According to the National Retail Federation, customers returned merchandise valued at $185.5 billion in 2009, approximately 8% of total sales. Of those returns, 8% or $14.8 billion were considered fraudulent in nature. While this is a huge amount, investors might want to consider how much retailers stand to lose in future revenue by mishandling returns. The 2007 NRF report Customer Returns in the Retail Industry concluded, "broad policy-based returns initiatives can adversely impact good customers, not just abusers, and consumer satisfaction suffers as a result." How certain are you that your retail stock's return policies and the people managing those returns aren't killing future sales?

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Customer Service Continues to Suffer
Every interaction with a customer is an opportunity for retailers to cement the relationship, including returns and exchanges. No one knows this better than Bruce Temkin, the head of customer experience research at Forrester Research (Nasdaq:FORR). He's spent the last 13 years researching and writing about the customer experience. If anyone knows customer service, it's him. He wrote a particularly interesting blog post last year about an insurance company that will go nameless. Essentially he switched companies after 17 years because his existing insurer treated him so poorly. His last words were "Try not to turn good customers into detractors." That's what can happen when retailers spend less time helping customers return items then they do selling them in the first place.

Danish customer experience consultant Telefaction suggests that 90% of unhappy customers never buy again from a firm that's given them poor service and that it costs businesses between three and 10 times less to keep an existing customer than finding new ones. If this is the case, why do retailers seem so oblivious to the situation? (Read more on retailers in 3 Hot Home Furnishing Stocks.)

Financial Consequences
In the 2007 report on customer returns referenced above, home centers like Home Depot (NYSE:HD) and Lowe's (NYSE:LOW) experienced a 9% return rate that year. Retailers generally reduce both gross sales and cost of goods sold to account for its historical return rate. Thus, the number you see on the revenue line in the 10-K is net revenue after returns and sales taxes. Therefore, it's a bit of guesswork generating a gross sales number. For the sake of this discussion, I'll leave out sales taxes and focus on returns.

In 2009, Home Depot and Lowe's net revenues were $66.2 billion and $47.2 billion respectively. Grossing them up by 9% (the average for home centers in 2007), Home Depot's returns for argument sake were $6.6 billion and Lowe's $4.7 billion. Now imagine that just 20% of these returns and/or exchanges went badly in one fashion or another. That's $2.2 billion in merchandise. If half of these customers choose to stay away permanently (not the 90% mentioned previously), you're talking about a billion dollars in potential lost sales each year indefinitely. It's a lot of money to throw away due to poor execution.

Return Policies That Work was bought by (Nasdaq:AMZN) in 2009. Part of the allure for the world's biggest online retailer was Zappos' incredible customer service. Nobody does it better, and returns play a big part in its fabulous reputation. It accepts returns 365 days a year providing free two-way shipping. The result: the company's best customers return the most products. They also spend the most money resulting in higher profits. It makes me wonder why bricks-and-mortar retailers don't do the same.

While it's true that internet-only retailers don't have the problem of fraudulent returns due to shoplifting, it is also true that the percentage of returns because of fraud generally runs between 6-8% annually with some small deviations. This is acknowledged by the NRF in its annual report on customer returns. Would it not make sense then to introduce a severely relaxed return policy that treats customers as adults? I believe the result would be greater customer satisfaction and ultimately higher revenues. Two examples of companies that do this are Macy's (NYSE:M) and Kohl's (NYSE:KSS). Both maintain generous return policies despite the fact the recession has slowed sales. Long-term, this under-appreciated component of customer service could pay dividends. (Read more in Retailers Getting A Bit Too Big For Their Britches.)

Bottom Line
If you currently own stock in a retailer or are thinking about investing in one, it's important to understand that how a company handles its returns is equally as important as how it handles its sales. To me, it's a lot like dropping the football at the other team's five-yard line on a surefire kickoff return for a touchdown. The first 95 yards don't mean much if you don't make it into the end zone.

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