What the wise do in the beginning, fools do in the end. That quote sums up Target's (TGT -0.71%) new strategy to fix its bloated inventory.
While supply chain constraints have caused shortages of some types of products, Target and other retailers are facing the opposite problem. The value of Target's inventory soared 43% in the first quarter against a 4% rise in sales. Walmart reported a similar disconnect between inventory and sales growth.
Target is seeing strong demand for consumable products like food, beverages, beauty products, and household essentials. Consumers don't appear to be making abrupt changes to their spending patterns in these categories in the face of sky-high inflation.
Instead of fiddling with grocery budgets and toilet-paper brand choices, Target's customers are buying fewer non-essential items. The retailer has seen a slowdown in sales of discretionary products, particularly home furnishings and décor. It now has too much inventory in those categories clogging up its stores and distribution network.
The early bird gets the worm
Instead of sitting on that inventory and hoping demand picks back up, Target is slashing prices and canceling orders. The company disclosed its aggressive strategy on Tuesday, along with updated guidance.
Target will markdown prices on merchandise that isn't selling to clear out excess inventory. This will hurt profitability in the second quarter significantly, but if Target is right about demand for the rest of the year, profits should bounce back strongly in the second half.
Target now expects a measly 2% operating margin in the second quarter, with markdowns and higher costs weighing on the bottom line. Given that consumer behavior is changing quickly and in unexpected ways, Target wants to be as nimble as possible so it can adapt quickly. In addition to pricing changes, Target is adding capacity near U.S. ports to help smooth out supply issues for other products.
Target is the first major retailer to announce widespread markdowns to clear inventory. If the company is wrong, it will have too little inventory later in the year and be unable to meet demand. That will hurt sales and profits in the second half.
But if Target is right, it will be sitting pretty as other retailers scramble to fix their own inventory issues in the coming months. By taking this aggressive step now, Target will likely be able to markdown prices less than if it had waited until other major retailers came to the same conclusion. While Target's profits will take a hit, that hit could be much bigger if the company were to wait.
If all goes according to plan, Target expects its operating margin to rebound to 6% or so in the second half. That's below pandemic levels, but it's not too shabby, given the rising costs for freight and transportation.
The right move
Target's new strategy and guidance cut came just a few weeks after its first-quarter report, so investors are right to be surprised. But this abruptness, I think, is a good thing. It shows that Target is willing to make quick decisions and take immediate action to better position itself for a highly uncertain environment.
Target likely won't be the only retailer to resort to price cuts to move unwanted merchandise. But by being the first, it can avoid a tidal wave of competition as it makes itself leaner and nimbler for the rough road ahead.
