Most department store stocks have tumbled since the companies reported their third-quarter results a few weeks ago. Macy's (M 1.31%), Kohl's (KSS 1.90%), and Nordstrom (JWN +0.00%) all posted solid comparable-store sales growth -- and the first two also achieved strong profit growth -- but that wasn't good enough for investors.
To some extent, the pullback was a natural reaction to sharp rallies for all three department store stocks earlier this year. However, some investors also appear to be worried that Macy's, Kohl's, and Nordstrom entered the holiday quarter with too much inventory.
This concern has been echoed by Nomura Instinet analyst Simeon Siegel, who recently warned that year-over-year inventory increases at department stores will undermine their pricing power. However, this argument overlooks an important shift in the retail calendar this year. Adjusting for this shift, the top department store chains are all maintaining their inventory discipline.
The argument
According to Siegel, "department stores as a group reported their first quarter of inventory growth after 10 quarters of declines" in the third quarter. The analyst acknowledged that retailers had accelerated some inventory purchases due to fears about extra tariffs on Chinese goods, but he maintained that "poor planning" was also to blame.
Indeed, Macy's ended the third quarter with inventory up 1.2% year over year. Inventory rose at an even faster clip at Kohl's (up 4.6%) and Nordstrom (up 7.4%).
Kohl's ended last quarter with inventory up for the first time in nearly three years. Image source: Kohl's.
The stakes are high. Not only does having excess inventory weigh on cash flow, it also tends to put pressure on gross margin, as more goods may need to be sold on clearance -- particularly if there is any unexpected dip in demand.
It's all about the calendar shift
What Siegel and other bears are missing is the impact of a shift in the retail calendar this year. In 2017, the third fiscal quarter for retailers like Macy's, Kohl's, and Nordstrom ended on the last weekend of October. In 2018, it ended a week later, on the first weekend of November.
That's a significant change, because it means that the third quarter ended a week closer to Black Friday this year. Most retailers dramatically increase their inventory ahead of the holiday shopping season that begins around Thanksgiving/Black Friday. More of that inventory buildup had occurred before the end of the third quarter in 2018 compared to 2017.
According to Kohl's management, its 4.6% inventory increase actually translates to a 2% decline in inventory per store after adjusting for the calendar shift. On a similar note, Nordstrom said that its inventory grew in line with sales on an adjusted basis. Macy's inventory would have been down significantly excluding the calendar shift.
The fact that Macy's, Kohl's, and Nordstrom all ended the second quarter with inventory down year over year should add to investors' confidence that the supposed inventory glut at the end of the third quarter was just an artifact of the calendar.
Let history be a guide
The calendar shift that impacted retailers' inventory levels as of the end of the third quarter is not unique to 2018: It happens every five or six years. A look back at 2013 -- the last time there was a comparable calendar shift -- provides yet another reason for investors to rest easy.
At the end of the third quarter of fiscal 2013, inventory was up 7% at Macy's, up 2.2% at Kohl's, and up 8.8% at Nordstrom on a year-over-year basis. Nevertheless, in the fourth quarter of that year, Macy's gross margin was flat year over year and Kohl's posted a 0.7-percentage-point gross margin improvement. Nordstrom did experience 55 basis points of gross margin erosion, but it was driven primarily by higher occupancy costs related to rapidly expanding the Nordstrom Rack off-price chain.
Thus, the level of inventory growth at the three largest U.S. department store companies last quarter was perfectly consistent with achieving strong gross margin results this quarter. Of course, Macy's, Kohl's, and Nordstrom still need to execute well in the fourth quarter to meet or exceed their forecasts. But so far, there's no particular reason to worry that they are off track.
