Retailer Target (TGT 0.70%) is bracing for a rough fiscal 2022 fourth quarter, which kicked off on Oct. 30. The company expects year-over-year sales growth to slow to a low single-digit pace, while its operating profit margin compresses to around 3%. Like its fiscal third-quarter earnings, the outlook fell short of expectations.
What you may not fully appreciate, though -- because little mention of it was made this time around -- is why the current quarter's results could be even uglier than suggested. The company's excess inventory problem not only persists but seems to be worsening.
Target's inventory levels are still sky-high
As a quick refresher, Target's subpar second-quarter margins reflected "actions to reduce excess inventory," echoing an explanation given for the first quarter's lackluster results back in May. Simply put, Target stocked up on too much merchandise coming out of the heart of the pandemic, anticipating stronger demand than what has actually materialized. All the markdowns and sales in the meantime haven't helped. Indeed, Target's inventory woes appear to be worse now than they were three months ago with its third-quarter earnings per share being halved on a year-over-year basis.
The graphic below puts the matter in perspective. The retailer ended last quarter with $17.1 billion of inventory, equivalent to 65% of its sales in the fiscal third quarter. That's the highest inventory-to-sales ratio since the third quarter of fiscal 2019 (late calendar 2018) when Target began using new technology to dial back its then-burgeoning inventory levels.
Data source: Thomson Reuters. Chart by author.
At the very least, relative inventory levels should be flattening out; they certainly shouldn't be on the rise.
Last quarter's inventory surge isn't an outright disaster. Most retailers appropriately bolster their in-store stock this time of year to meet the demands of holiday shopping. As the graphic above shows, Target typically ends the final quarter of its fiscal year with far fewer goods than at the beginning of the period. With the National Retail Federation calling for a 6% to 8% increase in 2022's holiday shopping, look for the same basic outcome this time around.
Nevertheless, given this retailer's current inventory bloat, it's still likely to end the current quarter with more goods than it would normally like to be sitting on, heading into a slow time of year.
Walking a fine line
The trouble linked to excess inventory isn't always apparent. From a consumer's point of view, what a retailer doesn't sell in December, it can simply sell in January or February. And that's certainly true for some sorts of goods like video games, towels, and baby diapers.
A great deal of Target's merchandise is seasonal, however, meaning demand will plummet once those products are out of season. For instance, it's difficult to sell a winter coat headed into the month of March, while interest in Christmas ornaments will start fading by mid-December and outright plummet by the end of the month. Toys aren't exactly a hot seller in January either since most kids receive plenty of them as gifts the previous month. As result, this type of merchandise must be discounted -- sometimes heavily -- to free up space for more marketable goods.
That's easier said than done.
Big-box retailers are typically a thin-margin business. Target is only looking for net-margin rates in the low single digits in the current quarter, but even when the company was firing on all cylinders back in 2018 and 2019, profit margins were typically right around 4%.
Data source: Thomson Reuters. Chart by author.
The point is there's not a lot of wiggle room when it comes to markdowns and discounts. Every penny counts as we can readily see from the recent decline in Target's gross profits and subsequent decline in net profits. These metrics improved sequentially last quarter but are still below standard.
Then, there's the nuance that doesn't show up on any chart. Wrong inventory or misaligned inventory levels can create lingering problems for far longer than just one quarter. Retailers' merchandise buyers often have to make purchases two, three, and even four quarters in advance. They can only buy more goods, however, if they know there's full funding available to pay for those goods. In light of its profit problems, fueled by its inventory headache, Target may be unable to make enough of the right purchases, not just for the coming quarter but the coming year.
Pass on this stock for now
The dots aren't too tough to connect. While a weakening economy is a challenge to be sure, Target's current and future results are also being considerably hampered by its current and past inventory problems.
Some of this headwind is already priced into the stock, particularly after the post-earnings plunge of 13% on Nov. 16. Even with the stock's sizable sell-off since late last year, though, it's not a name for most investors to take a swing at here. This problem won't be fixed in just a few weeks. It could take several quarters of well-navigated buying and desperate selling to restore Target's optimal merchandise mix.
