Luis Alvarez
According to research by Gordon Haskett, the highly promotional period for retail caused by inflated inventory levels could be coming to an end.
Recent earnings reports from companies like Under Armor (New York Stock Exchange: UAA), Capri Holdings (CPRI), and Adidas (OTCQX:ADDYY) have once again raised the specter of excess inventory that was a constant refrain in 2022. Under Armor (SAU), for example, noted that its margins fell sharply in the fourth-quarter holiday sales season as it tried to handle high levels of merchandise.
“We have definitely seen the promotional environment go a little deeper and we think it will last a little longer. And a lot of that has to do with some of the building inventory that’s available with all the brands,” Under Armour’s chief financial officer Dave Bergman told analysts during a call on Wednesday. “That’s something all retailers are going to have to work on in the coming quarters.”
While Adidas’s recent warning was clearly tied to a single product line, the comment from Under Armour, Capri Holdings (CPRI) and VF Corp. (New York Stock Exchange: VFC) suggests a persistent problem in the garment industry. In the latter, for example, inventories rose more than 100% year-over-year in its fiscal third quarter despite promotional activity.
“Inventory has been a challenge. It’s been overkill for us for a couple of quarters and it’s certainly persisting,” VF Corp. Chief Executive Officer Benno Dorer told analysts during the week.
However, he added that these problems have been largely driven by supply chain challenges that lasted longer than the company anticipated. Looking ahead to 2023, Dorer said he expects a large part of the bottlenecks plaguing the industry to be alleviated. In addition, industry-wide promotional activity is expected to control merchandise levels and ease margin pressure going forward.
This line of thinking was echoed in recent research by Gordon Haskett analyst Chuck Grom, who forecast a return to healthy inventory levels in 2023. In a research report released Friday, he noted that overall industry retail levels are they are normalizing, leaving the problems solved. by Under Armor (UAA) and VF Corp. (VFC) more indicative of company-specific execution issues in a retail sector than general industry trends. In short, while these reports have given the company “some pause”, the bullish argument is not eliminated with just a few reports.
“For most of 2022, retailers had to scramble and heavily discount to clear excess inventory,” he told customers. “As we enter 2023, it looks like inventory growth is more in line with sales with 3-month annualized inventory growth trending -2.8% in December vs. retail sales trending the drop of -3.8% in December. If current trends continue and inventory discipline remains a key focus going forward, we could see the inventory-to-sales ratio shrink with less margin pressure in FY23.”
Lighter inventory levels, along with lower transportation and freight costs, should serve as key drivers for the industry, Grom says. He added that he expects a wave of earnings reports from Walmart (New York Stock Exchange:WMT), Home Depot (HD), Lowe’s (LOW), Target (TGT), Five Below (FIVE), TJX Companies (TJX), Macy’s (M), Ross Stores (ROST) and Burlington Stores (BURL) in the coming weeks to reflect this broader trend. In fact, Grom raised the ratings on Five Below (FIVE) and Walmart (WMT) to Buy and Accumulate on Friday, respectively, due in part to its improvements in inventory management.
That said, Grom advised staying selective as he sees potential for “management teams to set very conservative guidance” in upcoming reports. As such, investors should focus on retailers that gain traffic, business opportunities, and retailers that address consumer needs rather than wants.
“From a portfolio approach given the confluence of moving parts, we believe it is appropriate to adhere to our Barbell strategy, in which we seek to hedge between names with more defensive attributes versus names with more offensive characteristics,” Grom explained. “In the past, we’ve found the Barbell approach to be extremely helpful in balancing risk, particularly in times of uncertainty.”
Buy-rated “offensive” names include Ross Stores (ROST), Dick’s Sporting Goods (DKS) and TJX Companies (TJX). Top defensive names include BJ’s Wholesale Club (BJ), Costco Wholesale Corporation (COST), Tractor Supply (TSCO), and Five Below (FIVE). Dollar General (DG) was removed from the buy rating list and switched to a cumulative rating on Friday despite its defensive nature as competition and downside risks loom over the stock.
Read more about Floor and Decor Holdings’ Grom rebate.
