Macy's annual Flower Show.

Department stores are facing an uphill battle, according to RBC Capital Markets analyst Brian Tunick.

The stores are stretched thin between spending big bucks on online efforts and creating off-price concepts, while suffering from shrinking margins and balance sheet worries. This past year there was more piling on for the sector as the warm winter left the stores overloaded with merchandise that had to be marked down. Tunick said margins are forecast to decline further in 2016.

The headwinds have been blowing for some time now. Key categories for department stores like handbags have been lost to specialty retailers and off-price chains. The handbag brands themselves have opened stores in the mall that directly compete with department stores.

The declining earnings are adding to balance sheet worries. Tunick points out that Kohl’s Corp., Macy’s Inc. and Nordstrom Inc. have debt ratios that are at their limits, limiting balance sheet flexibility. All three have grown their dividends over the past several years as net incomes have declined. The dividend payout ratio is close to 50 percent for all of the companies. On top of that, their cash balances have reached five-year lows. Investors will be putting pressure on these retailers to show some progress on turning things around.

The stores haven’t sat still. They have gone on the offensive to win the customers back. Efforts like shops-in-shop and bringing online retailers into the physical stores have been received well. The department stores are also spending millions to create and build an online business. Tunick worries that the costs are high especially as Amazon ramps up its apparel offerings.

Tunick has initiated coverage on Kohl’s with an underperform rating and a $42 price target. “We believe it will be tough for KSS [Kohl’s] to post better than a 1 percent comp in the next two years, making it difficult to leverage expenses and grow margins,” Tunick said. He believes initiatives like the Greatness Agenda are working, but he forecasts more store closures and thinks Amazon will overshadow any online sales progress.

Macy’s gets a sector perform rating and a $42 price target. Tunick believes competitive pressure will increase and while the initiatives like the acquisition of Blue Mercury are encouraging, the results are still to be determined. “Although, we are intrigued by the real estate optionality, we prefer to wait to see either more signs of top-line stabilization or more meaningful real estate monetization road map to become more constructive,” Tunick said.

Nordstrom also gets a sector perform rating and a $51 price target. “Although we are encouraged by JWN’s [Nordstrom’s] initiatives and investments in store selling, differentiated product, e-commerce and off-price, we expect recent weakness in top-line trends to persist while the continuing investment cycle prevents earnings flow through,” Tunick said. He is concerned about slowing growth at Rack and while the investment spending has peaked, the balance sheet is stretched.

Tunick pointed out that this didn’t happen overnight and that the department store declines started long before the recession. There has been only one year of positive sales growth since 2000 and that was in 2004. The department stores have seen their market share drop over the past 20 years from about 60 percent of retail sales to just roughly 25 percent.

Tunick also sees more store closures on the horizon. “We see more ‘blocks’ of store closures increasingly likely as the bifurcation in traffic and sales grows between high quality ‘A’ malls and low quality ‘C’ malls,” he said.

As Tunick wrote in his report, the department stores are indeed walking a tightrope between transformation and capital allocation.

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