Target (TGT -0.36%) updated investors on Tuesday, June 7, informing them that earnings for its second quarter (which ends July 31) will be worse than initially expected. The company downgraded Q2 operating margin estimates as it slashes product prices.
Consumer shopping behavior is quickly shifting away from items that were popular during the pandemic's earlier stages like home furnishings, discretionary products, and certain types of apparel. As a result, Target is stuck with inventory that has been on shelves for far too long. Folks are experiencing rapidly rising prices in categories like groceries and gasoline, forcing them to make cuts elsewhere in their budgets. Let's look at the details of the update more closely.
TGT Inventories (Quarterly) data by YCharts
Target has too much and the wrong kind of inventory
Target plans several actions in the second quarter, including discounting products, removing excess inventory, and canceling orders for new products. The aim is to remove things that consumers do not desire as much. Customers have quickly shifted spending toward essentials like food and beverages and reduced spending on categories like home goods. In its first quarter, which ended on April 30, Target held inventories worth $15.1 billion. That was up substantially from the $10.5 billion in inventory it had at the same time last year.
The combination of too much inventory and mismatched categories for what consumers demand created the urgent need for Target to take action. These moves are necessary to right the ship but will lead to lower profit margins in Q2. More specifically, Target updated its Q2 operating margin forecast down to 2%. This was from a previously expected margin of around 5.3%.
TGT Operating Margin (Quarterly) data by YCharts
Interestingly, for several quarters following the pandemic's onset, businesses complained about supply shortages and being sold out of in-demand items. That can explain why Target spent so aggressively on boosting inventory. However, the pandemic has snarled supply chains worldwide, making the usual inventory-purchasing process more complex. The products on Target's shelves now were likely ordered several months if not quarters earlier.
Economies have evolved rapidly in the previous few months alone. Fuel prices are changing people's habits. Widespread vaccination against COVID-19 has made folks more comfortable spending money on away-from-home experiences like dining at restaurants, going to a ball game, or watching a film at a theater. Those trends are leaving fewer dollars available in consumer budgets for the discretionary items they were formally buying abundantly when staying at home more often.
Target moves first to cut prices
Of course, the market did not like Target's news, and the stock has been down 2% since the announcement. In 2021, sales surged and Target reported record profits; now comes the hangover from that growth. Consumer spending is changing, inflation is biting into profits, and supply chain disruptions are making it difficult to match supply with demand.
That said, Target has managed the pandemic effectively for the most part. In hindsight, these recent moves may appear prescient if more retailers are forced to slash costs in unison later in the year. By cutting costs earlier, Target could be avoiding an industrywide sales price surge that will make it harder to get rid of inventory. This plan could take several quarters to play out, and investors should not expect Target to bounce back anytime soon.
