (NYSE:JWN) missed on both the top and bottom lines while Macy’s easily beat expectations. What caused Nordstrom to stumble and lose ground against Macy’s, and will this trend continue?
Lessons from J.C. Penney Company, Inc. (NYSE:JCP)
The dire fate of J.C. Penney has taught department stores some valuable lessons.
First, recognize and stay connected to your primary customer base. Second, constantly offer limited-time sales to keep customers coming back. Third, affordable luxury brands should be group together and emphasized to attract younger shoppers. Under former CEO Ron Johnson, J.C. Penney failed miserably on all three counts.
Nordstrom’s primary business is divided into three segments – full-line stores, Nordstrom Rack, and direct-to-consumer sales (including e-commerce). Same-store sales at its namesake full-line stores were flat from the prior year quarter, yet same-store sales at its off-price retailer, Nordstrom Rack, edged up 0.8%.
Following the off-price retailers
This indicates that the appeal of Nordstrom’s full-price offerings is declining, but the appeal of its discounted brand name goods is rising. This isn’t particularly surprising, since off-price retailers The TJX Companies, Inc. (NYSE:TJX) (TJ Maxx) and Ross Stores, Inc. (NASDAQ:ROST) recently reported April same-store sales growth of 8% and 7%, respectively.
Off-price retailers purchase off-season brand name merchandise at bulk discounts, storing and rotating them over several seasons to maintain a constantly refreshed supply of higher-end merchandise. This business model attracts a wide range of shoppers who are less concerned about the age of the style than the value of its brand. In this segment, Macy’s also competes with Nordstrom, TJX and Ross through its Bloomingdale’s outlet stores.
Although The TJX Companies, Inc. (NYSE:TJX) and Ross are known as discount stores, their margins aren’t as slim as you might think. Both TJX and Ross actually have higher profit margins than Macy’s or Nordstrom, as seen in the following chart.
Meanwhile, Nordstrom’s direct-to-consumer same-store sales, which include its e-commerce arm, rose 25%, highlighting the growing importance of online sales. Same-store sales across the company, with direct-to-consumer sales included, rose 3.1%, fueled by strong demand for cosmetics, women’s apparel and handbags.
Rising expenses and shrinking margins
Nordstrom seems to be well aware of the weakness of its namesake stores, and is compensating with aggressive expansion of its Rack stores and e-commerce initiatives. However, these initiatives have been costly, with gross profit margin in its retail segment sliding from 37.6% to 37.1%. SG&A (sales, general and administrative) expenses rose 5.3% to $801 million, but decreased as a percentage of its top line.
Yet a comparison of Nordstrom’s climbing expenses, which are rising at a rate faster than both Macy’s and J.C. Penney, is troublesome, especially since its gross margin dropped from 39.7% to 39.1%, while operating margin slid from 10.4% to 10.0%. This indicates that its aggressive expansion could be causing costly operating inefficiencies.
In addition, I believe that Nordstrom’s current strategy of expanding its lower-margin off-price channels will cause margins to contract further throughout the year. Moreover, e-commerce is a higher margin business, but increased investments in expanding its online presence, along with its Fashion Rewards programs, will offset short-term gains until its online system has fully matured.
Learning from Macy’s
Macy’s, on the other hand, has been controlling costs more carefully, using conservative, steady cost-effective initiatives such as its “My Macy’s” localization strategy to grow sales traffic without aggressive store expansions. “My Macy’s,” which was initiated in 2008 by CEO Terry Lundgren, abandoned the department store’s traditional model of carrying similar product lines nationwide. Instead, Lundgren asked local store management to decide what products would best suit their customer base.
Lundgren also successfully launched individually branded boutiques in Macy’s, boosting the brand recognition of its higher profile and in-house brands, which increased its appeal to younger shoppers. J.C. Penney attempted to replicate this strategy but failed, due to Ron Johnson’s abandonment of limited-time sales.
Macy’s approach has kept its gross margin flat at 38.8%, but its operating margin rose from 6.4% to 6.8%, reflecting better operating efficiency and cost controls than Nordstrom. Macy’s has repeatedly emphasized its “three-pronged strategy for growth” – emphasizing localized merchandise, improved staff training, and the use of an “omnichannel” (coordinated effort of the Internet, brick-and-mortar locations and warehouses) to quickly reach the maximum amount of customers.
Compared to Macy’s disciplined focus on these three goals, Nordstrom’s lack of confidence in its own plans shows with its full-year same-store sales guidance of 3% to 5%, which it reduced from its prior estimate of 3.5% to 5.5%. Macy’s, on the other hand, reaffirmed its full-year same-store sales guidance of 3.5%.
The Foolish Bottom Line
In conclusion, Nordstrom is at a crossroads. While its margins are still stronger than Macy’s or J.C. Penney, its same-store sales are slowing and expenses are rising. If sales growth can continue outpacing expenses, then it won’t become a problem, but the weakness of its namesake full-line stores and its dependence on off-price store expansion to grow its top line is a cause for concern.
While I believe that upscale retailers such as Nordstrom and Macy’s will flourish as U.S. consumer confidence returns, Macy’s is a more stable bet with a conservative but effective growth model. Both Macy’s and Nordstrom have had a spectacular year – shares of Macy’s are up 35% while Nordstrom is up 23%. Yet Macy’s is still the better value at current prices, with a forward P/E of 11 compared to Nordstrom’s forward P/E of 14.
While Macy’s is a more solid investment at current prices, Nordstrom should still continue to grow in 2013 as long as consumer sentiment, confidence and retail sales growth remain positive.
The article Will This Retailer Outgrow its Competition? originally appeared on Fool.com and is written by Leo Sun.
Leo is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.
