Don't Discount Macy's Inc.'s Inventory Problems

Between rising inventory and new off-price concept stores, Macy's profits are going to be pinched. Photo: Mike Mozart .

Macy's has a profit problem and it's about to get worse. With a stock that's down nearly 50% from recent highs, investors may want to adjust their seatbelts as the plunge may not be over yet.

The retailer's adjusted third quarter earnings came in at $0.56 a share, 8% below last year's profits. While that was $0.02 better than what Wall Street was expecting, Macy's ended up cutting its 2015 full year guidance, reducing its outlook to $4.20 to $4.30 due to faltering sales. Quarterly revenues of $5.8 billion were well below the $6.1 billion analysts expected and the $6.2 billion it posted a year ago. Comparable store sales fell 3.6% on an owned and licensed basis, the third consecutive quarter they've declined, and the retailer has announced plans to close as many as 40 of its full-line stores.

While Macy's blamed the poor performance in part on warm weather, it also said international customers in tourist centers weren't buying merchandise in quantities it had expected, particularly the name brand items it sells, which led to a concurrent decline in its center core area. As a result, slower sales are leading to rising inventory levels, which doesn't bode well for the future. And coming as it does as Macy's is rolling out and expanding a new off-price concept chain, the outlook for future profits at the department store seems bleak.

Macy's said inventory at the end of the quarter was 4.6% higher, while on a comp basis, it was up 3.1%, both well above where it would like or need it to be as it's having an impact on cash flows, which plunged year over year. Year-to-date operating cash flow fell $563 million below last year, to $278 million, or 66% less.

The problems are only going to multiply. Macy's, like the entire retail industry, is in the midst of the Christmas sales season, but it's going to start discounting to alleviate the inventory weight it's carrying, and once having started down that path it might find it's not easy to turn back.

As is well-known, J.C. Penney was met with disastrous results after it had tried to switch to an everyday low price policy from its previous regular sales strategy. It was only when it went back to offering doorbuster sales (and reversing nearly every other idea that had been implemented) that it was able to begin recovering.

But we've seen more recent examples of that at play, too. Tween retailer Justice suffered a collapse in sales as it tries to move away from "gimmicky" promotions toward a more full-price policy (and chafes at being compared to J.C. Penney) while Men's Wearhouse recently said its attempt to end the buy-one-get-three-for-free deals at its Jos. A. Bank division has met overwhelming resistance from customers causing comps to plunge 15% from last year.

So Macy's need to begin heavy discounting to generate more store traffic will make it difficult to wean customers away from expecting sales in the future.

If Macy's has to run heavy promotions to clear out the racks of inventory that failed to sell, profits are going to take a hit in the coming quarters. Photo: Phil Whitehouse .

But it's not making its job any easier either by opening its new off-price store , Backstage, that will feature name brand and private label merchandise designed specifically for the stores. That makes it different than Nordstrom Rack, Saks Off 5th outlet stores, or even Kohl's own new concept, Off-Aisle by Kohl's, which will curiously sell open box and returned merchandise. Yet it's going to condition its customers to not pay full-price, possibly cannibalizing sales from its Macy's stores just as happened with Coach , which also designed handbags and such for its outlet stores and saw customers stop buying at the full-price ones.

With Macy's planning on opening 50 of these Backstage stores over the next year or so, while sales at its main stores and Bloomingdale's continue to fall, investors can expect that not only will it continue missing revenue projections but its profit margins are going to be sliced even thinner too.

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The article Don't Discount Macy's Inc.'s Inventory Problems originally appeared on Fool.com.

Rich Duprey owns shares of J.C. Penney Company,. The Motley Fool owns shares of and recommends Coach. The Motley Fool recommends Nordstrom. Try any of our Foolish newsletter services free for 30 days . We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy .

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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