Equity View: Retailers Moving Beyond Inventory Problems

Summary

• A narrative has emerged that many retailers misjudged the reopening and are struggling with too much inventory.
• The data suggests otherwise – inventory problems have been concentrated in a few large, highly visible companies like Walmart and Target.
• The problem for many other retailers has been rebuilding depleted inventories.

Market Implications

• Unlike the 1Q and 2Q earnings seasons, inventories will not be the market mover when retailers start reporting next week.
• Key will be margins (are retailers passing on all their higher costs?) and the all-important holiday outlook given inflation and recession fears.

What Inventory Problem?

The big headline issue for retailers over the past couple of quarters has been inventories. When the economy reopened and people left their houses – whether to travel or return to the office – retailers found they had too much and/or the wrong kind of inventory.

This narrative has one small problem: the data does not support it.

The Top-Down View is Benign

Let us start with the broad, top-down approach. The US Census Bureau compiles and reports monthly data on retail sales and inventories (Chart 1). The sales/inventory ratio is based on a survey of inventories and monthly sales, seasonally adjusted.

The total retail inventory/sales ratio is 1.25, well below the pre-Covid level near 1.5. The primary reason is depressed inventories of autos at dealers due to a shortage of semiconductors that has made it difficult to complete and ship cars to dealers.

Ex the auto sector, the retail sales/inventory ratio is 1.17, slightly lower than 1.2-1.25 in the years before pre-Covid.

Other Inventory Issues Are Supply-Chain Related

The Census Bureau also publishes data on sales and inventories for wholesalers and manufacturers. Wholesale inventory/sales ratios roughly align with pre-Covid levels. Manufacturer inventory/sales ratios are still a notch above pre-Covid levels, but this is primarily because of supply-chain issues that have increased work-in-process inventories. Ford (F) and General Motors (GM), for example, recently reported inventories some 13% above year-earlier levels, largely because cars are awaiting semiconductor parts. And then there are consumer-facing tech companies that are working off excess inventories of semiconductors.

These issues should correct in coming months, cutting manufacturer inventories (and boosting auto dealer inventories).

Bottom-Up View Shows Problem Is Firm Specific

We calculated inventory/sales ratios over the past few years for the 100 retailers included in the XRT ETF and aggregated them into consumer discretionary and staples subsectors (Chart 3) – roughly a 60%/40% split, respectively. (Note that the denominator is last 12 month or annual sales, not monthly sales.)

The total inventory/sales ratio of 10.4% is in line with the level in mid-2019. The consumer discretionary ratio dropped to 12.2% versus 13.1% in mid-2019. Consumer staples is higher at 8.3% versus 7.8%, but for a reason.

The consumer staples sector includes Walmart (WMT). Ex WMT, the inventory sales ratio for this sector has fallen from 8.1% in mid-2019 to 6.8% recently.

WMT, along with competitor Target (TGT), trumpeted their ability to stock up ahead of the 2020 and 2021 holiday seasons. The result is that both companies sport inventory/sales ratios some 2pp higher than mid-year 2019 (Chart 4). Other big-box retailers such as Costco (COST) and Best Buy (BBY) managed to avoid excess inventory buildup. And many other smaller retailers struggled to maintain inventory during the worst of the supply-chain problems and are still trying to rebuild. That is why the overall inventory/sales ratio is little changed.

Companies like WMT and TGT attract a lot of press attention, so it appeared that their inventory problems were more systemic. In fact, this has been more of a company-specific problem. – and

Inventory Update Coming

Many of the major retailers report earnings in the middle month of each quarter. They eschew the more traditional calendar year reporting cycle to allow the mania of the holiday shopping season to settle. The flow starts next week.

The state of inventories will be a big focal point. We guess WMT and TGT have moved quickly to right-size their inventories. We also would be unsurprised if retailers who were short inventory have mostly caught up.

The big questions will be first, margins. We know many companies and manufacturers have been able to pass on most of their rising costs. Retailers are the final link as goods pass to consumers. Are they also passing on higher costs?

Second will be outlooks for the holiday shopping season. Given the still robust labour market, we expect retailers are anticipating reasonably good sales. However, freight and logistics companes have been among the few reporting declining volumes and bookings for 4Q during the 3Q earnings season. It will be interesting to see what that means for retailers in coming weeks and months.

Our short retail ETF position in XRT has underperformed the broader S&P 500 (SPY ETF) by about 35% since inception. Depending on how earnings go we may look to unwind this position.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)