Is This Department Store Operator Stuck in the Middle?

Michael Porter, a leading authority on competitive strategy, terms companies which don’t deliver either on product differentiation or on low cost strategies as "stuck in the middle". Kohl’s is trying to avoid that label by putting its emphasis back on national brands.

Mar 15, 2014 at 1:30PM

Media
Source: Kohl's

As the rich-poor divide widens, the middle class, a key target customer demographic for department stores, is fast disappearing. Unlike its other department store peers, Kohl's (NYSE:KSS) positions itself as a family focused, value-oriented, specialty department store and pushes its business model closer to that of the off-price retailers. Does that mean that Kohl's has a better chance of surviving in the tough retail market?

Going back to its roots
When the first Kohl's store was opened in 1962 in Brookfield, it didn't have a clear positioning and sold all kinds of products including candy and engine oil. It wasn't until 1987 through a change of control that Kohl's became a shopping destination for quality national brands, which at that point accounted for 80% of its product assortment. This resulted from a shift in focus to high-margin products such as apparel and jewelry.

Given its recent poor results of negative comparable-store sales growth in three out of four quarters in 2013, Kohl's is returning to its roots with a renewed focus on national brands. There have been early encouraging signs. National brands accounted for 47% of Kohl's sales in the third quarter of 2013, compared with 44% in the prior quarter. In 2014, Kohl's is launching new brands such as IZOD and Juicy Couture.

Kohl's also recognizes that its key differentiating factor among department stores is its image as a savings leader. It plans to increase the number of cash earn and redeem days under the Kohl's Cash scheme, where customers earn $10 Kohl's Cash coupon for every $50 purchased. More opportunities to save will also be offered to its Charge Card customers, who are already assured of special discounts of 15-30% at least 12 times a year.

Pure off-price retailers still have greater appeal
The proof of the pudding is in the eating. While the jury is still out on the results of Kohl's return to its roots as a national brand retailer, the company's positioning as a value-oriented retailer hasn't gained resonance with consumers historically, unlike that of its off-price peers. Comparing the historical same store sales of Kohl's and off-price retailer The TJX Companies (NYSE:TJX) validates this view.

From late 2007 to early 2009, Kohl's registered negative same-store sales growth for eight consecutive quarters. On a full-year basis, Kohl's saw negative comparable store sales growth of 0.8% and 6.9% in 2007 and 2008 respectively. In contrast, TJX delivered positive comparable store sales growth from 2007 to 2009, notwithstanding the Global Financial Crisis. This is the clearest indication that bargain hunting consumers shifted their purchases away from department stores to off-price retailers during the recession.

Burlington

Source: Burlington

This is a better retail concept
For investors who believe in the success of retailers combining the best of both worlds in terms of product differentiation and low cost strategies, off-price retailer Burlington Stores (NYSE:BURL) might be a more attractive investment choice.

With respect to product differentiation, Burlington places a strong emphasis on filling its stores with quality national brands. This is supported by its larger average store size (to accommodate more SKUs) and differentiated merchandising strategy. Burlington boasts a larger average store size than other off-price retailers at between 50,000 and 80,000 square feet. This is also comparable to department stores like Kohl's that have an average store size is approximately 72,000 square feet.  

Burlington also adopts a shallow merchandising strategy, intentionally stocking only a limited number of units for each style. As a result, Burlington relies on opportunistic in-season purchases as opposed to pre-season sourcing strategies that department store operators like Kohl's typically employ.

With regards to cost efficiency, Burlington has driven costs down to support its "Everyday Low Price" model that promises 60%-70% savings off department store regular prices. With better inventory management, it significantly minimized inventory holding costs by reducing aged inventories (90 days and older) by 43% from 2008 to 2012.

The results speak for themselves. Burlington delivered gross margins of 39% in the trailing twelve months, which were significantly higher than gross margins of 36% and 29% for Kohl's and TJX respectively. Between 2010 and 2012, Burlington has outperformed both off-price retailers and department store retailers in terms of sales growth with a CAGR of 6.1%, based on research data from NPD Group. Comparatively, off-price retailers and department store retailers grew their top lines by only 5.4% and 0.5% respectively over the same period.

Foolish final thoughts
It is tempting to invest with a value-focused department store operator like Kohl's when a new culture of frugality has set in and consumers are becoming more cost-conscious. However, the financial numbers suggest otherwise. Off-price retailers are more appealing to consumers when it comes to low prices, and Kohl's renewed focus on its national brand strategy is still under way. Instead, investors are advised to consider Burlington, which has gained favor with consumers because of a combination of low prices and in-season branded merchandise.

Good stocks keep their old customers coming back and continue attracting new customers. Burlington, an off-price retailer, has scored well on this metric, given its superior sales growth relative to the industry. The Motley Fool's chief investment officer has selected his No. 1 stock for 2014, and it's one of those stocks that could make you rich. You can find out which stock it is in the special free report "The Motley Fool's Top Stock for 2014." Just click here to access the report and find out the name of this under-the-radar company.

Mark Lin 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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