Are Concerns Over Nordstrom Stock Overblown?

By Markets Fool.com

Nordstrom is in the midst of a major multiyear investment phase as it builds a foundation to support long-term, high-single-digit sales growth. However, some analysts are urging investors to bail out of Nordstrom stock.

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It's true that Nordstrom's earnings growth has ground to a halt recently. It's also true that the stock has surged more than 30% in the last year. Both of these would seem to suggest that Nordstrom stock is ripe for a pullback.

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Nordstrom Stock 1 Year Price Chart, data by YCharts.

Bears may point to management's recent projection that earnings will remain flat once again in 2015 to argue for selling Nordstrom stock. However, the investments that are depressing profitability today will likely pay off in the form of long-term sales growth and higher margins toward the end of the decade.

Sales growth and margin compression
Nordstrom reported its Q4 and full-year results last Thursday. Nordstrom's quarterly revenue reached $4.04 billion -- up about 9% year over year -- beating the average analyst estimate of $4.01 billion.

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On the flip side, Nordstrom fell a few pennies short of the average EPS estimate. That said, both aspects of Nordstrom's performance were relatively in line with the company's guidance.

Nordstrom projected more of the same for the 2015 fiscal year -- a sales increase between 7%-9%, but flattish EPS. Free cash flow will also come under pressure, because Nordstrom plans to increase capital spending by about $400 million this year.

Nordstrom plans to ramp up its capital investments during 2015. Photo: The Motley Fool

Retail analysts at Barclays had predicted an earnings report along these lines earlier last week and subsequently indicated their lack of enthusiasm for Nordstrom. They downgraded Nordstrom stock to "Underweight," expecting a greater than 10% fall over the next 12 months based on their prediction that Nordstrom's margins could decline for at least two more years.

Don't worry about near-term margins
The Barclays analysts' concerns about Nordstrom's margins are overblown. There are four distinct causes of Nordstrom's margin decline, but they will likely all reverse themselves over the next five years or so, while setting the stage for strong sales growth. As a result, Nordstrom's earnings power could surge toward the end of the decade, boosting Nordstrom stock.

The first source of margin pressure is Nordstrom's entry into Canada. It opened its first store in Calgary in September, and early sales trends have exceeded expectations. But Nordstrom expects to lose about $60 million annually in Canada for the next two years (up from a $32 million loss last year) due to preopening costs associated with the stores opening in the next few years.

A second source of margin pressure comes from Nordstrom Rack. Nordstrom is currently opening about 25 Rack stores annually. Preopening expenses and the lower profitability of newly opened stores are weighing on the division's margins. As the growth rate moderates in the next few years, Nordstrom's management expects Rack margins to recover to historical levels.

The Nordstrom Rack chain has been growing rapidly. Photo: The Motley Fool

The third margin headwind comes from Nordstrom's heavy investments in technology and fulfillment. This category represents 35% of Nordstrom's planned capital spending for the next five years. In the near term, the increase in spending will outweigh the revenue benefit. However, these investments will be gifts that keep giving, driving long-term revenue growth.

Nordstrom's last margin headwind comes from its recent purchase of Trunk Club, an online personal stylist service. While Trunk Club is breaking even on an operating basis, purchase accounting rules will drive a loss of about $30 million next year.

Plenty of growth opportunities left
As long as Nordstrom keeps growing revenue at a high-single-digit rate, investors shouldn't worry too much about Nordstrom's profit margins. For example, by 2017 or 2018 -- when Nordstrom will have completed its first round of store openings in Canada -- the Canadian business should turn profitable.

Indeed, all of Nordstrom's current sources of margin pressure can be traced to specific long-term growth initiatives. As the incremental revenue flows in over the next five years or so, Nordstrom's profit margin should recover. As a result, Nordstrom's earnings could double between 2015 and 2020.

For investors, this means that Nordstrom stock is a keeper. The company is one of a few "bricks-and-mortar" retailers that have mastered e-commerce and omnichannel selling. This will help it maintain a high revenue growth rate for the foreseeable future.

The article Are Concerns Over Nordstrom Stock Overblown? originally appeared on Fool.com.

Adam Levine-Weinberg owns shares of Nordstrom. The Motley Fool recommends Nordstrom. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.