; recent price: $59), which carries Standard & Poor's highest investment recommendation of 5-STARS, or buy, is a top pick among the department stores we cover. Reasons for the high rating include what we consider to be its leading competitive position in luxury retail, an improving earnings before interest and taxes (EBIT) margin that creates the potential for positive earnings surprises, and favorable market conditions. In addition, we see the shares as undervalued based on our discounted cash-flow analysis.
The company operates 35 Neiman Marcus and 2 Bergdorf Goodman specialty stores, as well as 14 clearance centers. The specialty stores, which are located on premier real estate, cater to the luxury shopper seeking fashionable and high-quality apparel, accessories, and home furnishings, mainly from leading European and American designers. Personalized customer-service complements the distinctive merchandise assortments.
STOOD ITS GROUND. The company also operates a direct-marketing business for the Neiman Marcus, Horchow (home furnishings, linens, and decorative accessories) and Chef's Catalog (cookware and kitchenware) brands. In addition, Neiman Marcus holds a 51% interest in Gurwitch Bristow Products LLC, the distributor and marketer of the Laura Mercier cosmetics line, and a 56% interest in Kate Spade LLC, the manufacturer and retailer of namesake designer handbags and accessories.
In fiscal 2003, the specialty retail stores segment accounted for 81.5% of Neiman Marcus Group's revenues, and direct marketing 15.9%. The remaining 2.6% of revenues was derived from the Laura Mercier and Kate Spade businesses, which we see as being relatively underdeveloped.
Retail conditions were difficult in fiscal 2003 (ended July), but Neiman Marcus neither lowered merchandise quality and customer-service levels nor cut back its expansion plans to minimize margin risk. Instead, the company rationalized weaker-selling assortments and experimented with new apparel labels to add something different to its selling floors and attract new customers. The company also stayed on course with its investments in new stores, renovations, and systems improvements. In our view, these initiatives paid off, as sales and net income before extraordinary items increased 5.1% and 27%, respectively, in fiscal 2003, vs. the 2.2% and 14% declines of fiscal 2002.
BRANDS VS. CHANNELS. We believe Neiman Marcus' fiscal 2003 results underscore the success of its four stated strategic initiatives for the specialty retail business. First is the use of customer feedback and sales data to drive the selections in six product categories (such as women's fine apparel, shoes, and contemporary sportswear) that it sees as key sales drivers. We think by listening to customer input, the company has been able to increase full-price sales and lower its markdown exposure.
Second is to improve the quality, experience, and productivity of its stores. Neiman Marcus has a relatively small but, in our opinion, very productive real-estate portfolio. The company has identified three to five lower productivity stores where it believes better marketing and merchandising could result in higher productivity and local market share in fiscal 2004. It plans to spend about $160 million over the next five years for store remodels.
Third is to enhance relationships between sales associates and in Circle Rewards (frequent shopper) program members who share the same demographics as Neiman Marcus' very best customers, but who are not as loyal shoppers. We think that by building a more personalized relationship with lower-spend customers, the company can potentially increase shopping frequency and capture more share of wallet. Neiman Marcus is currently in the process of installing a new point-of-sale (POS) system in all of its stores (expected completion by the fiscal fourth quarter), which is expected to provide sales associates with more specific customer shopping data.
FEWER MARKDOWNS. Fourth is adding inventory planners to improve efficiency in merchandise buying, planning, and store allocation. The result, we believe, is better in-stock levels of very salable merchandise. At the end of the fiscal second quarter, inventories were up only about 1%, year over year, vs. a 12% revenue increase. Inventories are current and, we think, focused on the correct trends of the spring/summer selling season.
In direct marketing, Neiman Marcus manages the overall business by brands rather than sales channels, which, in our view, improves the efficiency of merchandising and distribution operations. For its most successful brand, Neiman Marcus, which has an annual run rate of more than $500 million in sales, the company has stepped up print advertising of the Web site, added new online services, and started to capture customer e-mail addresses in its specialty stores to promote multichannel sales. For the weaker performing Horchow and Chef's Catalog brands, Neiman Marcus believes that investments in Web-site enhancements and new product assortments could improve sales momentum.
Supported by further improvement in the economy, which we think will result in increased spending by core customers, we look for Neiman Marcus' revenues to advance 12.5% in fiscal 2004, to nearly $3.5 billion. We see specialty stores contributing about $2.8 billion, and direct marketing $572 million, of which Internet sales should exceed $200 million, vs. fiscal 2003's $150 million. Retail sales should benefit from improved product assortments and store expansion and renovation. Revenues from Kate Spade and Laura Mercier should increase moderately, due to new product extensions and demand for luxury cosmetics, respectively.
UNDERVALUED. Fiscal 2004 EBIT margins should improve by about 140 basis points, to 8.6% from 7.2%. We believe these improvements will be driven by a focus on full-price selling, lower markdowns, reduced promotional activity, and improved expense leverage on comparable-store sales increase of an estimated 11%. After modest share dilution and before extraordinary items, we see fiscal 2004 earnings per share (EPS) of $3.50, vs. fiscal 2003's $2.60. For fiscal 2005, we expect EPS of $3.78, reflecting a 6% revenue increase and an 8.8% EBIT margin.
Over the next few years, we expect the company to use its free cash flow to increase its square footage by 2% to 3% annually. The company's fiscal 2004 capital budget of $130 million to $140 million is expected to fund four store remodels, adding about 110,000 square feet, as well as information-technology investments. Two new stores are scheduled to open in the fall of 2005, and one is scheduled for the fall of 2006.
In our view, Neiman Marcus' quality of earnings is relatively high. After adjustments to the company's generally accepted accounting principles-based net income before extraordinary items -- so as to conform to Standard & Poor's core earnings methodology -- the company's fiscal 2004 EPS of $3.50 would be reduced by 5.2%, to $3.32. The difference reflects an estimated 19 cents in option expense and a 1-cent pension-related credit. This variance compares favorably to the more than 20% differential estimated for Saks (SKS
), on which we have a hold rating.
We believe Neiman Marcus stock is undervalued at a recent level of 16 times our calendar 2004 EPS estimate of $3.68 -- about a 16% discount to the price-earnings multiple of the S&P MidCap 400. Our expectation would be for this discount to narrow over the next 12 months, thanks to expected improvements in margin and earnings.
FICKLE CONSUMERS. Our 12-month target price of $70 is based on our discounted cash flow model, which assumes a weighted average cost of capital of 9.9% and a terminal growth rate of 4%. This value implies price appreciation potential of about 18%. Coupled with Neiman Marcus' recently initiated quarterly cash dividend of 13 cents a share (a 0.8% dividend yield), we think the shares are attractive for purchase.
Potential risks to our investment recommendation and our 12-month target price in our view, include: changes in consumer confidence that result in reduced discretionary spending on luxury items; changes in consumer preferences and fashion trends that result in inventory overstocks and increased markdowns; changes in the company's relationship with its key customers and vendors; delays in receipt of ordered merchandise; and short- or long-term disruptions in business resulting from political, social, economic, or other events. Analyst Asaeda follows retail stocks for Standard & Poor's Equity Research