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NORDSTROM INC Fair value report

Nordstrom's current market value of about $35 presents a great opportunity to buy a great company at a significant discount. In this valuation a negative 5% growth estimate is projected for the next two years and results in a fair value estimate of $46. A negative 25% growth model is required to justify Nordstrom's current market value which in my view is overly pessimistic. See the fair value calculator for details.

When discussing Nordstrom it is important to note two things that happened in 2007.
  1. The securitization of about $1,150 million private label and co-branded credit card receivables resulting in a major working capital increase, decrease in free cash flow to firm and increase in debt. See quotes from the Nordstrom earnings report below.
  2. An increase of $988 million in debt that was used primarily to buy back stock and pay off short term debt. The liabilities section of the balance sheet shows us that short term debt payments equaled $260 million, leaving about $720 million for share repurchases. In total $1,728 million worth of shares were bought back in 2007. Retiring about 39 million shares at an average cost of about $44.30 per share. See quotes from the Nordstrom earnings report below.
It is unusual for a company to issue so much debt to buy back it's own stock, unless it believes that it is significantly undervalued. The debt retirement process starts already in April 2010, so we can assume that their short term outlook is favorable. Given their historic growth, large family stake in the company and great reputation, I would tend to agree with them. In fact, the current market valuation is so pessimistic that the slightest good news or favorable economic outlook will probably cause the stock price to increase dramatically.
Risk to valuation:
Even though I have a favorable outlook, it pays to keep a close watch on earnings. The latest quarterly report showed a decline in EBIT of about 13%, driven largely by a decrease in same store sales of about 6.5%, Nordstrom project a same store sale decrease for 2008 ranging between -5% to -7%. If EBIT declines even further Nordstroms stock will likely follow suit.
Valuation details
Discussion of valuation parameters
  • beta: Beta's are a measure of risk, I applied the average beta for the retail industry in which is about 0.83. It is then modified to adjust for leverage (debt) resulting in a levered beta of about 1.01
  • The return on capital in the short term is reduced to 22% from last years 24% to reflect the economic uncertainty, and is further reduced to 18% for long term projections.
  • Growth is estimated at -10% for the next two years, and the rate of inflation after.
  • Adjustments to earnings, debt and cash flow evaluations are made below
EBIT$1.27 billion
Debt$2.62 billion
Equity$1.12 billion
Riskless interest rate5.40 %
Risk premium4.00 %
Cost of borrowing7.00 %
Growth period
Growth period:2 years
Growth rate:-10.00 %
Beta:1.01
Perpetual period
growth rate:4.00 %
Beta:1.08
Growth period
Return on capital22.09 %
Cost of capital8.21 %
Perpetual period
Return on capital18.00 %
Cost of capital8.42 %
Present value of Terminal value$10.43 billion
Present value of FCFF in Growth phase$1.82 billion
Value of operating assets$12.25 billion
Cash$358.00 million
Marketable securities$0.00
Value of Debt$2.62 billion
Fair Value of Firm$9.99 billion
Performance report
Earnings in (Millions)
$9,000
$8,000
$7,000
$6,000
$5,000
$4,000
$3,000
$2,000
$1,000
Revenue
Expenses
Net income
Earnings before interest and taxes (EBIT)
Adjusted EBIT
Free cash flow to firm
Free cash flow to equity
($1,000)
2002 2003 2004 2005 2006 2007
Analysis prepared on Tuesday, January 06, 2009.
Earnings adjustments
We avoid GAAP earnings in our valuations because accrual accounting allows an entity to record revenues before cash is collected and record expenses that do not involve payments of cash. Accrual income almost never matches the actual cash generated from operations. As investors we're primarily interested in the actual cash that a company generates from operations free of any form of manipulation.
    To get there we estimate free cash flows to firm first by making a number major adjustments to earnings;
  • Capitalizing R&D is not necessary for Nordstrom, but if they did, we would capitalize it. Accrual accounting requires that R&D be expensed as it occurs, but we recognize and appreciate that results from R&D creates growth. We treat it the same as all other investments by capitalizing it.
    values in Millions
    R&D asset lifetime5 years
    R&D expense$0
    R&D amortized$0
    R&D asset value$0
    The R&D asset value is used to adjust the book value of equity, this in turn is used in the return on equity calculations.
  • True one time charges muddle the growth picture of a stock because they tend to have a significant effect on profit but not earnings from operations. Valuations depend on our ability to predict future earnings growth, to get there we remove one time expenses from earnings.
  • The marginal tax rate is used to determine the taxes that aught to have been paid. Corporations have a number of ways to defer the taxes they pay, these deferments can have a significant impact on stated earnings. Eventually though they have to be paid causing another significant impact on earnings. In order to avoid these oscillations to earnings we use the marginal tax rate to determine the amount paid for taxes.
  • The other major adjustment to earnings that is made is by accounting for off-balance sheet item such as operating leases. Operating leases are treated as Operating expenses where they should be treated as financial expenses that have the same obligations as debt. Our second major adjustment therefore is in converting operating leases to their debt equivalent.
    Operating lease expenses and debt adjustment in (Millions)
    Current year$69
    Year one$71
    Year two$67
    Year three$62
    Year four$49
    Post year four$260
    Total$578
    Debt value$381
    Depreciation$48
    Debt Adjustment
    + Debt$2,236
    + Value of operating lease debt$381
    = Debt (Adjusted)$2,617
This leads to the following adjustments to earnings
Earnings Adjustement (values in Millions)
+ Earning before interest and taxes (EBIT):$1,247
+ R&D expense: $0
- R&D amortized: $0
+ Operating lease expense: $69
- Operating lease depreciation: $48
+ One time charges: $0
= Adjusted earnings before interest and taxes$1,268
- Taxes ( marginal rate = 35 % ): $444
= Adjusted earnings after taxes: $824
Now we have a better value for earnings that can be compared year to year to get a better picture of growth.
Cashflow analysis
Free cash flow is the actual cash generated from operations, it is similar in concept to Warren Buffets concept of owner earnings.
It is determined by subtracting from adjusted earnings the amount a company invests in growth. Growth investments include investments in R&D, acquisitions, investments in operations (working capital investment) and investment in fixed capital.
Investment expenses (Millions)
+ R&D investment$0
+ Working capital investment$716
+ Fixed capital investment$501
+ Acquisitions$0
Investment depreciation and amortization (Millions)
- R&D amortized$0
- Fixed capital depreciation$269
- Operating lease depreciation$48
= Reinvested for future growth$900
The amount a company reinvests will determine future growth.
Free cash flow to firm derivation: (values in Millions)
+ Adjusted Earnings Before Interest and Taxes (EBIT):$1,268
- Marginal Tax Rate:35.00 %
= Adjusted Earning after taxes:$824
- Reinvested$900
= Free cash flow to firm (FCFF)($76)
After equity is adjusted to include the R&D asset value and debt to include the Operating lease liabilities debt equivalent, managements effectiveness can be measured more accurately. The below shows the effect the adjustments to earnings have on the returns on capital and equity.
Returns on investment:
Return on capital (ROC)29.03 %
Return on equity (ROE)32.97 %
Adjusted ROC25.74 %
Adjusted ROE35.80 %
A good estimate for future growth is derived by multiplying the estimated future reinvestment rate with the estimated future return on capital.
Operating efficiency
The balance sheet provides insight into the company's operations. It contains all it's assets and liabilities. Of particular interest are it's current assets and liabilities, these are the short term assets and liabilities generated from it's operating activities. For a company that produces a product, for example, the current assets and liabilities are the items that the company uses to build the product such as inventory and raw materials, the money owed the company after selling the product to it's customers and the money it owes to creditors such as the raw material wholesalers as well as service providers. The following metrics are estimates that define how efficient a company is at executing the sales cycle.
  • Days inventory outstanding This metric measures how many days worth of inventory the company has in it's warehouse. It is measured as following DIO = (Inventory/Cost of sales) * 365.
  • Days payable outstandingPayables are the moneys owed to creditors such as the providers of the raw materials or service providers. Days payable outstanding is a measure of how long the company takes to pay its creditors. it is calculated as follows: DPO = (Accounts Payable/ Cost of sales )*365.
  • Days sales outstanding Sales are revenues, receivables are uncollected sales made on credit. A company has to collect sales as quickly as possible so it can use that money to create more products. This value is estimated as following: (Receivables / Revenues) * 365 or ( receivables/ Average sales per day).
  • Cash conversion cycle. This metric measures how quickly in days a company can produce a product from raw materials, sell it to a customer and collect those sales, it is estimated in the following way: CCC = DIO + DSO - DPO. a good way to measure how effective management is at making money is by looking at the cash conversion cycle over time. Warning flags are an increase of Inventory (can't sell product) and Receivables (can't collect on the goods sold on credit)
The following table shows the operating efficiency of NORDSTROM INC
Values in days200720062005200420032002
Cash conversion cycle1005861676996
Days inventory outstanding636871737888
Days payable outstanding373940394438
Days sales outstanding742929323546
Risk
Risk is an important measure that determines whether a stock is worth investing in and the associated fair value of that stock. The investor loses their entire investment when that company goes bankrupt. The measures below give an indication of bankruptcy risk and needs to be carefully assessed.
  • Current ratio The current ratio is a financial ratio that measures a companies ability to pay it's short term liabilities. When short term liabilities exceed short term assets the current ratio will be less than one and this indicates that a company may have problems meeting it's short-term obligations. It is calculated as follows: Current Ratio = Current Assets / Current Liabilities
  • Acid test or quick ratioT he acid test measures a companies ability to pay it's short term obligations quickly using cash and near cash. It is calculated as follows: Acid Test = (Cash + Investments) / Current Liabilities
  • Acid test (liberal) The more liberal version of the acid test allows a company to collect receivables and other assets except for inventory. Acid test (liberal) = (Current Assets - Inventory) / Current Liabilities
  • Debt to equity ratio The debt to equity ratio shows the proportion of debt and equity used to finance a company's assets. Debt and equity are both adjusted to account for Operating leases and R&D as described above. The debt to equity ratio is calculated by dividing Debt by Equity.
  • Interest coverage ratio The interest coverage ratio measures a firms ability to meet it's interest payments, it is calculated as follows: Interest coverage ratio = EBIT (adjusted) / Interest payment
  • Fixed charges coverage ratio Fixed charges include interest payments and operating lease expenses for this year it is calculated as follows. EBIT (adjusted) / (interest payment + operating lease expense)
The following table shows the risk ratios described above.
Risk ratios200720062005200420032002
Current ratio2.061.911.771.922.342.38
Acid test0.220.280.320.300.450.24
Acid test (liberal)1.471.221.181.231.481.29
Debt to equity ratio (Adjusted)2.350.480.530.771.011.31
Interest coverage ratio (Adjusted)17.1427.4820.819.645.774.38
Fixed charges coverage ratio (Adjusted)8.879.737.944.983.192.31
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Performance data
Revenue/Earnings data
Historic values
Earnings in (Millions)2007200620052004
Revenue$8,828$8,561$7,919$7,304
Expenses$8,418$8,121$7,368$6,911
Net income$715$678$551$393
Earnings before interest and taxes (EBIT)$1,247$1,148$931$725
Adjusted EBIT$1,268$1,175$943$747
Free cash flow to firm($76)$963$568$561
Free cash flow to equity($233)$826$445$418
Operating lease expenses
Historic values
Operating lease expense and debt conversion in (Millions)2007200620052004
Current year$69$78$73$73
Year one$71$75$72$69
Year two$67$75$72$69
Year three$62$65$66$64
Year four$49$65$66$64
Post year four$260$294$332$360
Total$578$651$681$700
Debt value$381$411$489$456
Depreciation$48$51$61$51
stock price calculator
Past growth rates
30 %
25 %
20 %
15 %
10 %
5 %
EBIT (adjusted)
Profit
Revenue
all 4 years 3 years 2 years
Cashflow in (Millions)
$1,400
$1,200
$1,000
$800
$600
$400
$200
Profit
EBIT
FCFE
FCFF
($200)
($400)
2002 2003 2004 2005 2006 2007
Reinvestment in years past.
( values in Millions )2007200620052004
+ R&D investment
+ Working capital investment$716($128)$111($7)
+ Fixed Capital investment$501$264$272$247
+ Acquisitions
- R&D amortized
- Fixed capital depreciation$269$285$276$265
- Operating lease depreciation$48$51$61$51
= Reinvested$900($199)$45($75)
Cashflow adjustments in years past.
( values in Millions )2007200620052004
Adjusted EBIT$1,268$1,175$943$747
Marginal tax rate35.00 %35.00 %35.00 %35.00 %
Adjusted EBIT(1 - t)$824$764$613$485
Reinvestment expense (gain)$900($199)$45($75)
Free cash flow to firm (FCFF)($76)$963$568$561
The rate of reinvestment in years past.
past reinvestment rates2 years3 years4 yearsall
Reinvestment41.56 %30.16 %18.73 %11.42 %
Working capital investment35.06 %29.40 %21.70 %11.37 %
R&D investment0.00 %0.00 %0.00 %0.00 %
Acquisitions0.00 %0.00 %0.00 %0.00 %
Net capital investments47.70 %46.57 %47.65 %67.85 %
Historic growth rates for important measures of earnings.
Past growth rates2 years3 years4 yearsall
EBIT (adjusted)7.64 %14.42 %17.40 %22.89 %
Profit5.31 %12.63 %18.67 %28.87 %
Revenue3.07 %5.39 %6.39 %7.82 %
Working capital.
( values in Millions )2007200620052004
Cash and equivalent$358$403$463$361
Short term investments$54$42
Accounts receivable$1,788$684$640$646
Inventory$956$997$956$917
Deferred taxes$181$169$145$132
Prepaid expenses$78$60$55$53
Other assets$428$561$422
Total assets$3,361$2,742$2,874$2,572
Accounts payable$556$577$540$482
Debt payments$261$7$307$101
Accrued Expenses$268$340$286$288
Tax payable$58$76$82$116
Other liabilities$492$433$409$354
Total liabilities$1,635$1,433$1,623$1,341
Working capital$1,726$1,309$1,251$1,231
Non cash working capital$1,629$913$1,041$930
Investment in working capital$716($128)$111($7)
Business Summary
DESCRIPTION OF BUSINESS
Nordstrom incorporated in the state of Washington in 1946 as the successor to a retail shoe business that started in 1901. It is one of the nation’s leading fashion specialty retailers, with 155 U.S. stores located in 27 states. The west coast and east coast are the areas in which they have the largest presence. Nordstrom is comprised of four segments: Retail Stores, Credit, Direct, and Other.
Retail Stores derives its revenues from sales of high-quality apparel, shoes, cosmetics and accessories. It includes 98 Full-Line ‘Nordstrom’ stores, 50 discount ‘Nordstrom Rack’ stores, two clearance stores that operate under the name ‘Last Chance,’ and one free-standing shoe store. The Nordstrom Rack stores serve as outlets for clearance merchandise from the Full-Line stores and purchase merchandise directly from manufacturers.
Through their wholly owned federal savings bank, Nordstrom fsb, they offer a private label card, two co-branded Nordstrom VISA credit cards and a debit card for Nordstrom purchases. The credit and debit cards feature a shopping-based loyalty program designed to increase customer visits and spending in their Retail Stores and Direct segments. The Credit segment generates earnings through finance charges and securitization-related gains on these cards.
Direct generates revenues from sales of high-quality apparel, shoes, cosmetics and accessories by serving customers on the Web at www.nordstrom.com and through their catalogs. Most of the Direct segment’s sales are shipped via third-party carriers from the fulfillment center in Cedar Rapids, Iowa.
The Other segment includes the product development team, called Nordstrom Product Group, which designs and coordinates the production of private label merchandise sold in the Nordstrom retail stores. In addition, this segment includes the corporate center operations.
Corporate Information
Executive Officers
Executive Vice PresidentBLACK LAURIE M
Executive Vice PresidentFINN LINDA T
Executive Vice PresidentKNIGHT KEVIN T
Executive Vice PresidentKOPPEL MICHAEL G
Executive Vice PresidentLITTLE DANIEL F
Executive Vice PresidentMinuk Jack H
Executive Vice PresidentMyers Margaret
PresidentNORDSTROM BLAKE W
Executive Vice PresidentNORDSTROM ERIK B
Executive Vice PresidentONEAL JAMES R
Executive Vice PresidentSoffe Loretta
Executive Vice PresidentBRASHEAR MARK S
TreasurerLoretta David
SecretaryMACKIE DAVID L
Executive Vice PresidentMeden Scott A
Executive Vice PresidentSUNDAY DELENA M
Executive Vice PresidentWitman David M
Executive Vice PresidentNordstrom James F JR
Executive Vice PresidentNORDSTROM PETER E
Executive Vice PresidentFavaro Paul F
Executive Vice PresidentBROMLEY JAMES H JR
Executive Vice PresidentCAMERON DALE
Executive Vice PresidentPatneaude Suzanne R
Executive Vi ce PresidentKalinsky Jeffrey S
Vice PresidentHowell James A
Executive VP and SecretaryIGLESIAS LISA G
Board of Directors
CAMPBELL PHYLLIS J
HERNANDEZ ENRIQUE JR
JACKSON JEANNE P
NORDSTROM BLAKE W
NORDSTROM ERIK B
SATRE PHILIP G
NORDSTROM PETER E
NORDSTROM JOHN N
OSBORNE ALFRED E JR
RUCKELSHAUS WILLIAM D
MILLER ROBERT GERALD
WINTER ALISON A
WALTER ROBERT D
Investors
NORDSTROM BRUCE A
Other investors
ControllerCollins Peter F
Family member and counselGITTINGER D WAYNE
ControllerLuther Lisa C
Earnings in (Millions)200720062005200420032002
Revenue$8,828$8,561$7,919$7,304$6,647$5,975
Expenses$8,418$8,121$7,368$6,911$6,404$6,012
Net income$715$678$551$393$243$104
Earnings before interest and taxes (EBIT)$1,247$1,148$931$725$489$278
Adjusted EBIT$1,268$1,175$943$747$524$359
Free cash flow to firm($76)$963$568$561$434$184
Free cash flow to equity($233)$826$445$418$298$9
Adjusted debt$2,617$1,035$1,116$1,385$1,646$1,793
Adjusted equity$1,115$2,169$2,093$1,789$1,634$1,373
Adjusted depreciation$317$336$337$315$289$279
Total reinvestment$900($199)$45($75)($94)$49
Adjusted EBIT$1,268$1,175$943$747$524$359
Adjusted EBIT(1 - t)$824$764$613$485$341$233
FCFF($76)$963$568$561$434$184
FCFE($233)$826$445$418$298$9
Cash conversion cycle1005861676996
Days inventory outstanding636871737888
Days payable outstanding373940394438
Days sales outstanding742929323546
Acid test0.220.280.320.300.450.24
liberal acid test1.471.221.181.231.481.29
Current ratio2.061.911.771.922.342.38
Fixed charges coverage ratio8.729.517.844.832.981.79
Interest coverage ratio16.8526.8620.549.365.383.39
 
Current Assets
Cash and equivalent$358$403$463$361$476$208
Short term investments$54$42
Accounts receivable$1,788$684$640$646$634$759
Inventory$956$997$956$917$902$953
Deferred taxes$181$169$145$132
Prepaid expenses$78$60$55$53$50$40
Other assets$428$561$422$394$112
Total assets$3,361$2,742$2,874$2,572$2,455$2,073
 
Current Liabilities
Accounts payable$556$577$540$482$512$415
Debt payments$261$7$307$101$7$6
Accrued Expenses$268$340$286$288$333$261
Tax payable$58$76$82$116$197$189
Other liabilities$492$433$409$354
Total liabilities$1,635$1,433$1,623$1,341$1,050$870
Working capital$1,726$1,309$1,251$1,231$1,406$1,203
Non cash working capital$1,629$913$1,041$930$937$1,000
Investment in working capital$716($128)$111($7)($63)
Notes from Nordstrom's annual earnings report
Securitization of Accounts Receivable

On May 1, 2007, we converted the Nordstrom private label card and co-branded Nordstrom VISA credit card programs into one securitization program, which is accounted for as a secured borrowing (on-balance sheet). When we combined the securitization programs, our investment in asset backed securities was converted from available-for-sale securities to receivables. Based on past payment patterns, our receivable portfolio was repaid within approximately eight months. During that time, we transitioned the co-branded Nordstrom VISA credit card receivable portfolio to historical cost, net of bad debt allowances, on our balance sheet.

Substantially all of the Nordstrom private label receivables and 90% of the co-branded Nordstrom VISA credit card receivables are securitized. Under the securitization, the receivables are transferred to a third-party trust on a daily basis. The balance of the receivables transferred to the trust fluctuates as new receivables are generated and old receivables are retired (through payments received, charge-offs, or credits for merchandise returns). On May 1, 2007, the trust issued securities that are backed by the receivables. These combined receivables back the Series 2007-1 Notes, the Series 2007-2 Notes, and an unused variable funding note that is discussed in Note 8: Long-term debt.

Prior to May 1, 2007, the co-branded Nordstrom VISA was “off-balance sheet” and finance charges and other income were recorded net of interest and write-offs. The co-branded Nordstrom VISA credit card portfolio was brought on-balance sheet and from May 1, 2007, all of the finance charges and other income related to the portfolio, net of transitional write-offs, were recorded in finance charges and other, net.
Notes from Nordstrom's annual earnings report regarding its Financing activities.

In the first quarter of 2007, the Private Label Trust used our previously existing variable funding facility to issue a total of $150 in Notes. On May 1, 2007, we paid the outstanding balance and terminated this facility. At that time, we entered into a new securitization transaction, issuing $850 in secured notes (the Series 2007-1 Class A & B Notes, due April 2010 and the Series 2007-2 Class A & B Notes, due April 2012) and establishing a variable funding facility backed by substantially all of the Nordstrom private label card receivables and a 90% interest in the co-branded Nordstrom VISA credit card receivables with a capacity of $300. During the third quarter, the combined Nordstrom VISA and Private Label Trust issued $220 of Notes to fund share repurchases, which we paid off by the end of the year

In December 2007, we issued $650 aggregate principal amount of 6.25% senior unsecured notes due 2018 and $350 aggregate principal amount of 7% senior unsecured notes due 2038 for proceeds of $988, net of discount. The interest rates were higher than historical average, due largely to recent fluctuating market conditions and the softer retail environment. We used the note proceeds to pay down our short-term borrowings and repurchase shares.

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