Just six years ago, Macy's (NYSE:M) seemed like an unstoppable cash-generating machine. However, since fiscal 2014, its revenue has gradually receded while profitability has plummeted. Contrary to popular belief, the rise of e-commerce hasn't been Macy's biggest headwind. Rapid expansion by off-price retailers like TJX Companies (NYSE:TJX) has been a bigger headache.

Both department stores like Macy's and off-price retailers were hit hard by the COVID-19 pandemic earlier this year, but the off-price segment is recovering much faster. As a result, many investors and analysts expect it to win the recovery, a result that would further marginalize Macy's. While there's something to be said for that theory, Macy's may be more competitive than many people believe.

Macy's falls while off-price retail rises

Macy's earned a $2.5 billion adjusted pretax profit on revenue of $28.1 billion in fiscal 2014, up from an adjusted pretax profit of less than $1 billion on $23.5 billion of sales just five years earlier. Alas, it has been all downhill from there. By fiscal 2019, sales had slumped to $24.6 billion, and adjusted pretax profit had fallen back to around $1 billion.

The exterior of the Macy's San Francisco flagship store

Image source: Macy's.

During the same period, off-price retailers rapidly gained market share. TJX generated $22.1 billion of revenue in the U.S. during its 2015 fiscal year (equivalent to Macy's fiscal 2014) -- well shy of the department store giant. Five years later, the roles were reversed. TJX generated $32 billion of revenue domestically in its fiscal 2020 (which ended Feb. 1). Its U.S. segments also posted a combined operating profit of more than $4 billion.

If anything, the performance gap has widened this year. In the spring, when most nonessential retailers were forced to close, Macy's had an advantage due to its well-developed e-commerce business. By contrast, most off-price retailers do little if any business online.

Since then, shoppers have returned to off-price stores in a meaningful way. Last quarter, TJX's domestic sales fell by just 3.5% year over year. A 15% comp-sales surge for its HomeGoods chain almost fully offset declines at T.J. Maxx and Marshalls. By contrast, Macy's sales fell 22.9% year over year last quarter.

The threat levels vary across merchandise categories

Off-price retailers have at least two major advantages over department stores. First, their more-flexible buying strategies help them to respond quickly to fashion trends and shifts in consumer demand. Second, their smaller, easy-to-shop stores, frequently changing merchandise assortments, and discounting encourage more frequent visits.

However, the threat department stores face from this niche varies widely between merchandise categories. Some of Macy's most important categories -- such as furniture, mattresses, and fine jewelry -- face no off-price competition. In many others, such as beauty and dressy clothing, off-price retailers may compete, but Macy's retains a meaningful competitive advantage.

Women's apparel is the area where off-price retailers have the biggest edge over department stores. And of the $379 million decline in Macy's top line between fiscal 2017 and fiscal 2019, $354 million was from women's apparel. (Home furnishings is another weak spot.)

Yet women's apparel represented just 22% of Macy's merchandise mix last year. Moreover, that includes categories like dresses where Macy's is still a strong competitor. In short, while an important slice of Macy's business is especially vulnerable to off-price competition, most of its revenue comes from areas that are more secure.

Macy's can compete in off-price, too

The threat that off-price retailers pose to department stores may be limited to certain categories, but it's very real. However, over the past five years or so, Macy's has developed a meaningful off-price business of its own under the Backstage banner.

A Macy's Backstage store inside of a full-line Macy's store

Image source: Author.

Today, there are well over 200 Backstage stores, most of them inside full-line Macy's stores. In the years ahead, Macy's intends to expand the chain, adding it to more full-line stores and opening a meaningful number of standalone Backstage stores outside of malls. The pandemic delayed these plans, but they will resume next year.

Macy's can't just go back to business as usual after the pandemic and expect to succeed. But by focusing on its best stores and strongest merchandise categories while expanding Backstage to tap into demand that is better served through an off-price channel, it can stay relevant for years to come.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.