The Party's Over for Retail Fraudsters

If showrooming and shoplifting weren't enough, retailers have long worried about a form of retail fraud known as "wardrobing," or returns of previously worn items. Bloomingdale's, part of Macy's (NYSE: M  ) , is making news, cracking down with highly-visible black tags that must be cut off before a dress costing more than $150 is worn. Apparel returned without an intact tag is refused.

Not so funny
The practice of "wardrobing" cost retailers $8.8 billion last year, according to the National Retail Federation. Even worse, the practice is growing, up from 61% in 2011 to 64.9% in 2012. Bloomingdale's' black-tag policy is reportedly causing some initial protests from consumers on social media but should see wary adoption by other retailers.

Notably, high-end retailer Nordstrom (NYSE: JWN  ) will not use such tags, although it has one of the more gracious return policies. Like most retailers, it has a discretionary policy on obviously-worn pieces it can refuse.

L Brands (NYSE: LB  ) , which owns Victoria's Secret and high-end accessories store Henri Bendel, maintains a database of frequent returners like many other retailers. L Brands also uses special inks on receipts to fend off counterfeit returns.

Of interest is that Macy's is seeing "wardrobing" to be increasingly common among younger customers, precisely the demographic the company is courting, especially with prom dresses. As multiple teen retailers and other apparel retailers have reported this earnings season, the youngest consumers are feeling the most strapped for cash.

Retailers don't want to create an adversarial, suspicious relationship with customers, but fraud of all sorts is on the rise -- including counterfeit receipts, counterfeit e-receipts, returns of stolen merchandise, shoplifting, and employee theft and collusion with outside sources. These various forms of fraud and theft are known collectively as "shrink."

"Shrink"ing returns
Shrink is the dirty little secret of retail, never mentioned on an earnings call. Bloomingdale's and Macy's spokespersons wouldn't comment to Bloomberg about wardrobing, claiming store policy on public comment on return fraud. Employee theft and shoplifting costs retailers an estimated $33 billion annually, averaging 1.7% of gross sales.

Macy's initiative displays the leadership of this iconic retailer. Although Macy's disappointed when it reported in August, blaming a wary consumer more willing to spend money on housing and cars than on apparel and home goods, Macy's is still "America's department store."

Nordstrom is similarly an admirable retailer. Nordstrom's customer service is renowned, and as spokesman Colin Johnson voiced the store's philosophy on return fraud to Bloomberg,"Our experience is that if you treat the customer with respect, they respect you back."

The question remains: which of these retailers will outperform going forward--Nordstrom with its gracious policies or Macy's hard-line effort to bring back that 1.7% of sales gone missing? Do you instead buy an L Brands, which is taking a middle-of-the-road approach to "shrink?"

The all-important holidays
The holidays are rife with special-occasion events, so getting customers acclimated to the big Bloomingdales change early was imperative. Holidays are the make or break period for retail. L Brands may have the edge as its cataloge reaches 390 million customers annually and it has a larger international presence with 792 stores ex-US. The company boasts that its Victoria's Secret website is "one of the fastest growing and profitable e-commerce destinations on the Internet."

While both Macy's and Nordstrom guided lower on their second quarter results, L Brands guided higher for the full year and reported 6% growth of comparable same-store sales. In the 2012 letter to shareholders, CEO Leslie Wexner stated that the company can double its business within five years because it owns the top three lingerie brands and the top personal-products specialty retail brand, Bath & Body Works.

Holiday brick-and-mortar sales for all three companies will likely lag last year's records, as a calendar shift leads to only 26 shopping days after Thanksgiving -- including Black Friday -- as opposed to 2012's 32 days.Online will be even more important, but all three companies look to be in good shape on that score.

Of course, returned merchandise will be a factor in holiday performance. According to that same NRF survey, over one-quarter of all merchandise returned throughout the year is holiday merchandise. Nordstrom's Santa-like generous return policy may lead to its taking more of a hit than the other two, even as Macy's Bloomingdale's stores protect themselves.

The Foolish takeaway
Investors should be cheered by Macy's taking a stand on this form of fraud. Over time, it may lead to an improved bottom line. Macy's is also the cheapest on valuation and has the highest yield at 2.2%.

However, Nordstrom generates shopper loyalty and respect, and has strong insider conviction, with the Nordstrom family holding one-quarter of the company's shares. Still, L Brands likely can outperform both of them with its global and internet footprints.

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