Conventional wisdom says that a brand’s off-price, or outlet, stores cannibalize its full-price counterparts and drain brand equity. This thinking has led retailers to try to put significant distance between their full-price and outlet doors—pushing outlets far from most major cities.

But full- and off-price doors can coexist in urban markets and may even have a mutually beneficial relationship. Only some of the same shoppers frequent both, helping a retailer expand its consumer base, and when they do shop both, the retailer is not only able to capture a higher share of wallet, but the off-price door can serve as a way for new consumers to try the brand, leading to increased sales in full-price stores.

A Fertile Market for Outlets

The $40 billion, high-margin outlet channel is growing like a weed.

First, the growth part. Forty new centers have opened between 2006 and 2014, and year-over-year sales growth is consistently in the double digits.1 In many cases, margins are consistently as good or better than full-price doors because rents are lower, unplanned markdowns are typically rarer and products are sourced specifically for the outlet channel, driving costs down.

The market shows no signs of turning fallow. Forty-eight new centers are expected to open by the end of 20172 as established outlet brands expand their doors and new retailers enter in search of green. Recent entrants include Chaps, Diane von Furstenberg, Helly Hansen and The Limited, with Rag & Bone, Alex and Ani, and Alice + Olivia among likely fresh faces for this year.3

Now, the weed part. Despite the channel’s growth and profitability, many retailers try to contain their outlet channel, making sure it doesn’t creep too close to their full-price doors to reduce the risk of cannibalized sales and diluted brand equity.

This channel separation often also extends to the online world. In a recent audit, Kurt Salmon found that only 28% of 67 retailers with physical off-price doors had an outlet e-commerce presence.

But with the outlet channel reaching a greater state of maturity, outlet stores are inevitably beginning to encroach on full-price stores.

For example, Tanger recently began construction on a new outlet center 15 minutes from Memphis,4 while Simon is building centers 25 minutes from Tampa and 30 minutes from Tucson.5 And a Kurt Salmon analysis found that 75% of the 7 million people in the San Francisco Bay Area live within a 30-minute drive of an outlet mall.

This trend holds true on an individual retailer level as well. Take Coach. Back in Full- and off-price doors can coexist in urban markets and may even have a mutually beneficial relationship. 7 2004, its outlets were usually located 50 to 100 miles from major cities. But by 2012, that distance had shrunk to just 30 miles.6

This encroachment into historically full-priced urban areas, coupled with the temptation for brands to continue growing their outlet sales, is making it challenging to maintain the historic level of separation and forcing many retailers to rethink their off-price channel strategy altogether.

But perhaps no retailer has exemplified and embraced this urban transition more than Nordstrom.

Nordstrom Racks Up Growth

Early on in the development of its Nordstrom Rack concept, Nordstrom recognized the value of placing its off-price doors close to its full-price stores within major metropolitan areas to capture a wider range of consumers and a greater share of their wallets by diversifying its retail offering.

Today, that idea is manifested in places like Seattle, where Nordstrom and Rack are located in the same shopping center, or in Cerritos, Calif., where a new Rack is opening across the street from a full-price Nordstrom this fall.

In fact, a whopping 64% of Rack stores are within five miles of a full-price Nordstrom and 42% are within one mile.7

Clearly, the company would not risk this level of channel overlap if the strategy was not paying off. In fact, the company says, “Many of our best Rack stores are across the street from our best full-line stores. We know our customers like the convenience of shopping both.”8

Why does this work so well? It starts with differentiated consumer positioning and experiences as well as differentiated products. Rack is a mecca for treasure hunters that features distinct products. Indeed, only 20% of Rack’s products are clearance items from Nordstrom’s stores and website; the rest are bought specifically for Rack, often from vendors looking to clean house.9

This differentiated positioning and offering allow the company to pull in a wider overall mix of consumers. The stores have somewhat different, yet complementary, audiences, with Rack drawing younger, aspirational Nordstrom consumers that hope to—and do, in some cases—transition to the full-price brand. This strategy extends to the online world, with Nordstrom’s purchase of 8 HauteLook in 2011. Courting this younger audience makes long-term sense, as Baby Boomer spending power will peak in a few years and brands will hunger for younger, loyal consumers to take their place.

While serving primarily two different consumer groups, roughly 30% cross-shop between Nordstrom and Rack. Having both banners in close proximity not only allows the company to capture a larger share of wallet among these cross-shopping consumers, but also drives trial of new products. This is the case because, for some consumers, Rack functions as a kind of introduction to the Nordstrom brand and the bridge and luxury brands carried by both retailers. In fact, the company says Rack is Nordstrom’s biggest source of new customers, pulling in almost 4 million.10 These customers get to try new luxury brands at Rack and fall in love with them, eventually driving them to Nordstrom for a fuller assortment of the latest full-price offerings from the same brands.

Nordstrom CFO Michael Koppel explains: “One of the things we’ve learned is that, when we do have some of these off-price events in brands, the sales in that brand accelerate in the regular price because we’re creating higher brand awareness across the ecosystem. … I’m not sure this is quite so much an off-price strategy as it is kind of a customer strategy and a way for us to attract customers at perhaps an earlier point in their lifecycle … about a third of our Rack customers shop our regular-price business.”

Rack now accounts for nearly 25% of Nordstrom’s sales. And while Rack has a lower gross margin than full-price Nordstrom stores, Rack is more profitable, with its operating profit margin estimated to be around 15% to 16%, compared 10% to 11% for full-price stores11 because real estate and labor are less expensive. Rack’s sales per square foot are also higher—$552 vs. $371 for full-price stores.12

Given these impressive results, it’s no surprise that Nordstrom is aggressively expanding its Rack stores. After opening a combined 49 Racks in 2013 and 2014 vs. three full-price stores in the same time period, Nordstrom now has 118 full-price and 177 Rack stores. Going forward, the company is planning to open 27 Racks and two full-price stores in 2015, with the goal of hitting 230 Racks in 2016.13

Other department stores have also started to pay attention to this transition, with Neiman Marcus, Saks Fifth Avenue and Bloomingdale’s all pursuing similar strategies.

A few specialty apparel retailers are also getting in on the action and pushing the historic boundaries that separated fullfrom off-price. For example, Tommy Hilfiger is making it easy for consumers to cross-shop both full- and off-price by integrating its two websites and shopping carts, both Gap and Banana Republic Factory Stores are advertising in People magazine, where they would historically advertise their full-price channels, and Tommy Bahama launched a flash sale site to reward existing customers and acquire new ones. The site is open for only a few days at a time. After the first sale, year-over-year sales continued to grow on Tommy Bahama’s full-price site, with the flash sale site serving as the highest referrer of new visitors to their full-price site.14

Making the Case for Proximity

But the question is whether the channel dynamics Nordstrom is experiencing are an aberration or applicable to a wider array of retailers. A recent Kurt Salmon survey of 1,000 consumers showed that many other brands could benefit from a more symbiotic approach to their outlet and full-price real estate strategy.

As illustrated in Exhibit 1, Nordstrom Rack has a higher percentage of outlet shoppers who cross-shop at the full-price Nordstrom than do J.Crew, Gap, Banana Republic, American Eagle, Old Navy and many more retailers, despite these consumers having much easier access to off-price stores.

zoom iconExhibit 1: Rack stores help drive Nordstrom traffic

This data supports the notion that Rack stores help pull sales into full-price Nordstrom stores and that other retailers may also benefit from following a similar strategy.

But does close proximity of off-price stores also draw sales away from full-price stores? The answer is mostly no—proximity doesn’t appear to change that. As illustrated in Exhibit 2, even though Nordstrom and Rack doors are generally much closer together than the full- and off-price doors of Banana Republic, J.Crew and Gap, the percentage of full-price consumers who cross-shop off-price stores is relatively similar, despite Nordstrom having a significantly higher mix of off-price stores.

zoom iconExhibit 2: Full-price shoppers don't trade down more when it's convenient

Additionally, as illustrated in Exhibit 3, the average full-price and off-price consumers’ cross-channel share of wallet is approximately the same for Nordstrom as for other retailers.

zoom iconExhibit 3: Nordstrom's cross-channel share of wallet is similar to specialty retailers

This is because off-price and full-price shoppers are generally looking for different products and experiences. Not surprisingly, 55% of consumers said they were mainly drawn to outlet stores in search of a good deal, while they ventured to full-price stores for product quality (28%) and selection (19%).

Consumers who prefer outlets and full-price stores are actually similar in terms of demographics, including income and zip code, but tend to differ on the importance of quality and having the latest product, with quality seekers 14% more likely to have shopped at a full-price vs. an off-price store.

Additionally, 47% of consumers who shop both full- and off-price stores said they primarily turn to outlets for a treasure-hunt experience, while full-price options rule for shopping trips where consumers want a specific item or brand or need a new outfit for a special event.

Collectively, these findings, coupled with Nordstrom Rack’s success, suggest that the off-price channel’s ever-increasing encroachment on urban areas can offer a sizeable growth opportunity. In fact, not only are outlets profitable on their own, in some cases they can help retailers grow their full-price sales. As Nordstrom Rack proves, it’s fine for a subset of consumers to shop both channels, as long as each channel’s role is clearly defined and captures consumers across different occasions or serves as a point of entry to new products or brands.

  1. Value Retail News, 2014
  2. Value Retail News, 2014
  3. RBC, 2015 Analyst Report
  4. Tanger Outlets, News, 2015
  5. Simon Property Group, 2015
  6. The Wall Street Journal, 2014
  7. Institutional Investor, Real Estate Finance and Investment, 2013
  8. Nordstrom, press release, 2015
  9. Racked.com, 2014
  10. SeekingAlpha.com, 2015
  11. William Blair Initiating Coverage, 2012
  12. Securities and Exchange Commission, 2015
  13. SeekingAlpha.com, 2014
  14. Retail TouchPoints, 2014