Moody's Has 2016 Operating Income at Down 18% for Department Stores

More headaches are ahead for department stores unless they speed up changes that address consumer preferences for value and convenience.

Ratings agency Moody’s Investors Service analyzed post-holiday sales and found that most major companies in the sector ran up negative comparable-store sales for the period. It has now revised its 2016 operating income forecast to an 18 percent decline from the previous expectation of an 11 percent drop. Moody’s also said it sees limited improvement in 2017.

The report, headed by lead analyst Christina Boni, said department stores seemed poised to get back on track at the beginning of the holiday season. That’s because they entered the fourth quarter with leaner inventory, an increasing online presence and a relatively upbeat U.S. consumer base. Post-holiday results showed comps down for many retailers, including a 2.1 percent decrease for Macy’s Inc. and Kohl’s Corp. J.C. Penney Co. Inc. dipped 0.8 percent.

While the sector seemed to be pulling all the right levers, results still managed to disappoint — a factor Boni said “speaks to the magnitude of the sector’s challenges.” Despite efforts to retain and attract more customers, many continued to look elsewhere for their purchases.

Boni noted that traditional department store consumers continued to defect to e-commerce, fast-fashion and off-price alternative channels, making “value and convenience” the new competitive mantra. While department stores have tried to fight back with buy-online, pick-up-in-store and accepting online returns, those actions haven’t been enough to fix the business model. The analyst said “2016 holiday results have clarified that department stores must recalibrate in 2017 much faster than we thought, or risk falling even further behind competitors.”

The downward revision to the operating income forecast was because results fell below the ratings agency’s “already-cautious expectations.” And there are more pressures ahead, with Boni noting that sales will continue to shift to online and off-price. “Over the next 10 years, we expect department stores to generate nearly 35 to 40 percent of their sales from e-commerce, compared with 20 percent today,” the analyst said.

Macy’s has already guided its 2017 comps to a decrease of 2 percent. Given the consumer preference for e-commerce, fast-fashion and off-price channels, Boni said value and convenience have become the “new competitive holy grail.”

While the credit analyst emphasized that the department store model is nowhere near being on the brink of becoming obsolete, she did note that the allure of physical proximity and price discovery means the sector will have to recalibrate operations.

She expects footprints will continue to shrink as the competitive advantages of running an integrated model of stores and online will warrant fewer stores and small store layouts. That’s a move that will make it tough for retailers to maintain operating margins and will require them to redeploy savings to technology to keep up with rapidly evolving customer expectations. Further, the sector will have to figure out how to balance inventory for in-stock positions and still meet delivery times for online orders.

“Fast-fashion and off-price have developed more efficient supply chains with shorter lead times, which results in faster turns and fresher product on its selling floor. Reducing inventory to align with sales is important to maintaining merchandise margins, but it must be balanced with product availability,” Boni noted.

The winners and losers in the race for value and convenience has off-pricers ranking highest when it comes to value, while department stores tend to have a great e-commerce penetration — although product freshness is a significant challenge, reflecting their lower inventory turns relative to off-price.

Kohl’s fared best for value, convenience and online capabilities, while Bon-Ton Stores Inc. and Dillard’s Inc. fared the worse because of their limited online presence. And while other department stores may have ranked higher than Bon-Ton and Dillard’s because of their emphasis on private label, Boni said, “Evolving purchase behavior suggests that these operators may still not be focused on the product that consumers want or expect.” Further, even delivering on low prices might have its shortcomings. Boni cited Kohl’s and J.C. Penney, noting that the customer may be expecting more value than the stores are actually delivering.