Companies Are Finally Rebuilding Their Inventories. What That Means for Profits.

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Target’s inventory grew 43.1% in the most recent quarter and sales grew 4%.

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Joe Redl/Getty Images

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After being empty for months, the shelves are finally being restored. This makes shoppers happy, but brings companies back into the game of managing inventory — and too much can actually hurt sales and, in turn, profits.

To start, a refresher that brought companies to this place: the pandemic. First, the lockdown, and demand shrank. Then, reopening, and demand increased, causing companies to close.

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Obviously, companies rushed to order supplies.

For example, Elf Beauty (ticker: ELF) told investors at the beginning of the year that it was carrying more inventory to ensure that supply matches demand. On Wednesday, the cosmetics maker posted numbers that showed the move did not lead to a decline in sales and earnings. And the stock went up.

dick sporting goods,
On the other hand, suffers from too much inventory. On Wednesday, the company downgraded this year’s outlook for both sales growth and earnings — down 3 percentage points and 15%, respectively, from the previous midpoint. This isn’t surprising, given that inventory has increased by 40%.

Too much inventory impairs a company’s ability to raise prices as much as it wants. In Dick’s case, the pricing power is already running out. Still, the stock jumped, but it’s the exception rather than the rule.

“Excess inventory is now a risk the market cares about,” wrote Mike Wilson, chief US equity strategist at Morgan Stanley.,
“The additional inventory element and risk associated with pricing are poorly understood and have just begun to be reflected in stock prices.”

According to Morgan Stanley, US companies have less than $800 billion in wholesale and durable goods plus apparel, totaling more than $700 billion and the most recent trend since at least 1997. Inventory at general merchandise stores grew nearly 15% year over year, the highest increase in decades.

The numbers show, very clearly, how much companies have increased their inventory and how quickly supplies have increased. And it points to another knot in inventory that growth in inventory is outpacing sales growth.

For companies in the S&P 500, the growth gap is greatest for retailers. According to Morgan Stanley, retail year-over-year inventory growth has recently been about 25 percent higher than sales growth.

That increase meant that companies had to sell their excess inventory, sometimes lowering the prices they had initially planned. To be sure, prices are still up, but slower price increases could lower profit margin estimates.

Target (TGT) is a perfect example of all of the above: a growing inventory, diluted pricing power, a profit margin miss.

Let’s break it down: Target’s sales for the most recent quarter of $25.2 billion beat analysts’ expectations of $24.5 billion, but the retailer needed a big beating for profits to exceed estimates. The profit of $2.19 per share was well below expectations of $3.07.

And that miss was because Target’s operating margin of 5.3% fell short of expectations of 8.1%, which brings us back to pricing: The company couldn’t fully offset rising costs with the price increase.

Growing inventory certainly didn’t help profit margins. Target’s inventory grew 43.1%, while sales grew only 4%. Having so much inventory makes it difficult to increase value as much as management wants — and analysts at Cowen are now warning of markdowns on products in the coming quarters.

For now, the point is that “total costs are rising much faster than retail prices, resulting in … our gross margin rates have declined,” management said on the company’s earnings call.

Target shares are down more than 25% since its May 18 earnings report.

The takeaway: Rebuilding large inventory is starting to backfire — and there’s really not much to do about Fallout.

Write to Jacob Sonenshine at [email protected]

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