The COVID-19 pandemic forced department stores to close their stores for much of the spring -- and even longer in some cases -- while weighing on traffic even after they reopened. As such, most major department store operators reported dreadful results for the first half of fiscal 2020.
That said, sales and earnings trends improved dramatically in the second quarter relative to the first quarter. This week, Kohl's (KSS 1.83%) and Macy's (M 2.14%) are set to report their results for the third quarter. Investors are eager to see if the pattern of sequential improvement continued.
Kohl's pivots to meet changing demand
In the first quarter, Kohl's rang up a substantial adjusted net loss of $495 million as revenue plunged more than 40% year over year. However, it reacted quickly to the COVID-19 pandemic, starting with the rollout of curbside pickup in early April at most of its stores. It was also able to reopen most of its stores in May as states and cities relaxed their stay-at-home orders.
As a result, Kohl's was able to stem the bleeding in its fiscal second quarter. Revenue fell 23% year over year, while gross margin improved sequentially to 33.1% from 17.3% in Q1. While gross margin was still down significantly year over year, this sequential improvement enabled Kohl's to limit its adjusted net loss to a very modest $39 million in the second quarter.
During Kohl's Q2 earnings call, management noted that the back-to-school season had gotten off to a slow start. Back-to-school is typically a big revenue driver for the retailer in the third quarter. Nevertheless, the sequential improvement Kohl's experienced in the second quarter probably carried into Q3. Back-to-school sales may have come later in the fall, as many schools started online in August and September but have since reopened. Additionally, Kohl's has been leaning into its strength as a seller of active and casual apparel, focusing its inventory on the items that customers are most likely to buy right now.
Indeed, analysts estimate that Kohl's revenue declined 12% last quarter. And while they expect another quarterly loss, Kohl's is projected to return to profitability in the fourth quarter, posting roughly breakeven earnings for the second half of fiscal 2020.
Macy's faces deeper challenges
Macy's results also improved sequentially in the second quarter, but not as much as Kohl's. Revenue declined 35% year over year in Q2, compared to a 45% drop in the prior quarter. Gross margin improved sequentially from 17.1% to 23.6% but remained quite low in absolute terms. Similarly, Macy's was able to reduce its adjusted net loss by 60% sequentially but still lost a good deal of money in the second quarter: $251 million, compared to $630 million in Q1.
Like Kohl's, Macy's rolled out curbside pickup to drive sales in the second quarter. For the full quarter, digital sales jumped 53% year over year and accounted for more than half of the department store chain's sales.
However, Macy's was playing with a bad hand. Unlike Kohl's, most of its stores are located in malls, many of which weren't fully open for much of the quarter. Macy's also has numerous stores in major cities that rely heavily on tourist traffic. That part of the business is likely to recover especially slowly. Finally, Macy's typically sells a lot of "dressy" clothing, which isn't in demand right now.
Still, Macy's is taking strides to capitalize on the parts of its business that are performing well, including home, luxury, and off-price. It is also cutting costs extremely aggressively. Analysts expect Macy's to report a 26% year-over-year sales decline for Q3 and an adjusted loss roughly in line with its second-quarter result. If anything, these estimates seem conservative.
Two very different turnaround plays
Executives at Macy's and Kohl's have emphasized that they expect continued volatility in the months ahead. Both retailers are operating with very lean inventory, which should help them manage through this volatility without resorting to big markdowns. Indeed, smaller regional competitor Dillard's recently reported a solid year-over-year increase in gross margin for the second straight quarter, thanks to tight inventory management.
Ultimately, Kohl's and Macy's hope to return to sales growth by gaining market share from weaker competitors that have gone out of business or downsized significantly this year. Kohl's clearly has an easier path, thanks to its off-mall store locations, focus on active and casual apparel, and expanding portfolio of national brands. Macy's prospects depend more on a demand recovery for dressy clothing, improvements in traffic to top-tier malls, and the return of its high-margin tourist business.
Still, while Kohl's stock trades for just five times its 2019 earnings -- providing plenty of upside if it makes a full recovery -- Macy's stock is even cheaper at just three times its 2019 earnings. At those rock-bottom valuations, Kohl's and Macy's shares have substantial upside if they show further progress in the third quarter.