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DICOUNTERS DOMINATE, FUNDAMENTALLY

NEW YORK -- Market share isn't the only vital statistic giving discounters a leg up over department stores.<P>Facing more agile and focused competition, department stores have underperformed the retail industry -- especially discounters who...

NEW YORK — Market share isn’t the only vital statistic giving discounters a leg up over department stores.

Facing more agile and focused competition, department stores have underperformed the retail industry — especially discounters who continue to steal customers and depress prices.

Department stores have reacted by reining in expenses and inventories and attempting to react more quickly. Still, the distance between them and their competitors on the broadline and speciality side continues to grow.

Many of the cold, hard numerical truths facing the department stores came to light in a statistical roundup of the last six years by J.P. Morgan Securities broadline analyst Shari Schwartzman Eberts.

According to the report, which pulled together data from several sources, department stores, including conventional formats and national chains, realized combined sales last year of $95.5 billion, a 5.5 percent drop from the preceding year and 4 percent of the total retail pie. Since 1996 department stores nudged their collective top line up just 0.4 percent.

On the other hand, discounters, including supercenters, drove their 2001 sales up 12.1 percent to $251 billion, making up 10.5 percent of the total retail market in the U.S. Only grocery stores commanded a higher percentage of the market, with 18.2 percent. From 1996 to 2001, discounters’ top lines swelled 60.2 percent.

Over the same five-year span, discounters also posted superior performances in areas ranging from sales per square foot and inventory turns to selling, general and administrative expense as a percentage of sales and return on invested capital.

However, with discounters, led by Wal-Mart Stores, increasing the percentage of food in the merchandising diets, department stores did boast superior margins and lower debt-to-equity ratios.

In addition to the growing disparity between sectors, the gap between weaker and stronger players within sectors continued to widen. Among the department stores, Kohl’s Corp. continued to set the bar higher with its value department store format as many of its competitors struggled. Likewise, the now-bankrupt Kmart Corp. dragged down results in the discount sector that also includes powerhouses Wal-Mart and Target Corp.

A comparison of the sectors’ financial metrics may miss some subtleties between the two types of businesses, but does not fail to pick up on the overall trends confronting them.

The numbers aren’t terribly surprising, said Eberts. “Everybody intuitively knows that the distance between discount and department stores continues to grow. Part of this is a response from consumers who are voting with their dollars. They prefer a value, off-the-mall format.”

Blame for the drop-off in department stores over the six-year period, she said, cannot be placed on the recession, since the economy “was going gangbusters” in the late Nineties.

The distance between the sectors’ performance in recent years makes plain the diverging results of the two retail channels. As the newer kids on the block, discounters borrowed heavily from department stores and, as their sales and market share grow, they are continuing to steal pages from their forefathers’ playbooks.

While still offering apparel at low prices, discounters have bitten into department stores by upping the quality of their apparel. By working both the price and product levers, they have attacked the value equation from both sides.

In apparel, Wal-Mart over the past five years has reinforced its quality controls, brought in talent to build up a fashion office and introduced trendier casual styles. The firm also recently rolled out its sporty George line, which hails from its British Asda division, to the U.S.

Wal-Mart, the world’s largest company, has a U.S. apparel business that’s also second to none, with sales estimated to be in the neighborhood of $15 billion annually. There’s room to grow, too, with about half of Wal-Mart customers buying its casual sportswear, according to estimates.

Trendier, though significantly smaller, in the discount sector is number two Target, which has estimated apparel sales of almost $9 billion. Target’s been beefing up its offerings with exclusive license agreements and designer partnerships with Michael Graves, Stephen Sprouse, Mossimo, Sonia Kashuk and Cherokee.

While improved quality and image within product categories have enhanced the respect afforded discounters by consumers, much of the mass merchants’ success has hinged on their one-stop shopability. Consumers no longer rely on discounters for just work boots and tennis balls.

The widening interest discounters have shown in diverse product categories is reflected in the types of retailers that have lost market share to them. Department stores felt it first, grocery stories more recently and, to judge by recent plans, drug stores may be the next to feel the discount-store stun gun.

With an emphasis on food and other consumables, discounters have boosted their traffic, shopping frequency and top lines. Faster moving products let inventories turn more often and boost sales per square foot.

On average, department stores from 1996 to 2001 turned their inventories 3.6 times a year, while discounters saw merchandise come and go 5.7 times every 12 months. As this reality ripples out across their financial structure, the distance between the two sectors increases. Average sales per gross square foot at department stores rose 2.6 percent over the six-year period to $240, while discounters pulled in $289, a 22.5 percent increase.

Quicker inventory turns also mean less stock needs to be kept on hand and reduced stress on the sector’s balance sheets, since inventory ranks among any retailer’s largest expenditures. Inventories as a percentage of sales over the six-year period averaged 19.3 percent in department stores, while discounters were significantly lower at 14.3 percent.

Although discounters’ low prices keep inventory turning, their acclaimed values and more recent emphasis on food have kept margins down as well. Where department stores’ gross margins (on a first-in-first-out basis) averaged 33.5 percent over the six years, discounters scored a milder 25.3 percent.

“Discounters’ margins are definitely lower, but their returns on capital are higher,” said Eberts. “They’re the preferred format. By and large, they are more efficiently operated, have better growth aspects and are investing their dollars at a higher return than department stores.”

Department stores over the six-year period averaged an 8.8 percent return on invested capital, lagging behind discounters, which posted a 9.6 percent return.

Not only are discount formats raking in more sales, they’re doing so with less expenditure. Selling, general and administrative expense margins at department stores over the six years mounted 27.2 percent, while discounters were able to keep those expenses to 20.4 percent.

Strong revenues complemented by lean expense structures have led discounters to higher profits. Over the six years, department stores averaged 4.3 percent growth in earnings per share, dramatically less than the discounters’ increase of 22.6 percent. Despite the fiscal dominance of the discounters, there are signs that indicate strength at the department stores. Their ability to minimize drops in profitability in the months since Sept. 11 is testimony to their operational efficiency.

“Given the stark decline in sales momentum last year, I would have expected to see more liquidity issues in department stores, but they were able to manage their receipt flow and inventory levels well,” said Eberts.

The sector’s reaction time, she said, was “impressive” and the tightly controlled inventories displayed a better payoff from investment in systems. Improved systems controlling the supply chain and smoothing communication with vendors, though, seem to be only part of the answer.

“Maybe it was systems, maybe it was discipline, maybe the writing was on the wall and they made adjustments in advance,” said Eberts.

Department stores were also able to maintain their balance sheets, keeping debt-to-capital ratio flat at 46 percent between 2000 and 2001. The measure has been fairly stable over the six-year period, with an average ratio of 45 percent. Discounters, though, saw their debt-to-capital ratio jump 7 percentage points between 2000 and 2001 to 48 percent. Over the six years, the sector managed a debt-to-capital ratio of 41 percent.

There are also signs that department stores are looking to build both sales and profits by moves into new markets and formats. The May Department Stores Co.’s aggressive penetration of the bridal business addresses both its desire for younger customers and its openness to compatible specialty formats.

Still, department stores are in “a very difficult position,” said Eberts. “As one of the oldest retail formats, they’ve been share donors for almost their entire life cycle, giving away whole categories of business” and leaving for themselves apparel and home goods. Abdicating lower-margin businesses, like electronics and toys, exacted a toll in store traffic, too.

“It’s hard to see the good outcome for department stores,” she said. “Not to say the whole channel goes away — as long as they continue to adapt, there will be a place for them in the retail landscape — but there has to be a major consolidation and streamlining before profitability can return to historical levels. There are too many stores selling apparel. Not only department stores but specialty, too.”