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Kohl's Is Ending Its Off-Price Experiment, While Macy's Doubles Down

Adam Levine-Weinberg, The Motley Fool

Within a span of weeks back in 2015, Macy's (NYSE: M) and Kohl's (NYSE: KSS) announced that they planned to test off-price store concepts. Over the past four years, Macy's has grown its off-price operations rapidly, while Kohl's never got past four of its Off/Aisle stores.

Last week, Kohl's decided to pull the plug on this experiment, announcing that it will close all four Off/Aisle stores by Aug. 3. Meanwhile, Macy's continues to invest heavily in its Macy's Backstage concept. Let's take a look at why the top two U.S. department store chains are taking different paths when it comes to off-price retail.

Solving different problems -- with different strategies

Initially, Macy's and Kohl's appeared to have the same rationale for testing off-price stores: Their core businesses were losing market share to off-price retailers, so they wanted to try operating their own everyday-low-price treasure-hunt concepts. However, they soon branched out in different directions.

Whereas Macy's first several Backstage stores were typical stand-alone locations, the company began rolling out Backstage shops in existing Macy's full-line stores in 2016. The goal was to boost store traffic by repurposing unproductive space in its cavernous mall-based stores with an off-price concept that would draw in new customers and encourage existing customers to visit more often.

The entrance to a Macy's Backstage store within a full-line Macy's.

Macy's began adding Backstage outlets to certain full-line stores in 2016. Image source: Author.

Kohl's has much smaller stores than Macy's. Furthermore, since most of its stores are single-level freestanding or strip-mall buildings, Kohl's has found that when a given store is too big, the company can often subdivide the building and rent out the excess space to a complementary tenant.

Instead, Kohl's goal was to use the Off/Aisle stores to help manage its inventory. Initially, the Off/Aisle stores were stocked exclusively with items returned to Kohl's. (The merchandise mix now also includes items not typically stocked at Kohl's, according to the company.) By creating a separate "exhaust valve" for returned merchandise, Kohl's hoped to improve its ability to manage inventory in its full-line stores and thereby maximize gross margin.

Off/Aisle was no longer serving a useful function

The key reason why Kohl's is doing away with the Off/Aisle concept is that it has become much better at managing its inventory over the past several years. The company ended last quarter with $3.7 billion of inventory, down from $4.2 billion four years earlier.

The exterior of a Kohl's store.

Kohl's has dramatically improved its inventory management in recent years. Image source: Kohl's.

By shrinking certain stores and installing new fixtures in others, Kohl's has been able to reduce the amount of inventory it stocks in lower-volume stores without making those locations look half-empty. This initiative has boosted the retailer's inventory productivity and helped lift its merchandise margin.

Since there is now little risk that returned items will create inventory gluts at its stores, Kohl's no longer has a use for dedicated outlet stores.

Macy's Backstage will just keep getting bigger

By contrast, the Macy's Backstage concept isn't going to become obsolete anytime soon. Malls -- and the department stores within them -- are still struggling with weak customer traffic. Macy's isn't going to pass up any opportunity to drive more traffic to its stores.

During 2018, Macy's stores with Backstage outlets benefited from a sales lift of more than 5% compared to comparable stores without the off-price concept. As a result, the company continues to expand Macy's Backstage aggressively. It ended the first quarter with 181 Backstage stores, of which 174 are inside Macy's full-line stores. Roughly 41 more locations are set to open by the end of the third quarter.

Macy's is also investing in the concept by building a dedicated Backstage distribution center that will open in the third quarter. The new facility will help the company flow fresh merchandise to its Macy's Backstage stores faster and more efficiently.

Thus, while Kohl's is preparing to wind down its off-price operations, Macy's continues to lean on the Backstage concept as a key growth driver. There are still plenty of suitable locations for additional Backstage outlets within the more than 500 Macy's full-line stores, so investors should expect to see Macy's continue to broaden its Backstage store footprint in the years ahead.

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Adam Levine-Weinberg owns shares of Kohl's and Macy's. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.