Retail's Unhappy Middle Ground

Department stores languish as wealthier rich buyers boost luxury shops and moderate earners facing rising costs flock to discounters

By Robert Berner

For the nation's major retailers, it's no fun being in the middle these days. The way the sector operates, the winners are serving the market's two extremes, either providing more unique and luxurious products on one hand or goods at low prices on the other. Increasingly, shoppers are choosing sides. And it's splitting retail like never before -- into the haves, with clear positions at either end of the spectrum, and the have-nots stuck in between.

Stronger income growth among upscale shoppers is fueling sales at the high end, while slow job growth and higher energy costs are steering more moderate-income consumers in search of bigger bargains. No retail sector is more squeezed from both sides than the department-store chains, most of which continue to lose sales to other retailers. That has opened the door for financier Edward S. Lampert, 42, whose plans to merge Kmart Holdings (KMRT ) and Sears (S ) could result in Sears vacating 200 to 300 of its 871 mall-based stores (see BW Online, 11/29/04, "Eddie's Master Stroke").


  Purveyors of designer duds and high-end items like Neiman Marcus (NMG.A ), Nordstrom (JWN ), and the Saks Fifth Avenue division of Saks (SKS ) are all riding the luxury wave, posting double-digit sales increases at stores open at least a year. Sales are also blossoming at Coach (COH ), the upscale handbag retailer.  For its most recent quarter ended Oct. 2, Coach's same-store sales rose 15.1%, helping to drive a 60% increase in profits.

This holiday season, the outfit is offering even more exclusive merchandise, boosting the number of limited-edition bags, which push the average price of a Coach bag up 13%. "It elevates the brand," says CEO Lew Frankfort.

Plenty of other retailers are seeking to catch the upward wave. Already known for running a pricey teen-oriented retailer, Abercrombie & Fitch (ANF ) CEO Michael S. Jeffries has added $198 Ezra Fitch jeans to his product offerings, a move aimed at lessening sales cannibalization from its lower-priced Hollister division. Ditto at J. Crew, where CEO Millard S. Drexler is featuring $498 men's blazers. "You've got to be in the better business or the cheap business,"  he says. "There isn't much in between."


  That's a lesson reinforced for the successful retailers at the low end. Wal-Mart Stores (WMT ) CEO H. Lee Scott Jr. eased up on the discount pedal in 2004, only to have to floor it again during the holiday season as other retailers slashed prices.

Rival Target (TGT ) hasn't had that problem. The chain's positioning as an upscale discounter has continued to draw higher-income shoppers than Wal-Mart and rack up same-store sales double that of Wal-Mart. Warehouse-club Costco Wholesale (COST ) is also benefiting from shoppers with more robust incomes who are searching for discounts on high-end TVs, designer handbags, and the like.

But consider the many retailers caught in the middle. Kohl's (KSS ), the provider of moderately priced branded casual apparel, has lost its status as a Wall Street darling. Analysts wonder if CEO R. Lawrence Montgomery may have overextended Kohl's through expansion. It has also faced tougher competition from a revitalized J.C. Penney (JCP ) and others. Still, questions remain as to whether new Penney CEO Myron E. Ullman III can perform the magic that departing chief Allen Questrom achieved in this crowded market.


  As May Department Stores (MAY ) continues to bleed sales, the jury is out as to whether its pricey purchase of Marshall Field's will help the company go upmarket. Toys 'R' Us (TOY ) however, has partly ceded the middle ground. With its toy sales under pressure from below via Wal-Mart and Target, it has been exploring unloading its toy-store division.

Overriding all this jostling is the biggest question in retail: Whether the planned merger of Kmart and Sears will work. The deal, expected to close in the first quarter of 2005, saves Sears CEO Alan J. Lacy, who has been unable to reverse four years of declining sales. Though Lacy would become CEO of the new company, it's likely Lampert would ultimately put in his own man, as he did at Kmart.

The deal would accelerate Sears' strategy to move off the mall by taking some Kmart sites. The retailers believe, too, that they would benefit from cross-selling some of their proprietary brands, like Kenmore appliances.

Yet it's a long shot whether Lampert can turn around two retailers that continue to lose sales to others. It's more likely that he'll invest the retailers' cash elsewhere, as his hero Warren Buffett did with a declining textile mill called Berkshire Hathaway (BRK ). Then, any turnaround success he achieves with the stores will be gravy.

Berner is a correspondent in BusinessWeek's Chicago bureau

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