Consumer spending was up in March, according to new data from the National Retail Federation, or NRF. However, investors still shouldn't rush out to buy retail stocks. The long-term picture isn't as clear -- especially for department store chains such as J.C. Penney (JCP +0.00%), Macy's (M 0.17%), and Nordstrom (JWN +0.00%). Increased spending can help a chain's top line in the short-term, but the competition's fierce and the improvement could get lost before it generates any real sales growth. What should potential department store investors focus on instead?
Source: J.C. Penney
Even sales growth didn't show across industries -- and the results might not set a trend for future months. NRF reported that overall retail sales for March increased 0.8% month-over-month on an adjusted basis and 1.6% on an unadjusted one year-over-year. Building and garden supply stores had the largest year-over-year growth at over 6%. Clothing stores posted growth of 2.3% while sales at general merchandise stores dropped 0.2%.
Department stores fall closest to general merchandise stores thanks to their product mix, so the improvement in consumer spending growth isn't as important for them. Investors must instead rely on a company proving that it has an advantage over its competitors.
Does J.C. Penney, Nordstrom, or Macy's have that competitive advantage?
Competitive advantages
Investment guru Warren Buffett coined the use of the term moat in an economic context to represent an advantage that one company has over a competitor. If the first company has a large advantage over its competitor it has a wide moat while if there's little difference between the two it has a narrow moat.
How can an investor determine the size of a retail store's moat? Simply work out what advantages it has, which can include economies of scale -- or store count -- or supply relationships. However, investors have two easy ways to determine the size of moats at department stores: look at the range of products they offer and observe how well their inventory moves out the doors.
Out of the three department stores mentioned above, Nordstrom is the only one that even has a moat according to Morningstar's criteria -- and its moat is narrow.
Why would Nordstrom have an advantage over J.C. Penney and Macy's? Nordstrom and Macy's both have more large, well-known brands that cover a range of prices. However, Nordstrom has a clear advantage when it comes to moving inventory.
JCP Days Inventory Outstanding (Quarterly) data by YCharts
Days inventory outstanding, or DIO, is a handy metric that shows how quickly a store can move inventory off of its shelves. Generally, the competitor with the lowest DIO has the advantage. Higher DIO numbers mean that the company's not moving products through the cash conversion cycle efficiently so it might resort to margin-choking promotional offers to simply get rid of overstock.
Macy's DIO has stayed fairly in-line with that of J.C. Penney over the past five years -- and that's not a compliment. J.C. Penney had some serious inventory turnover issues last year as returned CEO Myron "Mike" Ullman worked to undo the changes made during Ron Johnson's brief time at the reins. Those inventory issues have now begun to stabilize, but fixing them required some steep price slashing for a few quarters.
So Macy's doesn't have much room for a moat since its direct competitor Nordstrom has won the inventory game. Where does that leave J.C. Penney?
Could J.C. Penney gain a moat?
Part of Mike Ullman's reversal plans included bringing back some customer-loved brands that Ron Johnson had axed: these included Arizona, St. John's Bay, and Liz Claiborne, to name a few. However, while those brands certainly have loyal fans, the breadth of J.C. Penney's brands isn't comparable to that of Macy's or Nordstrom. Frequent promotional offers have served as the company's main advantage -- its comparable-store sales plummeted 19% after Johnson ended the coupons -- but something that can hit the margins isn't moat-worthy.
Foolish final thoughts
Consumer spending can bolster the performance of retailers when the trend sticks. However, department stores won't react the same way as, say, a building supply store will. Investors can make better-informed decisions by looking at the moat potential of each company and considering how or why that could change in the near future.
