Is This Specialty Retailer a Fashionable Investment?

Nordstrom is known as one of the strongest retailers you can find. This reputation is well deserved, considering the high-quality products, customer service, and shopping experiences it provides. However, there is one important factor that makes Nordstrom at least somewhat risky.

Targeting the high-end consumer
Nordstrom has benefited over the last five years thanks to its longtime niche: the high-end consumer. Since the depths of "The Great Recession," the high-end consumer has emerged mostly unscathed, while the middle-class has had to cope with a stubbornly difficult job market, a 2% payroll tax increase, and high gas prices.

This trend can't last forever; something has to give. Either the middle-class consumer sees increased prospects in the job market or the high-end consumer begins to feel the pain of a broad stagnation in the economy.

Fear and greed
In the second quarter, net sales jumped 6.4% to $3.1 billion, and diluted EPS improved 24% to $0.93. A lot of this success had to do with Nordstrom's Anniversary Sale falling in the second quarter. While comps improved 4.4%, this is a slowdown from the year-ago quarter, when comps improved 4.5%.

Nordstrom's long-term strategy is to invest in its physical and online stores, and to expand in Canada. The latter will likely impact margins, but it should boost sales. Over the long haul, Nordstrom expects high single-digit sales growth, and ROIC in the mid-teens.

As far as Nordstrom's Canadian expansion, it plans on opening the first of five stores in the Fall of 2014. Nordstrom also expects to open 14 Nordstrom Rack stores in 2013. Additionally, Nordstrom is expanding its partnership with Topshop, bringing its merchandise to 28 new stores (42 total). This has the potential to help sales.

In other important news:

  • Nordstrom saw an 18% bump in Fashion Rewards members, a big plus since these customers tend to shop more frequently and spend more money.

  • Direct Channel sales skyrocketed 37% thanks to an improved website and more merchandise offerings.

  • Nordstrom is opening a second fulfillment center, and a third is expected to be completed in 2015.

Related options
Many retail investors who consider Nordstrom might also take a look at the Gap . Gap is a larger company, sporting a market cap of $19.15 billion, versus a market cap of $10.93 billion for Nordstrom. It also operates in 90 countries, and it targets a much wider range of consumers with its extremely broad merchandise offerings.

With product and geographic diversification, as well as good quality at affordable prices, the Gap is likely to be more resilient to market corrections than Nordstrom. That is especially the case in the current environment. We already know where the middle-income consumer stands. We don't know how the high-end consumer will react if the economy suffers.

If you're looking for a specialty retailer that has been down on its luck, and you want value, then you might be tempted to consider American Eagle Outfitters which is trading at just 13 times earnings. In the past, this would be a good option. Today, too many headwinds exist.

American Eagle is a much smaller company than Nordstrom, with a market cap of $2.80 billion. This fact alone will make it less resilient to market corrections. Then you have declining teen apparel demand, which relates to teens finding it difficult to land a job and having little to no discretionary income.

On top of this, competition has been relentless in the space. This has led to high promotional activity and declining margins. Despite the risks associated with Nordstrom, it is still likely to be a better investment than American Eagle.

Also consider the stock market performances of these three stocks over the past five years. American Eagle has performed poorly during a raging bull market -- never a good sign.

JWN Chart
JWN Chart

JWN data by YCharts

Nordstrom is a high-quality company, and it is likely to be a long-term winner. You could invest now, but you might be able to get it at a better price at some point over the next year or two, as the market seems to be running on confidence and greed more than anything else. Remember, the high-end consumer might suffer from any broader market setbacks. If you're afraid of missing any upside potential, then you can scale in slowly and add to the position as the stock declines.

The retail space is in the midst of the biggest paradigm shift since mail order took off at the turn of last century. Only those most forward-looking and capable companies will survive, and they'll handsomely reward those investors who understand the landscape. You can read about the 3 Companies Ready to Rule Retail in The Motley Fool's special report. Uncovering these top picks is free today; just click here to read more.

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Dan Moskowitz has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.

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