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Retail therapy: US department stores adapt to shifting spending habits


Home / Perspectives / Retail therapy: US department stores adapt to shifting spending habits

Ilana Elbim, Credit Analyst
10 November 2016

Key points

Despite a benign economy, US retailers are under pressure. Unseasonal weather, falling tourist numbers and a shift in consumer spending away from clothing and towards experience is negatively impacting the sector

Additional pressure has arisen from pure e-retailers moving into fashion retail and quickly gaining market share

JCPenney and Macy’s have adopted similar strategies to re-invigorate sales and profits damaged by these conditions but while JCPenney is succeeding, Macy’s is struggling

Subtle differences in their business models and strategies are at the heart of the mixed fortunes of these two retail stalwarts

Out of fashion

The US retail sector should be thriving. Shoppers are upbeat, with the consumer confidence index at its highest point since August 2007, while both unemployment and household debt levels are relatively low. In 2015, according to the US census bureau, median real household income increased for the first time since 2007, rising by 5.2% to $56,516. Yet, despite this benign economic backdrop, US retailers are struggling (see figure 1).

Figure 1: Retail sales slow down


Source: US Department of Commerce as at 31 December 2015

Consumer behaviour has shifted in recent years. The hangover from the global financial crisis persists: shoppers remain cautious about spending money, preferring to save cash, as shown by higher savings rates. Nor do designer clothes and shoes have the same cachet as they did. Travel and eating out are greater priorities, reflecting the shift from possessions towards experiences, one of the key challenges facing US retailers (see figure 2).

Figure 2: US consumers pursuing experiences


Source: US Department of Commerce as at 31 December 2015

The continued strength of the dollar has also played a part, reducing the number of tourists visiting the US, which has negatively impacted retailers. Unseasonal weather over several quarters has further reduced foot traffic.

Technology is another major disruptor. Online sales are currently near 10% of total US non-food retail sales and could reach 20% in three years. Wealthier and younger customers are migrating online more rapidly than other demographic groups, boosting the growth of this distribution channel.

Figure 3: Increasing share of e-commerce


Source: US Department of Commerce as at 31 December 2015

Customers no longer simply go to a store to buy something they need. Instead they turn to the internet to find the best deal, looking for a good price, more product availability, and the convenience of ‘click and collect’ or home delivery. This has eroded both the sales and margins of mainstream US retailers, particularly department stores.

Death by a thousand clicks

While US department stores have been damaged by changing consumer spending habits, the strength of the dollar and unseasonal weather patterns, they are now being further impacted by the rising presence of e-commerce operators in the fashion market.

From the e-retailers’ perspective, fashion is a lucrative market, as exemplified by Amazon’s building presence in the market. They can compete with department stores because their delivery times are short enough to allow impulse purchases, especially among Amazon’s ‘Prime’ customers who tend to be higher income earners.

Department stores are finding it hard to fight back against these new competitors. Amazon in particular is excellent at ensuring the consumer gets the best price for a particular item. Online prices can be changed extremely rapidly – up to several times an hour. In contrast, it’s much harder for department stores to change the price tag on each item across all stores at the same time. As such, it is easy for an internet retailer to offer a better price than a department store, which then loses out on the sale.

Amazon’s success at diverting market share has shifted the priorities of the major fashion brands. Apparel retailers are now developing a stronger relationship with the e-commerce giant and other online retailers than the department stores as online retailers are becoming key wholesale customers.

Although US department stores are not being completely annihilated by this land grab by the online retailers, it is changing consumer habits and is one of the key challenges faced by these businesses. In this issue of Spectrum, we highlight how two department stores – Macy’s and JCPenney – are pursuing similar strategies to fight these challenges but seeing very different results.

JCPenney: on brand

Prior to facing its current challenges, mid-market retailer JCPenney came close to collapse. In 2011, the company hired Ron Johnson from Apple as its new chief executive, who focused the company on high-end retail. Johnson had been in charge of retail operations at the technology giant, where he developed a reputation for his strong skill set in retail.

Much of the company’s traditional customer base was alienated by the move towards higher-end products, which they did not relate to. This resulted in sales declining by almost a quarter in 2013, causing the company to post operating losses and the share price to decline by 51%. Following changes in management and strategy, sales have stabilised. Earnings before interest, tax, depreciation and amortisation (EBITDA) have constantly risen since Johnson left the business and were $715m in the last fiscal year, a significant improvement on the -$500m recorded three years ago.

While recovering from its brush with death, JCPenney has responded to the challenge presented by Amazon and other e-retailers by focusing on its private brands and on exclusive partnerships with apparel retailers. More than 50% of JCPenney’s sales now come from products that can’t be found anywhere else.

The company is also encouraging more customers to visit its stores by improving the in-store experience. That includes rejuvenating in-store salons and make-up counters aided by a partnership with cosmetic retailer Sephora. JCPenney has also hired more sales people to improve customer service.

But perhaps the most important weapon in the battle against its e-commerce rivals is building a connection between JCPenney’s stores and its online presence. This is done through a so-called ‘omni-channel’ strategy. This includes allowing customers to collect goods in-store, giving department stores a competitive advantage over e-retailers as it is cheaper to deliver to stores than to individual homes and can encourage impulse purchases in store during the collection process.


A whole new look – Sephora counters in store add a new element to the JCPenney shopping experience. Source: JCPenney


As well as pursuing a number of strategies to counter the challenge presented by e-retailers, JCPenney has adapted to changes in consumer buying patterns.

In February 2016, JCPenney began selling electrical appliances in stores again. This move aims to capitalise on the trend away from clothes purchases towards those purchases which improve experience, such as home-improvements (see figure 2), and to dilute the impact of weather on sales. The company is accelerating the number of stores offering appliances as this strategy is already proving successful according to its management – sales productivity is ten times higher than it was for the products appliances replaced in stores and margins are eight times higher.

Macy’s: a bad fit

While Macy’s did not experience the same strategic distress as JCPenney, it has been caught out by the steep decline in tourist footfall and by the e-retailers’ recent foray into fashion, both of which contributed to sales slumping by 3.7% in 2016 and operating profits declining by almost 14%.

Macy’s response to these challenges has many similarities to JCPenney’s. Like its mid-market rival, it has created a number of private brands with apparel and handbag manufacturers. It has also formed some exclusive deals with fashion retailers. These product lines together represent approximately 40% of the company’s sales.

The company is also looking to lure customers back to its stores through in-store cafes and by offering beauty services through the Bluemercury in-store beauty and spa retailer, which Macy’s acquired in March 2015. As with JCPenney, it is hiring more sales people.

However, in a diversion from JCPenney’s strategy, Macy’s has decided to set aside a specific part of its stores to heavily discounted items, even during sales periods. While this policy is currently raising footfall and revenues, the customers it attracts are less likely to consider the company’s other higher priced products, which could reduce profit and damage the company’s brand image in the long term.

This is not the only risky strategy the company is pursuing. It has decided to close 100 stores out of its total of 870. Closing more than 10% of its shops is a precarious strategy which could result in Macy’s losing customers.

Fewer stores make it much harder for Macy’s to pursue a viable omnichannel strategy as customers may not have a near enough store for online purchase collection. The company has also not yet specified which stores it will be closing, making it difficult to assess the full operational and financial impact of this strategy

Contrasting fortunes

Both these companies face the same competitive pressures and have adopted similar approaches, yet the strategy is paying off for JCPenney and not for Macy’s.

While JCPenney is further down the track to recovery as its major crisis was three years ago and Macy’s has only just begun to fight back, we still expect JCPenney to be more successful than Macy’s in the long run. That’s due to the nuanced differences between these two US department stores.

Macy’s business is more dependent on high-end consumers and tourists. Well-heeled shoppers are less interested in private brands, preferring luxury and well-known brands. These customers are also migrating online more rapidly than other demographic groups. Meanwhile, the strong dollar has considerably reduced tourist footfall.

Macy’s decision to have a section of its stores selling deeply discounted goods creates a confusing message for its customers – the high-end Bluemercury salon business and exclusive brands now co-exist with bargain sales items. In addition, closing so many of its stores could undermine its omni-channel strategy and its ability to compete effectively with Amazon and other e-retailers.

In contrast, JCPenney is a mid-market business. Its customers have responded well to the creation of private labels and the extension of existing ranges. The department store is also less reliant on tourists so the strong dollar has had a limited impact on sales. Overall, JCPenney’s business strategy is more coherent than Macy’s as it is better suited to its existing customer base.

Collecting online purchases in-store can be more convenient for the customer – and could encourage impulse purchases. Source: JCPenney

Paying their way

To ensure both businesses can continue to compete in an everchanging environment, maintaining capital expenditure is vital. Both Macy’s and JCPenney are investing in the development of private brands and building strong omni-channel capabilities.

Both companies are investing around a third of their EBITDA. JCPenney is planning to spend $375m next year on capital expenditure out of an expected EBITDA total of $1bn in 2016 and plans to continue spending around $450m each year after that. Macy’s is planning to spend $900m of an EBITDA that could be around $3bn, having already spent more than $1bn last year from EBITDA of $3.4bn.

Although the companies are spending similar proportions of their EBITDA on capex, there are considerable differences in their financial strategies.

Alongside maintaining high capex, JCPenney’s principal focus is decreasing its debt burden, built up during the time the company flirted with bankruptcy. It plans to primarily use an increase in cash flow to achieve this, which is very creditor friendly. Its official target is to have a net debt level of less than two times EBITDA by January 2020 from a current level that is close to five times EBITDA. This goal looks achievable as the current strategy is expected to generate higher EBITDA and cash flow.

In contrast, Macy’s has maintained elevated shareholder distributions despite having a relatively high debt burden. Although it did not buy back shares in the second quarter of 2016 on the back of weak performance earlier in the year, its management has not ruled out buybacks in the second half. As such, shareholder payments are only likely to decrease should performance materially weaken and its investment grade rating be put under threat.

While Macy’s gross leverage is close to three times EBITDA currently, the company aims to have a debt level equivalent to 2.5 – 2.8 times EBITDA, but through raising its EBITDA and not through proactive debt repayment. Macy’s is also considering selling and leasing back some of its real estate holdings, but there is very little detail on this strategy so far and no indication on how the proceeds will be used.

The outlook for JCPenney is more favourable than for Macy’s, particularly for credit investors. It places more emphasis on improving the enterprise value of the company and its credit profile through improved cash flow and a significant decrease in leverage.

In contrast, Macy’s current strategy could create problems for credit investors as it appears to be directed towards equity investors, with an emphasis on shareholder distribution and no real focus on reducing leverage.

Who knows their customer best?

The mixed fortunes of Macy’s and JCPenney illustrate the importance of US retailers maintaining capital expenditure and a coherent, pragmatic strategy so they can compete against e-commerce retailers and adapt to the structural changes affecting the industry. Companies have to tempt customers back to their stores through improved in-store experiences and create an omni-channel strategy to offer a service e-commerce retailers cannot rival.

The old retail adage – “know your customer” – is just as important in today’s fluid market place. Despite its recent problems, JCPenney now seems to have a much better understanding of its shoppers than Macy’s. This should translate into higher cash flow, which will allow it to reduce its net debt levels and reduce its credit risk.

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Ilana Elbim Credit Analyst Ilana joined Hermes in November 2015 as a credit analyst covering the automotive, leisure, and consumer sectors. Prior to joining Hermes she spent three years as a credit analyst at Fitch Ratings, where she performed fundamental credit analysis on a portfolio of European investment grade and high yield issuers. Prior to this, Ilana had completed various internships as part of her master’s degrees, including equity research at Natixis specialising in the luxury goods segment in 2012, and M&A research at KPMG in 2011. Ilana has a Master’s in Management, specialising in Corporate Finance, from the ESSCA Grande Ecole, France, and an Advanced Master’s in Finance from ESCP Grande École (ranked 2nd in the world by the FT in 2016).
Read all articles by Ilana Elbim

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