JWN | Not Now, Not At This Price

Takeaway: There is absolutely no reason to own JWN today at this price. But it's equally as difficult to short.

This JWN print followed the road map we expected. Weak quarter followed by a guide down for 2016. The 8% sell-off afterhours isn’t enough to get us more excited about this name as a long -- and quite frankly, we'd be surprised if it closed down that much tomorrow. 


If anything the print raised more questions than it answered. Primarily around the comp trajectory at Rack and the viability of the non-core businesses. The earnings drivers in the core are in place as JWN emerges from ‘investment mode’ in the second half of 2016. Especially if at that time we're in the midst of better consumption growth (we're not banking on it). Until then, we're comfortably on the sidelines. At this price, this is pretty much a 'do nothing' stock. 


Additional details…


What We Liked:

1) Comps: The topline actually held up relatively well accelerating on a 1 and 2yr basis sequentially despite the macro backdrop. There are puts and takes across the business – one being the -3% comp at Rack, the worst comp in its history. At the same time, e-comm growth in the off-price channel accelerated by 500bps to 51% YY. That of course comes with an offset lower on the P&L, as the company bought the comp with gross margins down 184bps in the quarter – the biggest hit to GM since 1Q09. We’re generally encouraged by the fact that JWN performed as well as it did with the rest of the Department store space cracking.


2) Lower capital intensity/cost rationalization: Now out of the peak investment year, we already knew that CapEx was coming down from elevated levels, but the company slashed its five year target by another $300mm. We expect that to come down even more from here evidenced by the fact that the Rack launch into Canada (first store opening date announced earlier this week) was pushed back a year to 2018. On the SG&A side, management talked to a $100mm cut in SG&A spending. It’s hard to give that a lot of credence without more detail, but it’s an encouraging change on the margin given JWN’s propensity to spend.


3) Guidance: Tough to see a 9% earnings guide down as a positive, but expectations headed into 2016 were overly bullish especially in 1H in light of the current state of consumer demand. No question that street models are coming down considerably from current levels after this print. But, the drivers for a positive change in the earnings trajectory are in place in the 2nd half of 2016.


What We Didn’t Like:

1) Nordstrom Rack Performance: As noted earlier, this was the worst quarterly performance from the concept, EVER. It comes as no surprise that we’ve seen a bifurcation in B&M comp trends at the same time off-price online is growing like a weed. The question that we have to answer is, will e-commerce continue to dilute the Brick and Mortar business? If so, we are looking at lower profitability across the board. Given that much of the valuation premium for JWN to its peer group is predicated on square footage growth (i.e. viability of the brick and mortar Rack business), this comp number will only stoke the concerns about a) the 300 store target and b) the viability of the business model.


2) Inventories: JWN already took it on the chin on the gross margin line, not once but twice over the past two quarters, and the current inventory position is still out of whack. That will lead to additional gross margin pressure in the first half of the year as the sales outlook is less than optimistic.

JWN | Not Now, Not At This Price - JWN SIGMA


3) Canada/Trunk dilution: Management conveniently lumped in the dilution from off-price into is calculation of the dilution from ‘non-core’ this quarter, but based on our best measurements of the bar chart we get to dilution of $62mm and $64mm from Trunk and Canada, respectively. Collectively that’s a $126mm hit to EBIT, a far cry from the $56mm guided to on the 3Q call. Some of the Trunk dilution is due to acquisition costs in FY15, but the outlook for ’16 is for another $30mm-$40mm of dilution for a business that was ‘break-even’ when JWN acquired it. On the Canada front, a boat load of capital has been allocated to setting up operations North of the border, with the outlook for $1bil in sales by 2020. We don’t think Nordstrom Canada will get there by then because of the productivity premium we’d have to assume (about 35%+ in the full line business) to get to that number. There is enough leverage for this model to work to offset about $50mm in dilution by 2017, but we need to see a positive inflection in the EBIT trends, starting now in order to get more positive.


Our note from earlier this week...

02/17/16 02:56 PM EST



Takeaway: When we finally get a glance of JWN’s sales numbers–they need to be truly horrendous. We’d actually look to buy it on a sell-off tomorrow.


Conclusion: This is a multi-duration call. Bearish over the near-term as macro headwinds put earnings at risk. But, levers are there once the consumer stabilizes/recovers. The reality is that this is the only department store that really needs to exist.


We assembled a rather hefty slide deck on JWN as it emerged as a battleground stock ahead of this week’s print.  Initially, we were very bearish. The precipitous increase in short interest from 6% to recession levels of 20% over the past month means that when we finally get a glance of JWN’s sales numbers – they need to be truly horrendous. By the look of its e-commerce business, that’s precisely what we’ll get. Sometimes, the consensus is right, and this time, it probably is.


Unfortunately, it’s still the consensus. And while we think that this quarter will be terrible. The rate of change on the sales, gross margin, sg&a, and capex lines will change on the margin in JWN’s favor by mid-year. At that point, we might actually look to go long this one. After all, it’s the only department store that really needs to exist, and it’s trading at less than 7x a doable EBITDA number.


In the end, we’d actually look to buy it on a sell-off on tomorrow’s numbers – something in the low-mid $40s sounds about right. Otherwise we might be interested in buying with a $5-handle later this year when the Macro environment is de-risked and JWN emerges from ‘investment mode.’


Additional details…


Trade (3 weeks or less): JWN is the only name amongst its peer group that has been radio silent throughout the holiday season that saw M and KSS pre-announce earnings growth rates of -20% (-30% ex. the Brooklyn asset sale) and -15%, respectively. Management lowered the 4Q bar by 9% post the 3Q print, and then the Street came down by another 7% over the past three months. Sales expectations still look too high given the general softness in the retail space (especially at the high end) over the holiday period and the fact that JWN is up against its toughest comp since 4Q12. E-commerce traffic trends have been soft across all of JWN’s concepts as it laps the launch year of the Rack website, while Full Price and Hautelook continued to weaken into quarter close. We’re about $100mm, or 2%, below the street.


These Traffic Trends Look Terrible


JWN | Not Now, Not At This Price - JWN Traffic


On the margin side, JWN likely took the biggest hit of any of the department store players in the quarter with gross margins down 160bps in 3Q, as it proactively managed its inventory position. Warm weather and weak demand will still be an issue in 1Q, and we expect inventory growth ahead of sales for the 16th time in the past 18 quarters. Canada and Trunk dilution is starting to roll off now that the sales base North of the border is forming a critical mass and the acquisition of Trunk Club is annualized. The company pulled a few SG&A levers last quarter by cutting its investment in its loyalty program (bullish for credit income). All in we’re modeling a 200bps hit to EBIT, broken out into 110bps of deleverage in the core, another 40bps from non-core investments, and the remainder allocated to the sale of the credit card receivables.


3Q15 SIGMA Chart


JWN | Not Now, Not At This Price - DEPT SIGMA


Trend (3 months or more): Not unlike the rest of the retail space, the street is looking for a snap back on the top line as we enter 1H16, chalking up most of the demand issues we saw in the back half of 2015 to just weather. We’re not buying it. And, after what we think will be another sales miss in the 4th quarter we expect the guide for 2016 to be conservative on the top line. Or, at least it should be given the price action on the stock over the past 3 months and the fact that short interest is at 5 year highs at 19% (up from just 6% in late November).


Here’s where we come out on each of the lines on the P&L in the first half of 2016…

  • Revenue: No comp growth in the brick and mortar side of the business with negative LSD comps at Full Line and flattish comps at Rack against easy compares last year. That’s offset by low teens growth in the company’s e-commerce business (inclusive of FullLine.com, Rack.com, and Hautelook), about a half a point of growth from Canada and Trunk Club, and 5% square footage growth. That gets us to LSD sales growth in the first half of the year at the retail level (flat revenue growth reported due to the loss of credit revenue).
  • Gross Margin: We’re looking at another 75bps of deleverage as the company continues to invest in its roll out of Rack and Canada stores, which caused about 30bps of deleverage on the gross margin line in 2015. As noted earlier, JWN took it on the chin on the margin side to keep inventories in check headed into 4Q15, but we expect the combination of weak demand and warm weather to lead to a negative move in the sales to inventory spread. That coupled with high inventories across the space = another ‘highly promotional’ environment in 1H15.
  • SG&A: Growth in the mid to low single digit range as the company laps the Trunk Club acquisition, East Coast fulfillment center, and the profitability in the Canada business operation starts to head North. Offset by about $25mm in credit revenue from the TD Bank agreement in each quarter.
  • Earnings: Add that all up and we get to a negative DD earnings growth rate in 1H. 5% and 10% below the Street in 1Q and 2Q, respectively.
  • Tail (3 years or less): Over a longer duration (3 years or less), we like the setup for JWN. Yes, macro headwinds and category risk are keeping this name on the long bench rather than the core set of names as trend earnings risk still looks likely. But, once we get through the macro reset


JWN has the makings of a textbook long. Here’s why…

1) For starters, we have to ask the question does JWN need to exist? We think the answer is unequivocally yes. It has arguably the best e-comm operation in all of B&M retail, premium content, a concentrated footprint in the top malls/MSAs outside of the Northeast, and can hit 300 rack doors without skipping a beat. We’re not convinced that the ‘non-core’ (Canada/Trunk) growth drivers are ROIC accretive, but expectations have come down to a level where we think the point is moot.


2) JWN is coming off a peak investment year, and while there is still $3.1bn left on the $4.3bn 5 year CapEx plan, 2015 marks the tops of capital investment. Margins are washed out as the company invests in the Rack rollout (27 doors added this year), Canadian entry, new East Coast fulfillment center, credit card receivables sale, and absorbs the Trunk Club acquisition. That should in turn fuel top line growth in the HSD range once we enter the back half of 2016 (consumer environment permitting).


3) We don’t have to make wild profitability or sales assumptions for this model to work. By 2017, we assume that Full Line EBIT margins are 100bps off 2014 levels, Rack EBIT margins are 50bps off of 2014 levels, slight improvement in e-comm margins as the business (Rack and Full Line) climbs to ~$4bil, and a profitability donut in the non-core side of the business (Canada/Trunk). At that point Canada will be around a $400mm business, with the entire full line buildout complete, and Trunk (which was break even when JWN acquired it) will have benefited from 3 years of integration. Any improvement in each of the four segments will add additional upside.


4) On that math we get to earnings of $4.13 in 2017 on a sales base just north of $16bn. 6% ahead of the street today and likely higher as numbers come down after 2016 expectations are reset. 

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