Nordstrom's a Better Bargain Than Kohl's

(Editor's note: Updates to reflect today's earnings releases from Kohl's and Nordstrom.)

BOSTON ( TheStreet Ratings) -- The term "trade down" became a familiar phrase in the investment lexicon after the credit crisis struck the U.S. in 2008.

Trade down, in reference to the retail industry, refers to consumers choosing lower-priced, discounted goods, as compared with higher-end items. Americans, hobbled by surging unemployment, high gasoline prices, investment losses and depressed home prices, were forced to cut back.

Teens who usually assembled a wardrobe at Abercrombie & Fitch ( ANF) were searching for back-to-school clothes at Aeropostale ( ARO). Their parents, who might have been used to dressing up at J.Crew ( JCG) and The Gap's ( GPS) Banana Republic were heading to TJMaxx ( TJX) or The Gap's Old Navy to save a few bucks. Starbucks ( SBUX) frappucinos and lattes weren't selling as well, as many stopped splurging, opting for the java jolt from their -- gasp -- household coffee maker.

Years of free-spending seemed to be a thing of the past, as many consumers, faced with mounting credit card debt, decided to change their ways. Many felt trading down would lead to a lifelong adjustment, not just a temporary change.

Yet there is evidence that Americans are ready to break out the plastic again. Major retail chains reported an 8.9% gain in April sales from a year earlier, and, according to a report by management consultant Bain & Co., global luxury sales are expected to rise 8% this year. A recent study by the New York Federal Reserve shows that credit limits increased for the first time since the third quarter of 2008.

Nordstrom ( JWN), which reported quarterly earnings after the close of the stock market today, is one example of a high-end retailer stung by the trade-down movement. In 2008, annual sales suffered their first decline in the company's history. Management moved quickly to adjust product offerings, bringing in lower-priced alternatives aimed at retaining wealthy consumers.

And the company bounced back in 2010, increasing revenue by over 12%, with same-store sales up more than 8%. Management has been focused on improving its core business via smarter inventory control, and by investing in its online business. With the planned expansion of its Nordstrom Rack "closeout" stores (19 are slated for launch this year) along with the acquisition of private "flash sale" marketplace HauteLook, Nordstrom has made it clear it wants to diversify its exposure to the highly affluent consumer.

Nordstrom posted per-share earnings of $0.65 and $2.23 billion in revenue, up from $0.52 per share and $2 billion in the same period last year. TheStreet Ratings' quantitative model has a "buy" rating and a $58.35 target on Nordstrom, offering a potential 21% upside from current levels. The company scores best for growth, driven by a 39% increase in earnings over the past year. Our model also likes Nordstrom's strong return on invested capital (ROIC) -- the recently reported 12.8% is up from 11.5% in 2010.

Nordstrom is a good value. Management provided updated guidance of $2.80 to $2.95 in earnings for 2011. If the company achieves, let's say, $3 for 2011, then the stock is trading at 16 times current-year estimates. And with Wall Street analysts forecasting $3.46 for 2012, the stock trades at a forward 2012 price-to-earnings ratio of only 13.9. The stock, in better economic conditions, has historically traded at 18 to 20 times earnings.

While luxury retailers like Nordstrom have performed well as consumer spending has picked up, discount peers such as Kohl's ( KSS) have faltered. Kohl's met expectations for its fiscal first-quarter earnings, although same-store sales growth in April came in at 10.2%, below the 15% predicted by analysts.

Despite the shortfall in same-store sales, TheStreet Ratings' model likes Kohl's, giving the stock a "buy" with a $60 price target (14% upside). Kohl's posted first-quarter EPS of $0.73 and revenue of $4.16 billion, up 6% and 3%, respectively, from last year. The model likes the retailer's efficiency in investing capital, with an ROIC of 11.4%, up from 10% last year. Solvency isn't an issue -- the shares look good with a manageable 26% debt-to-equity ratio and ample short-term liquidity.

The company made solid improvements in 2010 with its private and exclusive national brands, which reached about 48% of sales, up 3 percentage points from the previous year. Management is predicting that the company can grow between 10% and 15% over the next several years. With the stock trading at 12 times current-year earnings and at only 10.5 times 2012 estimates, the stock looks reasonable.

While the trade-down phenomenon was certainly a benefit to many discount retailers over the past few years, it appears that the tides may be turning. Discount retailers such as Kohl's can continue to thrive in an improving economy, yet as consumer spending strengthens, luxury retailers such as Nordstrom should be able to cash in. Consider both stocks a good investment, yet Nordstrom will be the better play if consumer spending accelerates.

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Equity research manager Chris Stuart, CFA, joined TheStreet Ratings after working as a senior investment analyst with Merrill Lynch covering small-cap equity and alternative investment strategies. Prior to that, Stuart worked for One Beacon Insurance as an actuarial analyst and at H&R Block as a financial adviser. Stuart earned his bachelor's degree in finance from the University of Massachusetts, Amherst. He holds a Chartered Financial Analyst (CFA) designation and is a member of the Boston Security Analysts Society (BSAS) and the CFA Institute.