Industry Insight: Overstocked, and now undersold?
How a shift from “just in time” to “just in case” supply chain management has led to a potential inventory problem for the retail sector
Pre-2020, the functioning of global supply chains was not likely to have been a major topic of concern for the average person. The world had experienced decades of relatively benign trade conditions during which major corporates had relocated their factories and manufacturing facilities to developing economies, where the low cost of labour more than made up for increased logistics costs. Amazon and other retailers promised to deliver by tomorrow items that had only been ordered today, masking what will often have been a weeks or even months-long journey from a factory thousands of miles away to our front doors.
When the pandemic hit in early 2020 and lockdowns in many countries around the world prevented all but the most-essential of businesses from opening, this on-demand delivery that many had taken for granted was now harder to come by, with shortages seen for various products including dumbbells, bicycles, and a number of items that had semiconductor chips in them.
With consumer demand strong, having been bolstered by more than a decade of easy monetary policy, pandemic stimulus packages, and forced savings, companies were concerned about leaving sales on the table, and during the second half of 2021 many corporates and industry consultants were speaking of a shift from “just in time” to “just in case” supply chain management. “Just in time” supply chain management became the favoured strategy for many corporates in the decades before the pandemic, as low costs and efficient working capital management were prioritised. Its aim was to run inventories as lean as possible and to utilise short-term, flexible contracts for manufacturing, but it has proven vulnerable as global trade conditions have deteriorated significantly because of the pandemic, and, more recently, Russia’s invasion of Ukraine.
““Just in time” supply chain management has proven vulnerable as global trade conditions have deteriorated significantly.”
Due to the challenges in the supply chain, corporates worked to ensure that they had enough stock, entering long term contracts or partnerships with suppliers, putting in orders earlier, and just generally purchasing more inventory. This was on display during the latest earnings season as several retailers and consumer goods companies reported sharp increases in inventory levels. However, having wanted to avoid leaving sales on the table, some companies have turned up with their recently replenished stock to find that the buyers have vacated their seats.
Walmart and Target, two of the world’s largest retailers, reported below-expectations earnings in the most recent quarter, with inventories growing strongly but demand weak for certain lines of products. Both have downgraded earnings guidance for the second quarter, with Target now wishing to right-size its inventory by marking down prices, which will impact merchandise margins at the company. Gap and Abercrombie & Fitch are two other examples, with both seeing rising inventories but noting lagging consumer demand.
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This represents an ongoing challenge for retailers as inflationary pressures persist, weighing on consumers’ discretionary income at a time when inventory levels have been built up. This is likely to lead to greater promotional activity during the second quarter, something which tends to be negative for a company’s margins and its brand equity, with those who have grown their inventories at a far faster pace than their revenues perhaps the most at risk. These effects are also likely to be most acutely felt at those companies that are selling more seasonal or trend-led products, such as mass-market fashion retailers, as these are likely to be less able to put stock in storage to be sold at a later date. Even for those that do have this luxury, the supply of warehouse space is low and therefore storage costs are high.
Against this backdrop should we avoid consumer goods businesses altogether? We think there are areas of the market that are relatively better positioned. Luxury goods businesses, particularly the highest-quality ones, continue to run very tight inventory levels and have local supply chains, having never relocated manufacturing to emerging markets due to the potential negative impact on the perception of the quality of their product. There remain waiting lists for the most sought-after luxury items, such as certain lines of watches and handbags, and luxury companies’ higher-end consumers are likely to be relatively less sensitive to the increased cost of living.
“Should we avoid consumer goods businesses altogether? We think there are areas of the market that are relatively better positioned.”
We also think that sportswear can be relatively less impacted. Performance sportswear is not very seasonal at all – running trainers, for example, will be bought all year round, and the styling tends to be relatively static. As with the luxury sector, the best businesses in the space have managed inventory very tightly to the extent that some lines of trainers sell above their recommended retail prices on resale exchanges such as StockX.
Off-price we believe is one subsegment of the broader retail sector that is well-placed to benefit long term from the current environment. The last year or so has seen concerns rise about off-price’s access to inventory due to the pressures on the supply chain. Those concerns now appear to be wide of the mark, with the three largest players, TJX, Ross Stores, and Burlington, all increasing their inventory levels in the recent quarter, and they are likely to have good access to stock at attractive prices going forward as companies look to right-size inventory levels. They are also used to dealing with out of season stock, and they benefit from consumers trading down – the sector has delivered very consistent comp store sales growth through previous challenging economic periods.
Amongst less discretionary retailers, such as those that are selling food and consumer packaged goods, we think that the membership warehouse model, such as that employed by Costco, looks resilient against the current market backdrop. These companies take a more opportunistic approach to inventories, in a not dissimilar way to off-price retailers, while they also benefit from a large and loyal customer base, with membership fees broadly covering the operating costs of the business.
Overall, we are cognisant of the risks to consumer-facing businesses in the current macroeconomic environment, but while we expect elevated inventory levels to be a challenge for a number of names in the space, there are other businesses that we believe remain relatively well positioned. Additionally, our preference for high-quality businesses that play to a thematic opportunity allows us to look beyond these potential short-term headwinds and to focus on the long-term investment case on stocks that are now significantly cheaper than they were at the beginning of the year.
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If you would like to discuss anything raised in this article in more detail, please don’t hesitate to get in touch.