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Don't Ignore This Glaring Problem for Retailers

By James Brumley – Jun 30, 2020 at 7:45AM

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The advent of COVID-19 in the United States caught store chains' buyers by surprise and left them stuck with too many goods that are now tough to sell.

It was no surprise most retailers' first-quarter results were poor. Although some consumer staples names like Walmart and Kroger benefited from the coronavirus-related lockdowns and the subsequent pantry-stocking they prompted, most non-essential stores were closed by sometime in March. There just wasn't as much business to be done.

Retailers' second-quarter reports probably won't be any better. Indeed, although most brick-and-mortar names are reopened in such a way that allows for proper social distancing, they could be even worse than Q1's year-over-year sales comparisons.

Revenue isn't the only concern investors should have on their retailing radars right now. Sales could actually start to recover somewhat from here, in fact, as stores start to figure out how to connect with consumers. Perhaps far more important to shareholders at the moment is the burgeoning levels of inventory that was already on hand and/or couldn't be cancelled in the meantime. The echoes of this problem could ring for several more quarters.

Clothing stores racks and aisles are overloaded with more inventory than retailers can manage.

Image source: Getty Images

Inventory overload

Kohl's (KSS -2.34%) serves as an example of what happens when the receipt of inventory swells at the worst possible time. For its quarter ending in early May (in the throes of the coronavirus storm), sales fell more than 43%, but inventory levels were only down 3% from their year-earlier value. To its credit, the company got rid of much of what it could while it could but at a price. Gross margins fell from 36.8% to 17.3% year over year for the three-month stretch ending on May 2, meaning the retailer had less liquidity to work with when buying fresh inventory for later in the year (like now).

Macy's (M -0.44%) is another name that couldn't cancel or postpone enough merchandise receipts for its quarter also ending on May 2. In its preliminary look posted in early June, Macy's top line fell from $5.5 billion to just a bit more than $3 billion for its fiscal Q1. But inventory levels of more than $4.9 billion as of the end of that quarter weren't much less than the $5.5 billion worth of merchandise it was sitting on at the same time a year ago. Gross margins tumbled from 38.2% to 17.1%.

Dillard's (DDS -2.36%) and Dick's Sporting Goods (DKS -1.94%) are two other noteworthy names that have run into inventory headaches -- namely, too much of it -- since the COVID-19 pandemic took hold. The markdowns are already happening, but they've not been enough to get rid of all the inventory either company needs to clear out to make room for newer goods.

It's not just Dillard's or Kohl's or Macy's, of course. Bond-rating agency Moody's noted in May: "All department stores are now saddled with spring inventory purchased before the shutdowns that they may not be able to sell online." The U.S. Census Bureau further reports that as of April, retailers' inventory-to-sales ratio jumped to a multi-decade high of 1.68.

It's going to take time for retailers to dig their way through it all.

Limited options

The problem isn't exactly new. The aforementioned Dick's has seen its inventory levels swell relative to sales for the past several years as the sporting goods market became even more competitive. But it's a problem that was exacerbated in Q1 even though only one month of the quarter was stifled by the COVID-19 headwind. The second quarter in its entirety was likely impacted for the same reason in the same way but to a greater degree

For the record, retailers aren't completely helpless in the matter. Some inventory orders can be canceled, while other orders can be returned to the vendor if they don't sell. In many cases, suppliers and brands are working with retailers to find a mutually palatable solution. The Gap (GPS -4.40%) is even taking some of its unsold seasonal merchandise off the floor and putting it into storage until the appropriate time next year. Dick's Sporting Goods is now accelerating the openings of its dedicated clearance stores.

All of these options even just for non-cancellable portions of inventory are far from ideal, however, and all cost money one way or another. Not only does that stale inventory get marked down more and more until it's eventually sold at less-than-prime margins; it ties up cash that could be used to purchase fresher inventory in the meantime.

And in Gap's unique case, consulting firm enVista's retail analyst David Naumann explained to RetailWire:

Mothballing seasonal merchandise for a year can be risky, as styles may change and it ties up working capital. The decision to mothball or not is based on predicting the best case situation based on inventory carrying costs, opportunity costs, and expected selling prices today vs. next season.

In other words, even if consumers become willing to spend more at stores later this year, they might not find the sizes and kinds of selection they'd normally expect to find. In some cases, they'll even see some seasonally minded items like swimwear or Easter dresses that made perfect sense in March but aren't appropriate for back-to-school shoppers starting to think about cooler weather.

Bottom line

It's a situation that will ultimately gum up purchases until all of that stagnant merchandise is out of the way, crimping margins the whole time while simultaneously limiting the purchase of newer inventory. That, in turn, translates into a headache that could linger much longer than consumers' unwillingness or inability to spend their discretionary dollars.

James Brumley has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Moody's. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Kohl's Corporation Stock Quote
Kohl's Corporation
$26.30 (-2.34%) $0.63
The Gap, Inc. Stock Quote
The Gap, Inc.
$8.47 (-4.40%) $0.39
Macy's, Inc. Stock Quote
Macy's, Inc.
$15.72 (-0.44%) $0.07
Dillard's, Inc. Stock Quote
Dillard's, Inc.
$280.00 (-2.36%) $-6.76
Dick's Sporting Goods, Inc. Stock Quote
Dick's Sporting Goods, Inc.
$104.46 (-1.94%) $-2.07

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