Consumers in the U.S. spend most of the year looking forward to the deep discounts and deals offered by retailers during the holidays, and this year shouldn't disappoint. Overall holiday sales are expected to climb more than 3% during the 2015 holiday season, according to the National Retail Federation. Retailers such as Macy's (NYSE:M) and Target (NYSE:TGT) are hoping to capitalize on this by rolling out seasonal deals ahead of Thanksgiving and the traditional start to the holiday shopping season.
But, should investors worry that heavy promotions at Macy's and Target will translate into thinner profit margins?
Not a bright holiday for all
Investors recently punished shares of Macy's after the department store chain blamed sluggish traffic for its disappointing third-quarter results. The company's profit plummeted as much as 46% to $118 million in the quarter, while revenue fell 5% to $5.9 billion. Analysts were looking for quarterly revenue of $6.1 billion in the period.
Disappointing sales coupled with growing inventories led Macy's to forecast a weak upcoming holiday quarter. CEO Terry Lundgren said margins would likely take a beating on the heels of steep markdowns. "I wish I could say tourists are going to begin to show up and start spending. But you can see in our forecast for fourth quarter we are not expecting that," he said on an earnings call with analysts. He went on to say that Macy's would be forced to mark down inventory. "That will be good for consumers but it will, obviously, put pressure on our own margins in the fourth quarter," Lundgren said.
However, investors shouldn't confuse Macy's expected margin weakness with an outcome of broader holiday markdowns. In fact, if you think the holiday promotions hurt profit margins for retailers like Target and Macy's, you're wrong. "Gross profit margins for retailers are actually the highest during the holiday season," according to LPL Financial. Moreover, some retailers generate as much as 40% of their total annual revenue during the holiday shopping season.
Sure, retailers are under a lot of pressure these days to offer popular merchandise at competitive prices. However, many of these retail chains negotiate special deals with suppliers in order to protect their profit margins during this time of year.
Still, retailers can achieve only so much upfront protection ahead of the holiday season. After all, Target, Wal-Mart, and Best Buy are just a few of the chains offering price-matching guarantees this year. This could have an adverse affect on profits because many of these companies will be forced to directly compete with Amazon (NASDAQ:AMZN) on price.
As we know, the e-commerce giant is at an advantage because without physical stores it doesn't have the overhead costs of its brick-and-mortar retail rivals. Amazon could see more than a 40% spike in profit during the holiday quarter this year, according to USA Today. As part of its holiday strategy, Amazon began offering Black Friday-esque deals more than a week in advance of Black Friday, with new offers coming online hourly.
Not only will retailers have to offer deeper discounts in order to steal traffic from rivals, but they also must offer these promotions for extended periods if they want to remain competitive in today's retail environment.
The day after Thanksgiving, known as Black Friday, used to be one of the busiest shopping days of the year. However, industry pundits are now speaking of "Black November" instead of Black Friday, as many retailers including Macy's and Target plan to open stores earlier than ever for holiday sales. Both of these companies plan to open stores at 6 p.m. on Thanksgiving Day.
Target got an extra early start this year by releasing its digital holiday catalog shortly after Halloween last month. Macy's followed suit early this month teasing its respective Black Friday deals including women's puffer jackets for just $19.99 and buy one, get one free fashion jewelry. Both Target and Macy's plan to offer Black Friday doorbuster deals both in-store and online.
While this will certainly help the brick-and-mortar retailers compete with Amazon, it could also hurt their in-store traffic if more consumers opt to shop online this year. Ultimately, that could lead to margin depression at Target and Macy's, since traditionally, those doorbusters draw consumers into physical stores, where they typically purchase additional (often higher margin) merchandise.
On top of this, if we see a repeat of last year's pattern, many retailers could be left with excess Black Friday inventory. Sales fell 11% last year during Black Friday weekend as in-store traffic declined more than 5%, according to data from the NRF.
The real problem for these retailers, then, will be if they aren't able to sell the majority of their inventory from the holiday season. You see, major retailers such as Target and Macy's typically increase their inventories heading into the holidays. However, it's not a perfect science, and overstocking merchandise now could force these stores to issue deep discounts after the holidays -- thereby eating into profit margins in the months ahead.
Consumers will find impressive deals in stores and online this holiday shopping season. However, these promotions won't come at a devastating cost to retailers. Macy's has already said that it expects its margins will suffer, but that has more to do with slow traffic and weak sales leading up to the holidays than it does with seasonal Black Friday deals and holiday promotions. Meanwhile, Target is poised to come out on top this year if it is able to move its seasonal inventory and still attract meaningful traffic to its stores, despite offering its entire lineup of Black Friday deals online.
Tamara Rutter owns shares of Amazon.com and Target. The Motley Fool owns shares of and recommends Amazon.com. 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.