May 2022 was a rough month to invest in retail stocks. In back-to-back reports in the middle of May, first Walmart (WMT -0.65%) and then its smaller rival Target (TGT -4.06%) both reported abysmal earnings for their respective first quarters of 2022, causing each stock to suffer its worst one-day decline since Black Monday in 1987.
Image source: Getty Images.
What went wrong
In the case of both companies, inventories were a big part of the story. At Walmart, they rose 32% year over year, far outrunning sales growth of just 2%. At Target, the disparity was even greater, with sales rising 4% year over year, but inventories growing 44%, according to data from S&P Global Market Intelligence.
Target was spending heavily ($1.2 billion) in the first quarter to build up its inventories of some goods, ensuring its shelves were well-stocked as a guard against supply chain snarls. Curiously, in the same quarter, the retailer was also taking charges to "reduce excess inventory," as management explained.
This suggests that even as early as the first quarter, Target was already becoming aware of serious imbalances in its inventory management, and taking steps to reverse excess ordering that must have begun last year.
Target didn't act quite soon enough, however.
Hope for the best, but plan for the worst
Three weeks ago, right after unveiling its disappointing earnings, Target warned investors that they should expect to see second-quarter operating profit margins in the neighborhood of 5.3%, and full-year margins of perhaps 6%. On Tuesday, June 7, however, just three weeks after announcing the bad earnings news, the retailer updated investors on how it plans to deal with its overflowing inventories -- and how big an impact this will have on profit margins.
"Additional markdowns, removing excess inventory and canceling orders" will all be necessary in order for Target to right-size its inventory, management warned, particularly in discretionary categories such as home furnishings. And these actions will cut deeply into profit margins in the year's second quarter.
How deeply? Target still hopes it can average 6% profit margins in the second half of the year at least (if not for the year as a whole). But management fears that second-quarter profit margins will range around 2%, down from a hoped-for 5.3% just three weeks ago.
That's a huge cut in expectations, and it cost the stock about 2% of its market cap on Tuesday, when the new guidance was announced. Target won't be alone in feeling the pain, however. Over the weekend, Bloomberg reported that Walmart, too, is moving to right-size its inventories -- and that it will take another couple of quarters to accomplish this.
What it means for investors
On the one hand, Walmart's inventory crunch sounds like it might be good news for Target. Its biggest rival in brick-and-mortar retail is suffering from the same troubles. Moreover, Target seems to have gained a march on Walmart, inasmuch as Target already began trying to work down inventories back in the first quarter, and is expecting to have done enough work on this to allow profit margins to start recovering as early as the third quarter.
Walmart, on the other hand, doesn't appear to have even begun its cuts, and will need the aforementioned couple of quarters to get its inventory problems under control. That suggests that of the two, Target will be the first company -- and perhaps the first stock, too -- to recover.
Elsewhere in the retail world, the problems could be even stiffer. Consider that Target and Walmart, with combined annual sales of $683 billion, will be slashing prices and dumping stale inventory on the market simultaneously. Walmart could drag out the process for as long as the next six months.
What do you think that will do to sales and profit margins at the smaller retail chains that must compete with these giants -- retailers like Best Buy (annual sales: $51 billion), Macy's (annual sales: $26 billion), and Kohl's (less than $20 billion)?
I'll tell you: It won't be good. For as long as Walmart and Target are dumping inventory, you can expect rival retailers to suffer weak sales and weaker profit margins in categories where they compete with the giants.
It looks like it will be a long, uncomfortable summer (possibly followed by a rather bleak autumn) for American retailers.
