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NEW YORK — Signs of deflation are everywhere, especially in the windows of stores advertising 25 or 30 percent off or more.
Apparel prices, already driven down by the rise of offshore manufacturing and the ascendancy of Wal-Mart Stores and other low-price operators, have been forced down even further by consumer indifference about apparel, lack of hot fashion items and the pressure on stores to make their budget targets. So, with prices lower, stores need to sell more units to wind up with the same dollar revenue, and that’s made retailers more inclined to hit the promotional panic button.
For example, Target stores said Thursday when it reported its fourth-quarter and yearly results that it took more than $1 billion in price reductions for the year, as reported.
Chief financial officer Douglas Scovanner said that comparable-store sales without the price deflation would have been up more than 5 percent for the year. Instead, they were up less than half that amount — 2.2 percent.
Recent government numbers bear this out. On Thursday, the Labor Department said wholesale prices on domestically produced women’s apparel fell 0.2 percent in January compared with December, and were off 1.5 percent compared with January 2002. And in its Consumer Price Index, Labor said women’s apparel prices fell 2.1 percent last year and apparel prices were off 1.8 percent overall.
“Apparel prices are suffering from cheaper imports and heavy discounting,” Rajeev Dhawan, director of the Economic Forecasting Center at Georgia State University, said last month in reacting to the news of continuing depressed pricing. “The rest of the world is not doing so well, so if they sell us apparel, it is at huge discounts and that also shows up in lower prices at retail.”
“We have too many stores and too much stuff, driving competitors’ use of lower prices as a primary weapon for growth,” said retail and apparel consultant Robin Lewis. “Once the low price was trumped by a competitor’s even lower price, it turned into a vicious cycle. Now, the inevitable result is unyielding pressure on profit margins, which I call the value vise that chokes companies to death.”
While consumers benefit from the downward pressure on prices, retailers are facing the worst of both worlds: deflation on the revenue side and inflation on the costs of operations side, the latter compounded by a severe winter and rising energy costs.
Thirty years ago, inflation ran rampant and dominated the consumer psyche. But stores benefit from inflation in some ways — they can raise prices far higher and much faster than it takes for expenses to catch up, increasing their profit margins. Retailers’ hands are tied in a deflationary cycle, however, because of a decline in gross margins from lower prices amid fixed — and often rising — costs.
Retail consultant Walter Loeb noted: “In order for a retailer to stay above water, it needs a 2 to 3 percent sales increase every year. That’s the same as a cost-of-living adjustment for the retailer. Because operational expenses increase yearly, that increase is the bare minimum required for most retailers.”
The consultant pointed out that the percentage required is likely to be far higher for certain department store sites because older locations typically have higher maintenance costs, whether to account for rent increases for leased sites or refurbishment costs.
Retailers, to meet their profit goals, have been on a discounting spree, betting that they can make up some of the lost dollars by selling more on a volume basis. Some are also up to their old tricks by squeezing more money from manufacturers in the form of give-backs, markdown allowances and charge-backs.
Adam Winters, senior vice president at Merchant Factors Corp., observed: “In order for a retailer to make more money, they need to squeeze the manufacturer. The concept of retail partner is such a falsehood. It can’t work, and in this kind of environment, I don’t see it changing. With the economy still soft, I expect retailers will apply more pressure on their vendors. It is all about pricing right now.”
While Winters doesn’t expect the country in general to head into a period of deflation, he does anticipate that deflationary pressures will continue to impact the apparel industry.
“Deflation is definitely getting worse in our industry. The suppliers are continually asked to source for cheaper and better goods. They’ve managed to do it bouncing from country to country, from India to Vietnam and the Caribbean Basin.
“I suspect the pricing pressures will get worse as consumers start pulling back on their spending. People just don’t feel good right now and that’s the barometer that we go by to gauge spending. In a country based on consumption, driven by consumers, what we need is [freedom from] worries over possible job losses and future terrorist activities,” he said.
Carl Steidtmann, chief economist at Deloitte Research, said: “I don’t think that retailers, particularly department stores, understand deflation. They almost need to have a major in mathematics to figure out the price on an item. You know, 10 percent off, then 20 percent off because of a coupon and then because it is Tuesday there’s another 10 percent off. For retailers, this whole idea of price issue rationalization is a way for them to fool themselves into not understanding the deflationary issue so that they can continue to operate in the mode that they know best.
“Retailers don’t want to have to deal with it. They’re also hoping that it will go away so they can go back to the days where they have some pricing power and not have to discount the merchandise.”
Steidtmann observed that apparel has become so value-obsessed, with quality and pricing pressure high and fashion distinctions low, that the only way for retailers to differentiate themselves is through price. He sees the problem getting worse.
“One thing is for certain, retailers are not going to wean consumers off price expectations on promotions. It’s the same problem across the board. Automobile companies and their zero percent financing would love to get the consumer off the promotional kick. But they’ve got last year’s numbers that they have to beat and the easiest way to do that is to promote,” the economist said.
Loeb agreed: “Department stores can’t get out of the morass of 30 percent off coupons. Another problem is that there’s no relationship between the customers and the stores to make consumers feel good about shopping at a particular nameplate. In the end, the retailers end up discounting to the lowest price in order to get some level of traffic.”
Loeb doesn’t see the cycle stopping. “I’m worried,” he said.
So what is the real problem plaguing department stores, and what should they be doing before the problem gets any worse?
First, the department store should take a good look at its business model, determine who its customers are and what kind of retailer it wants to be, noted Arnold Aronson, managing director of retail strategies for Kurt Salmon Associates.
Aronson explained that the different retailing environments once unique to department stores and discounters are starting to move closer together in approach. Mass chains are trying to emulate the trendier side of fashion, while traditional department stores are cutting operating expenses in order to meet price competition from their retail cousins in the mass channel.
Those moves are also blurring the lines between the two business models. The department store operates on the premise of high gross margins coupled with a certain level of customer service and a focus on convincing the consumer that higher-priced merchandise is what they should buy.
“The problem with the model is over the value equation,” Aronson said. “Is the customer getting enough bang for the buck? Is the department store making the right investment into those areas that are truly value added that the customer considers worth buying at the higher prices?”
Many department stores try to get a 35 percent gross margin. If they can get their expense ratio to a 27 to 28 percent range, they get to make a 7 or 8 percent profit, explained Aronson.
At the opposite end, discounters operate on a different business model. It is one that has a tighter expense structure with emphasis on self-service. If a discounter is assumed to have a 27 percent gross margin, it would need to keep its operating expense ratio at 19 percent to get the same 8 percent profit, surmised Aronson.
Even the competition between the two for market share has changed. It used to be a game of higher markups and bigger expenses versus lower margins and lower prices.
“With the slight homogenization that is occurring, where these two forces are moving closer together, one has to wonder whether it is smart for department stores to want to be more like discounters. Or even for discounters to take on some of the attributes of department stores. Are discounters still able to do that without sacrificing the efficiency and value of the dollar they are able to give to the masses, so to speak?” Aronson wondered.
So far, discounters such as Wal-Mart and Target are upping the focus on labels and fashion content, creating an epiphany for some shoppers who are now suddenly attracted to the value proposition they never knew existed before at the discount channel. In contrast, department stores are chopping away at the creative and cosmetic sides of their cost structure, jeopardizing the look, feel and emotional rewards once attendant to their stores. The problem is that customers see higher prices and fewer services and are less willing to leave their dollars with the department stores which, as reported, have seen their market share for products other than for automobiles contract to 10.2 percent in 2001 from 12.8 percent 10 years ago.
Aronson concluded that once retailers have a better focus on where they think they should be on the retail food chain, they can make better decisions on how to attract and meet customers’ emotional needs. Those decisions can range from merchandise mix, such as which designer brands to carry, to how to improve displays and make the presentations sexier and more seductive.
Steidtmann said that retailers can also fine-tune their operational expenses by decapitalizing their assets. “It really all goes back to their real estate, which is what gave department stores a new lease on life many years ago. They realized that no one went downtown anymore, so they targeted regional malls for their new store locations. Now, the shift for consumers is that they don’t shop at the malls anymore. Department stores were perceptive in the earlier shift, but have completely missed the latest one.”
One major reason retailers’ feet are stuck in the concrete is their generally short-term focus: numbers have to be met in the current quarter, as well as the current month and week.
However, owning hard assets in a deflationary period, observed the economist, reduces a retailer’s flexibility. Stores need to take advantage of opportunities to take real estate off their balance sheets either through sales of the property or lease-back agreements of their own real estate. Lease terms, when they come up, should be renewed for shorter periods to take advantage of decreasing rent costs.
To minimize inventory on a retailer’s books, Steidtmann favors getting suppliers to own and hold the goods until needed in the stores. It already is a common practice among food and general mass-merchandise retailers, and is certainly growing in the apparel sector.
Other areas to cut costs include outsourcing information technology, indexing wages to actual performance and a move toward more private label goods to create unique merchandise available only at a particular retailer — differentiation not tied to price.