Luis Alvarez
According to research from Gordon Haskett, the highly promotional period for retail sparked by bloated inventory levels could be nearing its close.
Recent earnings reports from the likes of Under Armour (NYSE:UAA), Capri Holdings (CPRI), and Adidas (OTCQX:ADDYY) have again raised the specter of the inventory overhang that was a consistent refrain in 2022. Under Armour (UAA), for example, noted that its margins contracted sharply in the Q4 holiday sales season as it sought to work through high levels of merchandise.
“We definitely have seen that the promotional environment went a little bit deeper and we believe it’s going to go a little bit longer. And a lot of that has to do with some of the building inventories that are out there with all the brands,” Under Armour CFO Dave Bergman told analysts during a call on Wednesday. “That is something that all retailers are going to need to work through in the coming quarters.”
While Adidas’ recent warning was clearly tied to a single line of products, the commentary from Under Armour, Capri Holdings (CPRI), and VF Corp. (NYSE:VFC) suggests a lingering issue in the apparel industry. The latter, for example, saw inventories rise over 100% year over year for its fiscal third quarter despite promotional activity.
“Inventory has been a challenge. It’s been an overhang for us for a couple of quarters and continues to certainly persist,” VF Corp. CEO Benno Dorer told analysts during the week.
However, he added that these issues have largely been driven by supply chain challenges that lasted longer than the company anticipated. Heading into 2023, Dorer said he expects a large degree of the bottlenecks bearing down on the industry to ease. Additionally, the promotional activity across the industry is expected to rein in merchandise levels and alleviate margin pressure moving forward.
This line of thinking was echoed in recent research from Gordon Haskett analyst Chuck Grom, who forecast a return to healthy inventory levels in 2023. In a research report released on Friday he noted that overall industry retail levels are indeed normalizing, leaving the issues called out by Under Armour (UAA) and VF Corp. (VFC) more indicative of company specific execution issues in one pocket of retail rather than overall industry trends. In short, while these reports have given the firm “some pause”, the bull argument is not eliminated by just a few reports.
“For most of 2022, retailers had to bite the bullet and resort to heavy discounting to clear excess inventory,” he told clients. “As we enter 2023, it appears growth in inventories is coming more in-line with sales with the 3-month annualized growth of inventories trending at -2.8% in December versus retail sales trending down -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 move lower with less pressure on margins in FY23.”
Lighter inventory levels, coupled with lower transportation and freight costs should serve as key tailwinds for the industry, in Grom’s view. He added that he expects a wave of earnings reports from Walmart (NYSE: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 coming weeks to reflect this broader trend. In fact, Grom upgraded both Five Below (FIVE) and Walmart (WMT) to Buy and Accumulate ratings on Friday, respectively, due in part to their inventory management improvements.
That said, Grom advised remaining selective as he sees a potential for “management teams setting very conservative guides” in the upcoming reports. As such, investors should focus on the retailers gaining traffic, trade-down opportunities, and retailers that address consumer needs rather than wants.
“From a portfolio approach given a confluence of moving parts, we think it’s appropriate to adhere to our Barbell Strategy where we look to hedge out 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 uncertain times.”
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 shifted to an Accumulate rating on Friday despite its defensive nature as competition and tax benefit reduction risks loom over the stock.
Read more on Grom’s downgrade of Floor and Decor Holdings.
