Target (TGT -1.34%) and Walmart (WMT 0.17%) stocks have been the talk of the town as of late after both suffered their worst single-day declines in over 35 years. Each discount retailer is typically a stable company known for returning value to shareholders through dividend raises and share buybacks. Target is the faster grower, while Walmart is usually a better value.
However, Target stock now finds itself down 42% from its all-time high while Walmart is down 25%. Here's why both companies find themselves in a difficult but unavoidable position -- and why, ultimately, both could be good buys now.
Image source: Getty Images.
Some context
To understand why two stable stocks could fall so far so fast, you first need some context. Let's go back to 2020 when consumer demand was dramatically altered by the COVID-19 pandemic.
In a world of disrupted supply chains and rapidly rising unemployment, retailers were initially caught off guard. Then the stimulus came, and consumer demand picked up. But lead times were long, and supply chains remained disrupted. To avoid shelves being barren, companies like Target and Walmart had to order ahead. After all, higher-than-expected inventories are better than not having the products customers want to buy.
The backdrop is that inventories were already relatively high entering the period of rising inflation. Today, the rising cost of goods, freight, and fuel is squeezing margins. Pair these added costs with high inventories and weakening consumer demand for discretionary products, and you put the vast majority of retailers in a precarious position as they struggle to push products out. If the economic situation worsens, then consumers will likely continue to shift their product mix to lower-priced items, which hits Target more than Walmart, considering it has higher-priced items and a more discretionary product mix.
All told, Target ended its first quarter of 2022 with $15.1 billion in inventory and Walmart ended its most recent quarter, which is its Q1 for fiscal 2023, with $61.2 billion in inventory. Both of those readings are the companies' highest-ever quarterly inventory levels.
Record-high inventories would be OK leading up to a period of booming consumer demand and a rapidly growing economy. But record inventories heading into a weakening economy are a recipe for trouble.
Tough luck
It's hard to blame Target or Walmart for what happened. Both companies did a great job navigating the turbulence of demand and supply imbalances during the worst of the pandemic. Few forecast inflation would get so out of hand so quickly, which left Target and Walmart exposed to higher costs and left little room to raise prices given the discount nature of their product offerings.
To illustrate just how dramatic the margin pressure is on Target, consider the following excerpt from its Form 8-K filed on May 17:
First quarter operating income margin rate was 5.3% in 2022, compared with 9.8% in 2021. First quarter gross margin rate was 25.7%, compared with 30% in 2021. This year's gross margin rate reflected higher markdown rates, driven largely by inventory impairments and actions taken to address lower-than-expected sales in discretionary categories, as well as costs related to freight, supply chain disruptions, and increased compensation and headcount in our distribution centers.
Target is now forecasting a full-year operating margin of 6%, but still expects it can hit in excess of 8% over the long term. The results were similar for Walmart, which was unable to pass along costs to the consumer and has little room to do so going forward given its value proposition to provide the lowest prices on essential goods.
Where to go from here
The fall from grace for Target and Walmart stocks goes to show how unique this bear market is. Whether it's labor, shipping, fuel, or raw material costs, virtually every company is feeling the pain of inflation.
Although the Federal Reserve's policy to raise interest rates to weaken consumer demand and bring down inflation casts a wet blanket on the stock market, it should produce a positive net result over time. Target and Walmart would probably prefer the Fed rip off the proverbial bandage and put an end to inflation as fast as possible, so the economy can get back to positive real gross domestic product growth.
The good news is that both companies have the balance sheets to get through a recession. There will likely be more pain ahead, but given their industry-leading positions, reputations for raising dividends, and inexpensive valuations, both companies look like good long-term buys now. Plus, buying equal parts of each stock will give an investor a dividend yield of more than 2% while providing exposure to two of America's leading discount retailers.
