Why Nordstrom, Inc. Stock Could Keep Moving Higher

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Shares of Nordstrom (NYSE: JWN) swung wildly after the company reported mixed results for the fourth quarter on Thursday afternoon. While sales growth came in better than expected in the final quarter of 2017, rising expenses continued to put pressure on Nordstrom's profitability.

Investors eventually decided that they liked the results, sending Nordstrom stock to a 6% gain on Friday. Indeed, the outlook for the fashion retailer is brighter than it might seem -- and not just because the founding family is looking to take the company private. Nordstrom is finally nearing the end of a long period of heavy investment that dented its earnings, putting it in position to achieve strong free cash flow growth beyond 2018.

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Strong sales results don't translate to earnings growth

Nordstrom didn't achieve as much of an improvement in its sales trends during the November-December holiday period as some of its rivals. Still, at least it managed to return to comp sales growth, with a 1% comp sales increase in its full-line business and a 2.9% comp sales gain for its off-price Nordstrom Rack brand. (On a combined basis, comp sales rose 1.2%.)

However, sales growth accelerated in January, especially in the full-line business. For the fourth quarter as a whole, full-line comp sales increased by 2.4%, and off-price comp sales increased 3.7%. Including both sides of the business, Nordstrom posted a 2.6% comp sales gain in the fourth quarter.

Despite the uptick in sales growth, Nordstrom's full-year adjusted earnings per share came in at $2.90, barely reaching the low end of the company's most recent guidance. This was down from $3.11 in fiscal 2016, as operating expenses continue to rise at a faster pace than revenue.

Free cash flow declines -- but remains higher than earnings

Nordstrom's free cash flow also declined on a year-over-year basis in fiscal 2017, falling from $816 million to $630 million. However, free cash flow had been unusually high in 2016, due to a significant reduction in working capital.

More importantly, free cash flow continues to outpace adjusted earnings by a wide margin, reaching $3.73 per share last year. While Nordstrom stock may seem pricey at around 18 times trailing earnings, its valuation looks far more reasonable when measured relative to its free cash flow. Furthermore, Nordstrom is well positioned to increase its free cash flow significantly between now and 2020.

Reaching an inflection point

During Nordstrom's earnings call last week, CFO Anne Bramman indicated that the company is reaching an inflection point in terms of profitability. First, the Nordstrom.com e-commerce business now has enough scale that the cost to serve a customer is similar between stores and online. Additionally, management believes that losses from growth initiatives like Nordstrom's entry into Canada, the Nordstromrack.com e-commerce business, and the Trunk Club personal stylist service have already peaked and will moderate going forward.

As a result, Nordstrom expects a modest improvement in its underlying earnings power in 2018. Including the benefit of tax reform (partially offset by revenue recognition changes that will reduce earnings), the company projects that EPS will rise to $3.30 to $3.55 this year. Nordstrom is also likely to post substantial free cash flow growth in 2018.

Looking further ahead, Nordstrom's recent investments in Canada, Nordstromrack.com, and Trunk Club should start to turn profitable around 2020. Meanwhile, Nordstrom will open its long-awaited flagship store in Manhattan in late 2019. This will allow the company to reduce capex from an estimated $740 million in fiscal 2018 to $600 million or less annually in 2020 and beyond, further boosting free cash flow.

A management buyout by the Nordstrom family during 2018 could offer shareholders a nice premium over the current stock price. But even if the company stays public, Nordstrom stock is well positioned to keep rising during the next several years.

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Adam Levine-Weinberg owns shares of Nordstrom. The Motley Fool recommends Nordstrom. The Motley Fool has a disclosure policy.