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Department Stores See a Fragile Recovery, but Momentum Uncertain

Department stores have been the weakest performing sector in U.S. retailing in the past three years, but those chains that are better capitalized have slowly been gaining ground on the back of strong sales, a new report from Moody’s department store analyst Christina Boni said.

The next big challenge for department stores in 2019, according to Boni, is maintaining momentum and finding growth. While early data suggests that the 2018 holiday season was “respectable,” the report noted that “it did not indicate a significant acceleration in sales trends, despite the benefit of a longer calendar between Thanksgiving and Christmas.”

Successful inventory control will be critical for expanding operating margins, Moody’s said, and as department stores rely on technology and pay higher freight and shipping costs, they are depending on these gains to offset the cost of investment.

Retail’s square footage contracted 13 percent in 2018 and will shrink further in 2019, according to Moody’s, mostly depending on the fate of Sears’ remaining stores.

“We have forecast that the sector will continue to narrow its operating income loss to approximately 4 percent for 2018 and 2 percent for 2019, as stronger operators continue to embrace the forces of structural changes and adapt,” Boni said.

Many department stores are making efforts to stabilize their margins, which will eventually lead to expansion, the report noted. Other department stores—notably J.C. Penney—continue to review their store base with the potential of cutting more units in 2019.

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“Companies will continue to fine-tune locations as they gain a better understanding of how their brick-and-mortar presence can drive sales in specific areas,” Boni said.

More than any retail sector, department stores have faced some of the most challenging performance hurdles in recent years, Moody’s said. In 2016, when the sector posted a 13 percent decline in operating income, that’s what prompted some to question whether the retail model “had finally broken,” Moody’s noted.

“And yet, while there have been casualties along the way–the Bon Ton and Sears bankruptcies in 2018 stand out–we believe the sector is slowly taking a decisive turn for the better,” Boni said. “As these companies cut losses, the next big challenge will be figuring out how to turn nascent sales growth into operating income growth.”

Department stores will have to maintain strong balance sheets to stay competitive because it’s expensive for the sector to adapt its “traditionally cumbersome business model to one that is leaner and better suited to serving customers seamlessly between online and in-store.”

For example, Macy’s has had to clear more inventory than it expected this January, which will contribute to a decline in its gross margin rate for 2018.

“One of the more important growth strategies that department stores are honing is improved inventory control and the supply chain,” Boni wrote. “They are doing so on a number of fronts, including improved supply chain efficiencies, increased buy online ship to store, buy online pick up in store and direct ship from vendors, which helps retailers increase their traffic and avoid the cost of the last mile, while direct ship to vendors increases the number of available SKUs without increasing inventory risk.”

Despite some positive indications, the report said, “Increasingly, the path of liquidation is proving the most practical.”

The market’s “growing impatience,” Boni said, will put a spotlight on struggling companies like J.C. Penney this year, adding that the company “has been a significant laggard, with its gross margin under significant pressure as management continues work to reduce inventory.”

While its liquidity remains solid, with approximately $2 billion of revolver availability and cash, the Moody’s said, “J.C. Penney needs to make progress quickly as its elevated leverage limits free cash flow. The company is currently focusing on clearing inventories to improve its store experience and product freshness. Management pulled its 2018 earnings guidance as its path forward remains uncertain. More recently, its holiday sales dropped 3.5 percent on a shifted basis for the November-December 2018 holiday period as the company has focused on repositioning its product offering.”

Inventory reduction will be critical “as management works to sharpen its product offering and improve the ease of shopping at its stores,” Boni said.

On a positive note, Moody’s expects better performers like Macy’s, Kohl’s and Nordstrom Inc. to continue to focus on reducing friction between online and in-store and improve the efficiency of their inventory.

“The better players are addressing these demands and some, like Macy’s and Kohl’s, are taking additional steps to further strengthen their balance sheets,” Boni said. “That is probably just as well, because department stores will need to be well armed as they fight a rising tide of competitive challenges in 2019.”