Department Stores: Investing Essentials

The glory days of department stores ended a long time ago. In the 1950s and 1960s, Americans did a large proportion of their nonfood shopping at department stores, which served as focal points of social interaction. At the time, going to a new suburban shopping mall was considered an enjoyable all-day activity.

In the past several decades, discount retailers have gradually taken market share from department stores by offering lower prices on many items. Smaller brand-oriented specialty stores have also become fashionable places to shop for apparel. More recently, the growth of e-commerce has created another layer of low-cost competition.

Can department stores survive in the 21st century? Photo: The Motley Fool

For all these reasons, many department stores have struggled during the past decade or so. But not all department stores are on the outs -- a few forward-thinking chains are solidifying a place for themselves in the 21st century retail landscape.

What are department stores?

Department stores typically sell a wide variety of goods, typically centered on clothing, shoes, accessories, home furnishings, and -- in some cases -- appliances. They are organized in "departments," which represent different categories of merchandise (hence their name).

Price-wise, department stores run the gamut from very affordable chains geared to the middle class up to luxury-goods retailers that cater to an exclusive clientele. The former group includes companies like J.C. Penney (NYSE: JCP  ) , while the latter group includes privately held Neiman Marcus.

How big is the department store industry?

The diminished stature of the department store industry is highlighted by its small revenue base relative to discount stores, which are approaching $1 trillion in annual revenue in North America. The largest department store chain in 2014 is Macy's (NYSE: M  ) , which operated approximately 840 stores and had annual revenue of about $28 billion as of 2013.

Macy's is the largest department store chain by sales in 2014. Photo: The Motley Fool

In total, there are five North American department store chains with at least $10 billion of annual revenue. Including those companies and several smaller chains, the sector's annual revenue is a little more than $100 billion. By contrast, Wal-Mart alone generated nearly $400 billion of revenue in North America in 2013.

How does the department store industry work?

Department stores typically send buyers all over the world to find merchandise so that they can offer a wide assortment in their stores. Most -- though not all -- department stores then use a "high-low" pricing strategy to drive sales while protecting margins.

The high-low strategy involves significantly marking up listed retail prices from the wholesale cost paid by the department store. This means that department stores earn very high margins on full-price merchandise. Then they run frequent sales and coupon offers, lowering the final price for most customers.

J.C. Penney's "honest" pricing experiment in 2012 failed. Photo: The Motley Fool

This age-old trick takes advantage of human psychology -- people like to think they are getting a special "deal." In 2012, J.C. Penney tried to implement a more "honest" pricing policy -- it cut back drastically on sales and eliminated coupons, while lowering listed prices. The strategy was a failure, and was reversed just a year later.

What are the main drivers for department stores?

Department stores depend on favorable economic conditions, because discretionary purchases represent the vast majority of their sales. Economic downturns can hurt department stores in several ways. First, with lower demand, sales volume typically falls. This means that fixed costs have to be spread over a smaller revenue base.

Second, department stores need to offer bigger promotions in order to attract customers when the economy is weak.

Department stores must use big clearance markdowns when sales miss expectations. Photo: The Motley Fool

Third, department stores (which often have to order merchandise far in advance of when they plan to sell it) may face inventory gluts if demand suddenly drops. This forces them to take big clearance markdowns to get rid of unwanted merchandise. All three issues cause margin pressure, and the net result can be a quick slide into the red.

Thus, the department store business tends to be highly cyclical. When times are good, it's not that hard to make a profit. But weaker companies can get into a lot of trouble when the economy weakens and consumers tighten their purse strings.

Longer term, another major driver for the sector is the rise of other retail concepts: discount retailers, fast-fashion stores, off-price stores, e-commerce retailers, etc. All of these other parts of the retail landscape are growing faster than the department store sector. With lower costs, they can offer lower prices to lure price-sensitive shoppers away from full-service stores.

Department store chains that are adapting to the changing retail landscape still have solid long-term prospects. For example, Macy's has aggressively built up its e-commerce and "omnichannel" capabilities to drive sales growth. While Macy's recently stopped reporting e-commerce sales, it had previously been posting 30%-40% annual online sales growth.

Stores that differentiate themselves through higher service are also better-positioned to stay relevant, because their customers can afford to pay for personalized attention. By contrast, department stores competing directly with lower-cost merchants and relying primarily on in-store purchases are likely to struggle.

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Adam Levine-Weinberg

Adam Levine-Weinberg is a senior Industrials/Consumer Goods specialist with The Motley Fool. He is an avid stock-market watcher and a value investor at heart. He primarily covers airline, auto, retail, and tech stocks. Follow him on Twitter for the latest news and commentary on the airline industry!

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