Luis Alvarez
A highly promotional period for retailers fueled by inflated inventory levels could be coming to an end, according to research by Gordon Haskett.
Recent earnings reports from the likes of Under Armor (NYSE: UAA), Capri Holdings (CPRI), and Adidas (OTCQX:ADDYY) have once again raised the specter of inventory that has been a constant refrain in 2022. Under Armor (UAA), for example, saw its margins shrink sharply in the fourth quarter holiday sales season as it struggled to work through high levels of merchandise.
“We’ve definitely seen the promotional environment go a little deeper and we believe it will continue a little longer. And a lot of that has to do with some of the building inventory that’s out there with all the brands,” Under Armor CFO Dave Bergman told analysts on a call Wednesday. “This is something that all retailers will have to work on in the coming quarters.”
While Adidas’ recent warning was clearly tied to one product line, comments from Under Armour, Capri Holdings ( CPRI ) and VF Corp . (NYSE: VFC) suggests a long-standing problem in the clothing industry. The latter, for example, saw inventory growth of over 100% year-over-year in the third fiscal quarter despite promotional activities.
“Inventory was a challenge. That’s been prevalent for us for several quarters and it certainly continues to be,” VF Corp. CEO Benno Dorer told analysts during the week.
However, he added that these issues were largely driven by supply chain challenges that took longer than the company expected. Going into 2023, Dorer said he expects the large degree of bottlenecks weighing on the industry to diminish. In addition, promotional activity across the industry is expected to contain commodity levels and ease pressure on margins moving forward.
This line of thinking was echoed in recent research by Gordon Haskett analyst Chuck Grom, who predicted a return to healthy inventory levels in 2023. In a research note released Friday, he noted that overall industry retail levels are indeed normalizing, leaving problems for so-called Under Armor ( UAA) and VF Corp. (VFC) more indicative of company-specific execution issues in one retail segment rather than overall industry trends. In short, while these reports have given the company “some pause,” just a few reports doesn’t eliminate the claim.
“Through most of 2022, retailers have had to bite the bullet and resort to deep discounting to clear excess inventory,” he told clients. “As we head into 2023, inventory growth appears to be coming more in line with sales with 3-month annualized inventory growth trending -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 a fall in the inventory-to-sales ratio with less pressure on margins in FY23.”
Lower inventory levels, along with lower freight and freight costs, should serve as a key tailwind for the industry, according to Grom. He added that he expects a wave of Walmart earnings reports (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 the coming weeks to reflect this broader trend. In fact, Grom upgraded Five Below ( FIVE ) and Walmart ( WMT ) to Buy and Accumulate on Friday, in part due to improved inventory management.
Despite this, Grom advised to remain selective as it sees the potential for “management teams setting very conservative guidance” in upcoming reports. As such, investors should focus on retailers that gain traffic, exchange opportunities, and retailers that address consumer needs rather than wants.
“Given a portfolio approach with respect to a set of moving parts, we believe it is appropriate to adhere to our Weighting Strategy where we seek to hedge between names with more defensive attributes versus names with more offensive characteristics,” Grom explained. “In the past, we have found the Barbell approach to be extremely useful in balancing risk, especially in uncertain times.”
“Offending” names rated as buys include Ross Stores ( ROST ), Dick’s Sporting Goods ( DKS ) and TJX Companies ( TJX ). Major 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 on Friday and moved to an Accumulate rating despite its defensive nature as risks of reduced competition and tax breaks loom over the stock.
Read more about Grom’s downgrade of Floor and Decor Holdings.