By Nandita Bose and Siddharth Cavale
CHICAGO (Reuters) - U.S. department store chains, hit by slowing sales for more than two years, have used layoffs, store closings and cutbacks to maintain one aspect of stability: profit margins.
An analysis of two important indicators of retail profitability, gross margins and operating margins, shows retailers like Kohl's Corp (N:KSS), JC Penney Co Inc (N:JCP), Macy's Inc (N:M) and Target Corp (N:TGT) have done a better job at delivering on profitability than maintaining sales growth.
This has given some investors hope for a recovery in a sector battered by the rise of online shopping led by Amazon.com Inc (O:AMZN), and competition from off-price chains like TJX Cos (N:TJX) and fast fashion retailers like Inditex's Zara.
"Margins have been relatively better compared to sales and they are finally taking important steps like closing unprofitable stores," said Charles Sizemore, founder of Sizemore Capital Management LLC, who owns shares of Wal-Mart Stores Inc (N:WMT) and other retailers. "The story right now is bad but we do expect some of these problems to bottom out over time."
Gross margins at all four chains have remained steady over the past four years, helped by cost cutting initiatives like store closures. Operating margins have shown recent improvement at some chains like Kohl's and Target, steadily improved for JC Penney, but contracted for others like Macy's.
Macy's gross margins at the end of the third quarter of 2016 stood at 39.8 percent, up slightly from 39.2 percent in 2013. Gross margins for Target, which straddles the discount and department store categories, were 30.2 percent in third quarter 2016, roughly unchanged from 30 percent in 2013. JC Penney improved its gross margins over the four-year period, whereas Kohl's has held steady.
Operating margins are more sensitive to changes the retailers have made through layoffs.
Target stood at 6.5 percent in 2016 up slightly from results for the last two years but down from 10.6 percent in 2013. Target in that time has left foreign markets and sold off lower-margin, non-core businesses like its pharmacy operations.
Kohl's operating margins were 7 percent in third quarter 2016 up from 2015 and similar to 2014 but down from 8.2 percent in 2013.
Macy's had seen operating margins contract to 1.9 percent in 2016 from 5.7 percent in 2013. JC Penney stood at 0.8 percent in 2016, up substantially from improving every year from a rock bottom level of negative margins of 14.4 in 2013.
"Sales are not impressive, but investors are most concerned with profitability and long-term value," Neil Saunders, chief executive officer at research firm Conlumino said. "These companies have done a better job keeping the business running on the operational side and delivering on profitability."
SQUEEZING COSTS
In recent weeks, most department stores have reported a drop in holiday season sales, which includes stores and online. Some have even slashed their earnings outlooks. This contrasts with industry-wide results, a 4 percent increase in the 2016 holiday season, to $658.3 billion, according to the National Retail Federation.
The companies continue to make economy measures such as reducing inventory, pressuring suppliers for lower prices and cutting supply chain costs.
For example, Kohl's has said it will offer discounts during the holiday season but cut down on promotions during the rest of the year.
Christina Boni, vice president and senior credit analyst at ratings firm Moody's, expects operating margins at many department store chains to remain steady unless sales fall dramatically.
"These companies still have the ability to stabilize their business by taking costs out of the system and generating significant free cash flow to invest in new areas, which will improve operating margins," she said.