In the retail game, inventory is a lot like water. If you don’t have any of it, you’ll die. Too much of it can kill you as well. Jumanji taught us a version of this, all those years ago.
In the grocery market, the impact of inventory levels isn’t often spoken about. It’s rare for fresh and perishable supply chains to experience issues that result in a material lack of supply, other than in cases like an outbreak of avian flu.
Retailers focus on selling as much as possible before it turns to waste, with the level of waste driving the gross margin achieved.
The margins in fresh produce are among the lowest of any category in a retail store, so throughput is the lifeblood of a grocery retailer. The model isn’t nearly as defensive as most people think.
Interestingly, you won’t often see a retail strategy that marks fresh produce down as it gets closer to the sell-by date. The risk is that consumers end up with an inferior product even if they paid a discount for it. This is different from categories such as apparel and general merchandise, where discounting and markdowns are firmly part of the model.
These are higher-margin categories, which is why there is space for markdowns. Even the 50% off end-of-season sale makes a small profit for clothing retailers, with full-price gross margin typically running at about 60%. Success is measured by the proportion of full-price vs markdown sales, with gross margin often coming out at the 40% mark. A grocery retailer is lucky to run at a 20% gross margin.
General merchandise categories (such as televisions) don’t usually carry the same gross margin as clothing. Fashion is a risky business, which is why clothing retailers are rewarded with the highest margins in retail. A television doesn’t go out of fashion, though major suppliers will put pressure on retailers to clear stock before the new model arrives. A full-price general merchandise sale will typically carry a gross margin of more than 30%.
One of the most lucrative categories is health and beauty, the foundation on which Clicks built its business. Even a consumer staple such as shampoo carries an appealing margin. A particular mint-scented shampoo doesn’t go out of fashion very easily. It also doesn’t perish on the shelf.
Understanding the fundamentals of each product category in a retailer is an important part of appreciating the impact of too much or too little inventory on margins. In apparel, for example, having too many markdowns in a particular season can easily take profit growth into the red. The business is still profitable, but less so than before. That’s not what shareholders are paying for, which is why the valuation inevitably takes a knock.
Gross margin consistency also goes right out the window when there are major supply chain disruptions. The pandemic resulted in an extraordinary backlog in shipping, with a direct impact not just on the level of stock on the shelves, but also on the cost to get it there. This drove higher inflation, a problem that quickly becomes rather sticky even after shipping costs have calmed down.
In the initial stages of the supply shortages, a number of consumer-facing companies achieved terrific results because they could ramp up prices on existing and new stock. The party didn’t last long, as supply started to come through while freight costs were still elevated. This put pressure on cost of sales and gross margin, particularly as consumers couldn’t absorb all the pricing increases as inflation picked up.
Eventually, supply chains normalised to the point where retailers found themselves with far too much stock on the shelves. This led to a highly promotional environment, which means plenty of markdowns and pressure on gross margins. When there is also pressure on operating costs, the net result is a contraction in operating margin and an unpleasant situation for shareholders.
Having now dealt with the retail environment over the past three years and how we got to where we are today, we can consider inventory levels and whether things have normalised in the US retail environment. Most importantly, is this the right time to be buying these retailers?
We begin with Walmart, with share price growth of 22.5% in the past year. The trailing dividend yield of 1.47% is expensive, though it’s been at this level a few times in recent years. Before that, we only saw yields this low at the top of the 2000s bull market. In contrast, earnings multiples have been all over the show, which demonstrates how dividend aristocrats like Walmart will sacrifice just about anything before cutting their dividend.
Price-to-book value might be a decent sanity check, currently at 5.7 times and way above the 10-year average of 3.96 times. With return on equity of 12.8%, that’s an effective return on equity of 3.2%. With US 10-year treasuries at about 4%, it’s hard to justify this.
From an inventory perspective, the Walmart management team talks about a “clean” exit from the previous financial year into the new season. In the latest quarter, inventory was down 7% year on year and 9% in Walmart US. To really drive the point home, they talk about how in-store staff can focus on customer service rather than just dealing with the huge flow of inventory coming into the stores.
Walmart makes mention of the shrink issue, which includes in-store theft that is becoming a big problem in the US. The management team at Target has a similar message, though they use stronger wording that includes a reference to organised retail crime. You might be fooled into thinking these are South African retailers based on some of the comments in the press releases.
Target’s inventory is 16% lower year on year, with reference to a “cautious position” in discretionary categories that resulted in a decline in inventory levels of more than 25%. Target also found itself at the centre of controversy and boycotts over its LGBTQ+ kids clothing line. This was the primary driver of a significant sell-off in the share price, down 13.3% over the past year and a particularly nasty 23% over the past three months.
Regardless of your personal views, the market doesn’t like controversy around a brand and a potential loss of sales. On a 3.2% trailing dividend yield, the boycott might be an opportunity. Before rushing in, it’s worth noting a price-to-book of 5.2 times, which isn’t much lower than Walmart. The impact of different dividend payout ratios is evident when comparing these retailers.
Moving further up the value chain, we find Nike as a good example of a company that suffered a significant drop in gross margin as inventory levels simply became too high. In the latest quarter, inventory was flat year on year in value and down in units. In apparel, inventory units are down more than 20% vs the prior year. The mix of products at the end of the quarter was in line with pre-pandemic levels, so that suggests a normalisation in the supply chain and inventory position.
Despite this, gross margin fell by 140 basis points to 43.6%, with inflation putting pressure on input costs and freight. There were also markdowns required to achieve the exit position of inventory, so the worst of that is hopefully behind Nike.
Shareholders will certainly hope so, with Nike having achieved just a 3.2% compound annual growth rate (CAGR) for investors over the past three years. Operating margin has contracted sharply from more than 16% for most of 2020 and 2021 to just 9.5% in the latest quarter.
The trailing dividend yield of 1.3% still feels extremely expensive, though it is now higher than pre-pandemic levels. The p:e multiple of about 33 is also quite similar to pre-pandemic levels. When it comes to stocks priced for perfection, Just Don’t Do It.
At Levi’s, the inventory problem has been entirely different to most other players in the industry. Supply problems carried on long after the others, with the implementation of an enterprise resource planning (ERP) system causing issues. I remain convinced that one of the best short strategies is to sell any company that announces an ERP project, as they always cause trouble.
If there isn’t enough stock on the shelves, sales will suffer. The problems were particularly bad in the wholesale business, so inventory was in the wrong place at the wrong time thanks to the ERP teething issues.
Levi’s has other problems, like price-sensitive customers who have driven a need for price reductions in the US. Levi’s was also caught on the wrong side of the cotton market, buying too much raw material when prices were high.
The margin squeeze in the middle isn’t quite over yet. The share price fell sharply after results were released, now sitting on a critical support level and down 20% in the past year. The trailing dividend yield of 3.6% is the highest the stock has ever seen.
This is only a handful of examples of stocks in this sector. The overall message is that there is no one-size-fits-all answer at the moment, with some company valuations at low levels that will appeal to value investors and others at multiples that only growth investors would consider. With the US Federal Reserve hiking cycle likely to continue for a while still, the best approach in this sector is to invest in stocks that offer a margin of safety in the valuation.
Otherwise, you might end up with a depressingly low CAGR like the one that Nike has delivered. Valuation matters more than brand!