Retail's Inventory Problem

In this podcast, Motley Fool senior analyst Bill Mann discusses:

• Why the CEOs of Walmart (WMT 0.13%) and Target (TGT -0.61%) should have warned investors sooner about their latest quarterly numbers.

• The inventory glut these major retailers will have to work through.

• Lowe's (LOW 0.47%) benefiting from the residential home environment.

Motley Fool senior analyst Tim Beyers talks with Arista Networks (ANET -0.39%) CEO Jayshree Ullal about how her company is diversifying its revenue stream and one thing investors often get wrong about Arista.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on May 18, 2022.

Chris Hill: [MUSIC] We've got retail home improvement and a closer look at a growing cloud networking company. Motley Fool Money starts now. [MUSIC] I'm Chris Hill, joined by Motley Fool Senior Analyst Bill Mann. Thanks for being here.

Bill Mann: Hey Chris, what do you want to talk about today?

Chris Hill: Same thing as yesterday. Let's talk some retail. You and I are going to figure out what is happening with America's biggest retailers because I feel like we are one level down from just saying supply chain issues.

Bill Mann: Yeah. Look, it's not funny. We have Walmart lost a huge amount of market cap a couple of days ago. Its Target's turn today their stock is down as much as it has been on any single trading session since the great crash of 1987 back when it was Dayton Hudson and not Target. Lowe's is down pretty sharply today as well. I think the thing that's been interesting to me, this earnings season is, you had Visa for example, it came out and said, hey, spending is strong, the consumer is doing great, and Amazon came out and said the consumer is doing great, and then suddenly you've got one after another after another, like no, it is bad out there, and we have inventory issues that are harming our results, and we don't really know what's coming up next.

Chris Hill: Yesterday, part of the story with Walmart was people spending a greater percentage of their ticket on groceries, and the impulse items were not moving off the shelves. Today, Brian Cornell, the CEO, Target, basically came out and said we got the inventory wrong, and I give him points for honesty. It's a little surprising because Cornell and his team have been so good for so long on their merchandise mix, particularly apparel, but there is a degree to which they blew this. We're seeing this in a stock price movement, which is in the same way that Walmart, which rarely makes big moves.

Bill Mann: Yeah.

Chris Hill: It's surprising to see it down 11 percent on Tuesday. Target makes bigger moves, falling 24 percent, holy cow.

Bill Mann: Yeah, that's the technical term actually to, it's holy cow.

Chris Hill: Yes.

Bill Mann: I don't know what more you can say. Now, I will say this. We do need to give companies a little bit of leeway because we are dealing with an incredible supply chain issue. Target, like most retailers, values its inventory on something called last-in, first-out. The most expensive inventory is that which goes into their cost of goods sold. It may not be as financially bad as it seems. We also have to remember that coming out of COVID, and I hope we're coming out of COVID, but I think that we can, let's just, without making predictions, say that the consumer behave differently in the first quarter of 2022 than the average consumer behaved in the first quarter of 2021 was really hard to predict. I think that we will see Target level set. I am a little disappointed. If you're going to play the quarterly guidance game, Target has known for a while that they had a problem and I'm really surprised that they did not get out ahead of this and wait all the way until earnings to surprise people.

Chris Hill: I am as well. You and I are not alone in thinking that about Target and for that matter, about Walmart and McMillan and his team. That's part of what is surprising here. Is it safe to assume this is going to, and by this I'm referring to the inventory glut that now exists at both of these retailers, it's going to take 3-6 months to work this through, assuming they manage it correctly?

Bill Mann: Maybe. But think about it this way. If you are still in a supply chain, if you don't have security in your supply chain, if some supplier offers you a six-month supply of some good that you know that you can sell, you're going to take it. You should get it in even if there is a cost to the short-term in the meantime, because that component, you talked about the war in Ukraine, we could talk about some of the food insecurity issues that are coming down the pike and both Target and Walmart have sufficient food components to their business. All of this are things that the companies themselves have to figure out how to operate it. I think it's probably a bigger disaster for Target and Walmart to have empty shelves than to have a stock room full of things that they can't sell right away. I don't expect this to get better anytime soon. The Target said that they believe that their costs are going to be about a billion dollars higher this year in the form of both labor and what they pay for products. It's not great. I just don't understand, if you're going to play the quarterly guidance game, why we got to this point before they bothered to mention it.

Chris Hill: Hopefully both of these large important retailers are going to ramp up their communications because three months from now, not only do we get the next earnings report from both Walmart and Target, we're also going to get color on what is the second most important season of the year for retailers, which is back-to-school shopping, and the earliest a bit of guidance on holiday, which is the most important part. Hopefully both of them take that there. I'm assuming both CEOs are listening to this podcast.

Bill Mann: Big fans of the show. Brian Cornell, big fan of the show.

Chris Hill: Lowe's first quarter not as good as what we saw on Tuesday from Home Depot, which is a little surprising only because for a while now these two have moved together in terms of the general direction of their results. Lowe's first quarter profits a little bit higher than Wall Street was expecting. Revenue was the tiniest bit lower. Look, there's been a cold spring, and if you want to look at revenue missing by 0.4 percent, which is what the expectation was, look Lowe's is in blaming the weather, but it's not unreasonable to think yeah, that's probably worth half a point.

Bill Mann: Yeah. Entirely different issue and it bears remembering that both Lowe's and Home Depot fabulously run companies. What I'm about to say should not be seen as a pejorative of it all, but they have benefited mightily from people staying at home, people renovating their houses, people doing things like building in home offices, and at some point that is going to ramp down some. They have also benefited really from various parts of the new housing market plenty. That's something that is under threat. It hasn't really happened yet in most markets, although realtors are seeing a lot less foot traffic, rising interest rate environment. One of the first things that is sensitive to that is home purchases. I think maybe what you're seeing from Lowe's and the stock is the sock is off about four percent as we record this, which means it'll end anywhere from up to down 30 by the time it comes out. Who knows? It's 2022. But at this point in time, it's a baddish day. Maybe down four percent is the 2022 version of up.

Chris Hill: Well, here's a positive if you are Lowe shareholder, which I am. They didn't lower their guidance. Part of what was surprising about Home Depot on Tuesday was they actually raised guidance for the full fiscal year. Lowe's didn't raise it, but they maintained it. To your point, Marvin Ellison, CEO at Lowe's, made some comments basically echoing what you are saying. I'm paraphrasing here, but he basically said, look, it's not that the macroeconomic stuff in terms of inflation, in terms of Russia and Ukraine, it's not that these things don't matter. It's just that there's not at the moment a material impact on the home improvement industry. He talked a little bit about the things that are working in their favor in terms of residential housing. One more reason to like Marvin Ellison, he's just like, yes, now we're absolutely benefiting from the current environment.

Bill Mann: Yes. That's why I mentioned earlier what I was saying was not meant as a knock under any circumstances. Now, the thing that you pointed to early and I do want to point this out. Why did Home Depot do OK, but Lowe's not do as well? That really comes down to they feel like they are the same exact type of experience. Home Depot does have much more of its revenue coming from the professional service part of the market, and Home Depot is much more heavily levered to the do-it-yourselfers, the weekend warrior types. The you and me types. [laughs]

Chris Hill: They decidedly unprofessional type.

Bill Mann: That's right. I'm here to say that I do have some projects, so Lowe's is going to benefit from me. But in general, do-it-yourselfers have pulled back a little bit. They are not looking for projects to do in the same way that the professional services, they are still working through much more of a backlog.

Chris Hill: Let's end on the dramatic stock movement of Target. When you look at everything, we've talked about the comments from Cornell, etc., and you look at the stock down 24 percent in a single day, do you view that as a buying opportunity for people who have thought to themselves for a while yeah that's on-balance, that's a solid business, I'm just looking for an opportunity because that's what it seems like?

Bill Mann: Yeah. I actually would. It is noteworthy that their gross margin for the quarter debt and debt to latter went from 30 percent to 25 percent. I think what you're looking at now is I don't want to use the word transitory, but there is always a transition when you go from a steady-state, which we have done at super low interest rates. Money coming out in the form of direct payments from government to the people in this country, to a time in which suddenly our dollars have to be stretched further, but consumers have always and will once again adjust to the new normal. This is a super well-run company, one of the best performing stocks in the world over the last 30 years and a 25 percent down day, again who knows, by the time the day ends I would view as being a pretty substantial overreaction.

Chris Hill: Bill Mann, always great talking to you. Thanks for being here.

Bill Mann: Thanks Chris. [MUSIC]

Chris Hill: Now for retail and home improvement, it's time for a closer look at Arista Networks, a $33 billion Cloud networking company. Arista helps connect computers, servers, and devices for companies like Microsoft and Meta Platforms. Its infrastructure that you rely on, but you probably aren't thinking about. Tim Beyers caught up with CEO Jayshree Ullal to talk about how Arista is diversifying its revenue stream and one thing investors often get wrong about this company.

Tim Beyers: For those who don't really know the networking business that well, can you do this simply, what is this? Why are we upgrading and what's driving this?

Jayshree Ullal: Well, you might have heard the old saying from Sun Microsystems, the network is the computer. I think the vision of that is in full reality in Arista's implementation. When you look at what's driving it, there are so many users, so many subscribers, and every one of us is running with lots and lots of devices. One user doesn't equal one device anymore. There's a proliferation of devices, proliferation of workloads, which can be virtual machines, containers, or physical machines. You and I just talked about the proliferation of applications. When you look at this, you go, oh my god, you could have every user generating 10-megabit or even one gigabit of bandwidth by virtue of all of the applications and uses they're doing. Aggregate that and you now need terabits of capacity and that's why the Cloud Titans build regions that are megawatt and gigawatts, because they're aggregating it across multiple tenants and multiple users. In the past when networking was a nice-to-have or an occasional connection, it was never overloaded.

Today, the network can be the bottleneck because all of those compute and storage cycles are putting pressure on it. That's why you're seeing that 10 gigabit, when Arista first started, really took 10 years to materialize. Hundred gigabit has taken half the time to materialize and Arista has emerged as the number one market leader in 100-gigabit. I think 200 and 400 gigabit will continue to interleave with 100 gigabit. It's not going to be either or. You might need some tributaries for lower speeds. I hate to call 100-gig lower speeds, but it can be for some people depending on the users you have, and some others may need much higher capacity in the spine or aggregation of gaming, or video, or streaming applications. My belief is the next decade is rich for the combination of 100, 200 and 400 gigabit. By the way, don't forget, 800 gigabit and terrabit ethernet will be in the horizon in that timeframe. It's not quite either or, but really a lot of interleaving of these architectures.

Tim Beyers: Is it fair to think about it as a little bit like the interstate highway system, not the Internet, or maybe the Internet highway system, if you had data packets as cars and there's so many that we're building this out and creating a more expansive system where we can move things where we couldn't before we had or just a lot of congested areas and now we're opening up new ways to get data where it needs to be?

Jayshree Ullal: I think that's a great analogy and you have to open up the ramps too. You can't just have fast-free ways, you need a lot of fast ramps as well to the freeway.

Tim Beyers: Yeah, hence more opportunity for Arista. Let's talk a little bit about the Cloud Titans. You've done a really good job diversifying revenue outside of the Cloud Titans. If I read the filings right, Microsoft, was at over 20 percent? It's now down to 15 percent of revenue last I looked. Meta is now under 10 percent. Clearly the Cloud Titans are important but not the massive driver of revenue that they once were. Talk to us a little bit about what you're doing to diversify revenue and what do you expect looking forward?

Jayshree Ullal: I'm very proud of the Cloud Titans and I hope they continue to be a large part of our lives. You might have seen in the announcement that Microsoft gave us a ringing endorsement and continues to view us over the last decade and hopefully the next decade as a strategic partner, not only for the Cloud, but also increasingly for the intelligent edge. Our development with Meta that we do a lot of joint products together with them as well. Both of them are alive and well and I think it will be a very strategic part of our growth this year and for years beyond. But having said that, we want to take the lessons learned from that and those Cloud principles and apply them to other customer sectors. They may not be as large with other customers but still the principles apply.

The principles of scale, performance, quality, automation, throughput, latency, AI principles, security principles. This is what has led to the diversification where the Cloud Titans can still be 30, maybe even 40 percent of our business or more in a given year, but the enterprise and financials are doing extremely well and they can be literally neck-to-neck with these Cloud Titans. Then we have a third sector, what we call the provider sector. With the service providers in the specialty Clouds, these are folks that may not be as large as the Cloud Titans, but are still building their own database Cloud or Clouds that are special to their applications, hosting Cloud, content Cloud, you name it. What's nice is I think we've developed a nice end-by-end matrix where we have diversification of our customers and we have diversification of our product line as well. Our core datacenter products are still very much north of 60 percent of our business, but we're expanding into adjacencies such as routing and campus as well as we discussed earlier, software and services and renewals. Increasingly over time, our core business will be 60 percent, but another 40 percent comes from adjacencies and new markets as well.

Tim Beyers: That's really good to hear. Last question. I would call this a Foolish question because at the Motley Fool, we are really interested in the way that teams work and you've been at this since 2008 and you have a really long history in this industry. You're not a founder of Arista, but I almost think of you as founder adjacent because you've been with this company for so long. I wonder, how do you work with, you mentioned Andy Bechtolsheim. There's a whole bunch of founders that are still involved in technical development at Arista. Can you talk us a little bit through how products get stood up and how you work together as a team on new ideas?

Jayshree Ullal: I'm so glad you asked the question. I think the CEO gets too much credit or debit, and really I want to give a huge shout-out to the team whose along with me led this and seen us through many highs and lows. We are a family. We are the Arista family and nothing could make me more proud. When I came here we were 30 employees, primarily engineers. There is Ken Duda one of the key founders who led our software mission and I shared an office. I remember those days fondly, maybe he doesn't because I spoke on the phone too loudly and interrupted all his coding time. But however, I remember it fondly because I really embraced his culture. Culture for teamwork, culture for getting software right and building the right foundation and culture for quality. He in turn really embraced my customer-driven principles and the desire to not just innovate for the sake of innovation, but to bring that innovation to the context of a customer and drive it from a business point of view.

I think this is really important that you called me founder adjacent. It's a great way to say it. That really, while Arista has key founders like Andy and Ken, we also had a founding team of leaders who've brought us into this journey. Hugh Holbrook and Adam Sweeney in engineering, Anshul Sadana our COO. Chris Schmidt, Ashwin Kohli, Douglas Gourlay on the sales side. Ita Brennan and Marc Taxay on the finance and legal side. John McCool who drives our manufacturing. Many of us have worked together for not just years, but decades. The ability to argue, debate, and yet align is so important between founders and founding team. Very proud of the leadership team, very proud of upholding the Arista way. From time-to-time, we've had to change and adapt to the situation the way it is rather than the way we'd like it to be, but we don't have the separation between founders and non-founders, we're one team.

Tim Beyers: I love that. Let me ask one question and let you go. What is something that the market, the general public, people who have heard the name Arista Networks get wrong about your company? Something that's just a misconception.

Jayshree Ullal: Well, I think they associate us too much with the Cloud and Cloud Titans. I know there are some companies would be dying to get in the Cloud and we're very proud of that heritage, but they define us on only one angle or one spectrum when we're really so multi-dimensional. If there's one thing I'd like to see them get right, it's to really understand the diversification. We're proud of our Cloud heritage and we're proud of diversifying from it too.

Tim Beyers: Great. Well, thank you very much. I hope we'll do this again.

Jayshree Ullal: I look forward to it, thanks again.

Chris Hill: That's all for today, but coming up later in the week, we'll have a conversation with the one and only Michael Lewis. As always, people on the program may have interest in the stocks they talk about and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill, thanks for listening. We'll see you tomorrow.