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The problem with department stores' comeback plan

If you can't beat 'em, join 'em. But even if you join 'em, there's no guarantee it'll solve your problems.

As department stores look for ways to jump-start their revenues, several have turned to the popular off-price category as a potential solution. But as it turns out, the category may not be the magic bullet some had hoped it would be.

A shopper walks past the Macy's Backstage store in Queens, New York.
Mary Altaffer | AP
A shopper walks past the Macy's Backstage store in Queens, New York.

Over the past few months, there have been several signs that the business of selling name-brand goods at a discount might be harder than it looks.

After opening six pilot locations for its Backstage offshoot in the fall, Macy's will open just one more of these shops in 2016. Kohl's, which introduced its first discount Off/Aisle location in June, will likewise cut the ribbon on just two more of these stores this year. And Nordstrom, long considered a front-runner among department stores in this space, reported negative same-store sales at its Rack brand three of the last four quarters.

Nordstrom's results, paired with tepid rollout plans at the two other retailers, come as off-price natives TJX and Ross continue to extend their lead in the space.

"They're all [the department stores] going up against two very formidable competitors," said Craig Johnson, president of Customer Growth Partners.

The sheer size of TJX and Ross makes their economies of scale difficult to replicate. At the end of its fiscal fourth quarter, Ross operated roughly 1,400 U.S. stores between its namesake and dd's Discounts brands. TJX, which owns TJ Maxx, Marshalls and HomeGoods, had nearly 2,700 domestic locations at that time. Macy's, by comparison, had fewer than 900 stores.

Such massive reach has enabled TJX and Ross to recruit a small army of buyers who are specifically trained to find the best overflow merchandise. What's more, Johnson said, retailers and wholesale brands "love" dealing with the two companies because they help them get rid of excess merchandise and are the "quickest payers" in the industry. These relationships helped sales trends at Ross and TJX yet again outpace those of traditional department stores during the fourth quarter — even as TJX CEO Carol Meyrowitz transitioned out of the role after nine years.

"It is not just a superior off-price retailer," Johnson said of TJX. "It's one of the best-managed retailers of any kind."

Separately, a report Wednesday by Morgan Stanley found that Ross and TJX are the only two apparel or department store retailers it covers that have grown earnings every single year for the past decade. That includes 2008 and 2009, when the U.S. economy was in recession. Still, they're not done. Both stores are expanding their footprints in the U.S., with TJX saying last month it sees the potential to add more than 1,400 stores in North America.

"While department stores have been clamoring to get a piece of the off-price magic, we think the recent disparity in performance ... helps illustrate how difficult TJX's scale, global reach and buying organization ... are to replicate," Evercore ISI analyst Omar Saad told investors.

Indeed, after a year chock-full of announcements from department stores planning to enter or grow their footprint in the off-price arena, 2016 has gotten off to a quiet start. On a conference call with investors in February, Macy's CFO Karen Hoguet underscored that the decision to open just one more Backstage location in 2016 was not because it was disappointed with its six pilot stores.

"We are trying to learn from these before we expand them more broadly," she said.

The company will also test putting Backstage stores within about 15 of its full-price locations. Though Hoguet admitted this strategy could cannibalize sales at its traditional stores more than operating a stand-alone location would, it also requires a smaller investment.

Kohl's is taking a similarly prudent approach with its Off/Aisle concept. Unlike typical off-price stores, this offshoot was started on the premise of selling like-new items that were returned to its traditional locations. After cutting the ribbon in June on a pilot store in Cherry Hill, New Jersey, the department store has announced plans for just two more of these locations this year. CEO Kevin Mansell said in October that the retailer decided to expand this concept after "seeing the potential" from its first store. Both locations will open in Milwaukee later this month.

With nearly 200 locations, Nordstrom is the farthest along in its off-price expansion. As pricing pressures have held back sales at the retailer's traditional locations, its discount Rack shops have helped fuel results for the company. However, Rack took a significant step back in 2015, reporting negative comparable sales during three separate quarters. Despite recent softness, Nordstrom management reiterated its goal of operating 300 of these locations by 2020. The company noted that Rack stores continue to be highly productive, and provide "terrific returns" for shareholders.

Customer Growth Partners' Johnson said he also expects trends at Rack to bounce back, attributing some of its softness to the warmer-than-expected winter. He added that trends at Rack look stronger when incorporating the results from its off-price websites. To that point, whereas net sales at Rack stores grew 7 percent during the fourth quarter, they jumped 50 percent on Nordstromrack.com and the company's flash-sale site, HauteLook.

Though Johnson said it makes sense for department stores to pursue the off-price market, he cautioned that it "runs the risk of getting saturated." He said the category is gaining half a point of market share each year, and now accounts for more than 16 percent of the U.S. apparel market. Johnson specifically questioned Kohl's entrance into the space, saying he's not sure it's quite as compelling for a retailer already known for its low prices.

"In any segment of a business you will get winners and losers, and the people who really know it versus the dabblers and the debutantes," he said.