Are Department Stores Getting the Wake-Up Call on Inventory Management?

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Amid a disastrous second quarter for department stores (and most apparel retailers, for that matter), one company stood out: Dillard\’s.

Dillard\’s didn\’t exactly have a great quarter. Retail sales declined 35 percent year over year, and the company posted a net loss of $8.6 million. However, that was actually a smaller loss than what Dillard\’s reported for the comparable period in 2019. (The second fiscal quarter tends to be a seasonally weak period for the company.)

Aggressive inventory management actions were the reason why Dillard\’s managed to improve its profitability on a year-over-year basis while its closest peers posted huge earnings declines. This remarkable performance under extremely tough circumstances highlights how it is imperative for department stores to stop overstocking their stores and focus on quality over quantity.

A Win for Inventory Management

During March, Dillard\’s management recognized that the Covid-19 pandemic was crushing demand, and it moved aggressively to implement markdowns to clear out seasonal inventory. This caused retail gross margin to plunge to 12.8 percent in the first quarter from 37.8 percent a year earlier. However, the aggressive markdowns helped the retailer exit the quarter with inventory down 14 percent year over year. (Dillard\’s inventory clearance efforts were aided by the fact that it did not proactively close all of its stores in mid-March, as peers like Macy\’s and Kohl\’s did.)

[callout]Carrying high inventory goes hand in hand with lazy merchandising. This is a particularly common issue for department stores, which usually have a lot of square footage and carry a wide range of items instead of making bold choices to showcase the right brands in curated collections.[/callout]

Leaner inventory allowed Dillard\’s to cut back on markdowns in the second quarter, even compared to 2019. Retail gross margin improved by 2.4 percentage points year over year, reaching 31.1 percent. This helped the company narrow its loss relative to Q2 2019.

Other department stores weren\’t so nimble. For example, reported inventory was down just 3 percent year over year at Kohl\’s at the end of the first quarter. That contributed to a 5.7 percentage point decline in gross margin last quarter. Macy\’s fared even worse. Despite exiting Q1 with inventory down 10 percent, gross margin plunged to 23.6 percent in the second quarter from 38.8 percent a year earlier.

Obviously, the Covid-19 pandemic has created a unique situation this year, tripping up even some of the best-run retailers. Store closures and stay-at-home orders caused in-store sales (still the bulk of sales for most retailers, including every major department store chain) to dry up with little warning, making massive markdowns virtually inevitable. But poor inventory management was a recurring problem in the department store industry long before Covid.

The Self-Defeating Urge to Stock More

Indeed, prior to this year, Dillard\’s has hardly been a model of good inventory management. Just a year ago, it ended the second quarter with $1.6 billion of inventory, up 12 percent from $1.43 billion five years earlier, even though merchandise sales had declined 6 percent during that five-year stretch. It should be no surprise that gross margin plunged by more than 5 percentage points over that same period.

As sales trends weakened in the years after 2014, most department store chains seemingly felt an irresistible urge to increase inventory. It\’s like they thought the way out of their sales woes was to stuff their stores with even more goods. This was a mistake for three key reasons.

The first is simple: markdown risk. Operating with lean inventory exposes a retailer to the risk of out-of-stocks, leading to lost sales. On the bright side, it allows for firm pricing discipline. By contrast, a retailer that buys too much and then sees weak demand will suffer from the double whammy of low sales and margin erosion due to markdowns.

Poor inventory management was a long-term problem for J.C. Penney under former CEO Marvin Ellison. In the first quarter of fiscal 2018 (Ellison\’s last full quarter at the helm), gross margin was just 33.7 percent, down from 36.4 percent three years earlier, when the retailer boasted higher sales with less inventory. A decade ago (prior to Ron Johnson\’s disastrous tenure as CEO), J.C. Penney\’s gross margin routinely exceeded 40 percent in the first quarter.

Getting inventory under control has been a top priority for new CEO Jill Soltau. J.C. Penney reduced its inventory by more than 11% last year, and gross margin rebounded by 2 percentage points.

Similarly, Kohl\’s CFO Jill Timm noted on a recent earnings call that in the years that Kohl\’s has kept inventory lean (such as 2017 and 2018), gross margin has risen. By contrast, gross margin fell from 36.4 percent to 35.7 percent last year, when Kohl\’s inventory rose for the first time in several years.

Addition by Subtraction

A second reason why carrying more merchandise is a mistake is that offering customers too many choices can lead to decision paralysis. Research has found that in many circumstances, offering consumers more choices leads to lower sales. Psychologist Barry Schwartz (building on earlier work by Sheena Iyengar) calls this the \”paradox of choice.\”

There is a lot of debate about what causes this counterintuitive phenomenon and how widespread it is. One hypothesis is that many consumers want to make the best possible decision rather than just buying something good enough to meet their needs. The more choices available, the greater the likelihood that they can\’t decide which is the optimal choice and end up walking away.

New Bed Bath & Beyond CEO Mark Tritton referred directly to what he called \”purchase paralysis\” in justifying a massive inventory reduction plan. In one early example of success, Tritton told The Wall Street Journal in February that Bed Bath & Beyond had cut the number of can openers on offer \”from more than a dozen to about three\” and that sales had increased following the move.

In short, if department stores\’ inventory creep was driven by the belief that offering an expanded merchandise mix would boost sales, it was a faulty premise.

Lazy Merchandising

The third problem with carrying high inventory is that it often goes hand in hand with lazy merchandising. This is a particularly common issue for department stores, which usually have a lot of square footage and carry a wide range of items by design. Whereas merchants should be making bold choices to showcase the right brands in curated collections, in the department store context it is all too easy for them to spread their bets around instead.

Of course, this adds to the risk of decision paralysis. And whereas on-trend merchandise ought to be prominently displayed and marketed, a department store that isn\’t curating its assortment well relies on the consumer to find these items within an overstuffed store.

Over the past few years, Kohl\’s has added several well-known brands to its lineup, including Under Armour, Nine West, and (most recently) Lands\’ End in apparel. Despite these brand launches, sales were sagging at Kohl\’s even before the pandemic.

Fortunately, Kohl\’s announced earlier this year that it would phase out eight underperforming women\’s brands in 2020. The goal is \”improving the overall clarity through reduced choice counts,\” according to CEO Michelle Gass. The jury is still out on whether this will move the needle for Kohl\’s, but it\’s a step in the right direction.

A Fresh Start?

One can only hope that America\’s remaining department stores are following the old adage, \”Never let a good crisis go to waste.\” The sharp slowdown in sales this year has forced them to slash their inventory. Dillard\’s is already seeing the benefits in the form of year-over-year gross margin improvement. Weakened balance sheets will give department stores added incentive to operate with lean inventory in the years ahead.

Hopefully management teams in the industry have learned their lesson. Offering some good merchandise within a sea of subpar inventory is a recipe for failure. Presenting a highly curated, manageable assortment is bound to lead to misfires at times, but in the long run, it\’s far better than the alternative.

Full disclosure: The Author owns shares of Dillard\’s, Kohl\’s, and Macy\’s.

 

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