Macy's Profitability Is Likely to Drop

After months of heavy discounting and promotions, the results are in for holiday retail sales. According to the Commerce Department, Americans spent $431.9 billion in December on retail and food purchases. Apparel retailers like Macy's  (NYSE: M  )  came out on top this year, as clothing sales jumped 1.8% along with an increase in online retail purchases. Retail purchases on electronics, automobiles, appliances, furniture, and sporting goods, however, declined. 

For the past three years, Macy's has forged ahead of its retail rivals J.C. Penney (NYSE: JCP  ) and Dillard's (NYSE: DDS  ) by offering the trendiest brands at unbeatable prices, which has given Macy's the highest gross margins among its peers.

Furthermore, this growth has led to a superior return on equity, or ROE, for Macy's shareholders. However, this may not be the case for the foreseeable future.

Doing what is necessary
In order to drive growth in the future Macy's current initiatives are focused on the continual development and enhancements within its omnichannel business. This focus has been made largely because Macy's senior management has identified omnichannel marketing -- the use of brick-and-mortar stores, radio, mobile devices, online shopping, etc. in unison -- as the future of their business. Realizing the changes taking place with consumer trends in the market along with technology playing a more critical role, Macy's has decided to increase its investments in technological advancements at the expense of its gross margin, which dropped in the third quarter ended November by 40 basis points to 39.2%.

Other likely causes of this decline in gross margin can be traced to a fall in the merchandise margin and an increase in online purchases, resulting in higher shipping expenses for the third quarter. While its sales have remained strong, this latest development spells trouble for its gross margin and return on equity going forward as net profits are likely to decrease as a result, giving shareholders less of a return for their invested capital. After all, a decline in the gross margin must be met with cost cuts elsewhere or a commensurate increase in revenue.

Macy's has said that it plans to keep a tight grip on its selling, general, and administrative expenses in order to minimize the adverse effects on its gross margin, but this seems like a tough balancing act.

Pressure from the outside
Macy's moves are largely defensive due to the pressure it is feeling from other top retailers. Omnichannel marketing is a reaction to our increasingly interconnected world, and it doesn't expand Macy's reach. For instance, Amazon.com is really starting to turn up the heat on all retailers, forcing them to enhance their omnichannel efforts on all fronts or suffer the consequences. Macy's is choosing to accept the challenge, confident in its offering.

For one, Macy's may experiment with mobile apps by making customer reviews and product information available at the touch of a finger as well as alerting customers to current sales promotions through mobile devices. In addition, Macy's may integrate digital media into its product displays. While these efforts will prove beneficial in the long run, Macy's gross margin and ROE will suffer in the short run.

On top of its game
Compared to competitors Dillard's and J.C. Penney, Macy's has successfully increased its ROE over the past few years while keeping its gross margin above 40% (see table below). J.C. Penney, on the other hand, has suffered dramatic losses in its gross margin and ROE, causing the net margin to fall below zero.

While both Macy's and J.C. Penney run their fair share of promotions, Macy's gross margin has remained strong while J.C. Penney's has plummeted. This is because Macy's has been successful at encouraging consumers to purchase more items at lower prices while J.C. Penney has been unsuccessful at making this happen, causing the gross margin and profits to significantly decline.

Quite often, when the gross margin falls the ROE falls with it, as in J.C. Penney's case. This is not the case for Macy's, though, whose ROE has increased steadily year over year despite the gross margin slightly declining. Dillard's has experienced the most improvement in its gross margin with a fairly high ROE -- still trailing Macy's ROE -- which could change in the near future.

Company Name

Gross Margin

FY 2012

Gross Margin

FY 2011

Gross Margin

FY 2010

Dillard's

37.09%

36.82%

36.39%

J.C. Penney 

31.31%

36.03%

39.19%

Macy's

40.27%

40.4%

40.71%

 

Company Name

Net Profit Margin

FY 2012

Net Profit Margin

FY 2011

Net Profit Margin

FY 2010

Dillard's

4.98%

7.24%

2.87%

J.C. Penney 

-7.56%

-1.52%

2.19%

Macy's

4.82%

4.76%

3.39%

 

Company Name

Return on Equity

FY 2012

Return on Equity

FY 2011

Return on Equity

FY 2010

Dillard's

15.7%

11.4%

8.1%

J.C. Penney 

N/A

N/A

6.9%

Macy's

23.3%

20.9%

15.7%

Foolish takeaway
Although Macy's share price has been on the rise over the last year, its fourth-quarter and full-year performance might not be strong enough to keep pace with increased omnichannel spending, especially since its gross margin is expected to drop. Remember, a drop in gross margin must be met with an equal decrease in expenses elsewhere or an equal increase in sales to balance out the effects of omnichannel investments.

Even though Macy's has done quite well for itself, this may not be the best time to make an investment in the company, as these moves are largely defensive. Foolish investors may want to look elsewhere before investing in Macy's, as the gross margin and ROE are likely to shrink over the next several months unless sales quickly ramp up, which seems unlikely given the current retail environment.

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