A year ago, most department stores' profits took a beating as the sector suffered from a deadly combination of high inventory and weak demand. This situation forced companies such as Macy's (NYSE:M) and Kohl's (NYSE:KSS) to offer big margin-killing markdowns to clear out unwanted merchandise.
After last year's horrific results, many investors are wondering whether 2016 will bring a repeat. Some pundits think retailers are actually discounting more -- not less -- this time around. If that were true, it would be dire news for chains such as Macy's and Kohl's. Yet while discounting remains the norm, department stores remain on pace to produce better gross margin and earnings results in Q4 relative to the year-ago quarter.
Q4 2015 was a disaster
Ideally, retailers would like to keep inventory growing no faster than sales. When inventory grows faster than sales, some merchandise ends up sitting unsold. Eventually, retailers have to clear out those extra goods, which can mean selling them at cost, or less.
Last year, department stores entered the fourth quarter with too much inventory on their hands. At Macy's, inventory was up 4.6% year over year at the end of Q3 2015, even though sales had been declining throughout the year. Meanwhile, Kohl's ended Q3 with inventory up 5.7% year over year against a backdrop of 1% sales growth.
If sales had accelerated in Q4, this excess inventory might not have been a problem. However, the U.S. experienced the warmest winter on record last year, undermining demand for cold-weather gear. As a result, comps plunged 4.3% at Macy's in Q4 2015, while comps at Kohl's grew by a slower-than-expected 0.4%.
With high inventory and weak demand, both chains had to use deep clearance markdowns to entice shoppers to buy cold-weather merchandise. For the fourth quarter, gross margin fell from 33.9% to 33.1% at Kohl's and from 40.3% to 37.4% at Macy's. This margin deterioration drove 14% adjusted EPS declines for both companies in Q4 2015.
Are retailers cranking up the discounts again?
Last week, Suzanne Kapner wrote in The Wall Street Journal that "chains winnowed inventories this year in the hope that scarcity would allow them to be less promotional. It didn't work: Discounts are even deeper this year."
Kapner cited two main pieces of evidence for this conclusion. First, a study by DynamicAction found that the number of online purchases that included discounts jumped 79% year over year in November and more than doubled in the first week of December.
Second, Nomura Instinet analyst Simeon Siegel reported that of 21 retailers he tracks, 19 were more promotional during the first week of December than they were a year earlier. Both pieces of evidence appear to show a worsening retail environment. However, that's not necessarily the case.
There's nothing wrong with a good promotion
While retailers such as Macy's and Kohl's are delighted when they can sell merchandise at full price, they don't count on doing so. Department-store executives know that most customers won't buy something if it isn't "on sale," so they plan accordingly by implementing high initial mark-ups.
In other words, the "original price" advertised by a department store could be three, four, or even five times what the company paid for it. (Macy's and Kohl's were both recently sued by the Los Angeles city attorney's office for this practice.) For example, suppose Macy's pays $18 for an item. It might set the list price at $60. That provides plenty of leeway to sell the item for 50% off ($30) while still pocketing a strong 40% gross margin.
If sales aren't strong enough with a 50% discount, Macy's might offer an additional 20% off the sale price, reducing the price from $30 to $24. At that point, gross margin would be just 25% -- not great, but not terrible. Items that still haven't sold by the end of the season would be put on clearance. They might be offered for 70% off (or $18), at which point Macy's would be selling the items at cost.
This example highlights a key point about the retail industry: Promotions don't necessarily hurt margins. What really kills profit margins is selling a lot of merchandise on clearance at the end of the season. That's what happened at most department stores last year.
Department stores are having no such trouble this year. For example, Miriam Gottfried of The Wall Street Journal has been making weekly trips to several retailers (including Macy's) this holiday season to keep track of discounts. She found that Macy's offered big discounts during the first week of December on certain items but that discounting declined the following week, as Macy's had already sold through a lot of its inventory.
Don't fear the discounts
Department stores still aren't experiencing boom times. The U.S. Department of Commerce recently reported that sales at clothing stores were flat in November.
However, companies such as Macy's and Kohl's are well prepared this year, with inventory down 5% and 10% year over year, respectively. Furthermore, cold weather has swept across the U.S. in December, which could boost winter apparel sales by $350 million for the month. That should help Macy's and Kohl's sell through their stock of winter clothing and accessories.
Even with favorable weather, mass-market department stores such as Macy's and Kohl's still need to offer discounts to attract customers. But there's no sign that those discounts are out of hand -- or that Macy's and Kohl's will be weighed down by a glut of clearance merchandise next month.
Adam Levine-Weinberg owns shares of Macy's. 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.