Take a walk down your local grocery store aisle, and you are looking at the product of a complex operation that keeps those shelves stocked with just enough product . . . at least that is what the company hopes. Add hundreds or even thousands of store locations to the mix, and then you will begin to understand just how challenging it can be for companies to manage their inventory levels. 

This week's episode of Industry Focus: Consumer Goods dives into inventory management. Hosts Sean O'Reilly and Vincent Shen talk about how companies approach this balancing act, the differences across retail sectors, key investor metrics, and one company that has seemingly perfected its operations to deliver incredible margins and profits.

A full transcript follows the video.

This podcast was recorded on May 17, 2016. 

Sean O'Reilly: This episode of Industry Focus is brought to you by Rocket Mortgage by Quicken Loans. Rocket Mortgage brings the mortgage process into the 21st century with a fast, easy, and completely online process. Check out Rocket Mortgage today at quickenloans.com/fool.

Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Tuesday, May 17th, so we're talking about consumer goods. I'm joined by Motley Fool analyst Vincent Shen, who's going to take us to school on that most exciting of topics, retail inventory management. How's it going, Vince?

Vincent Shen: I'm doing well, Sean. I personally think it's quite exciting, actually.

O'Reilly: Oh man, I didn't even need coffee to do this. I'm so excited.

Shen: (laughs) Realistically, and on a more serious note, this is a really important part of the business for a lot of retailers. I'll take you through the gamut of some of the different sectors we think of, how they manage it, and then take you to the gold standard with a company that has truly outdone many of its competitors.

O'Reilly: Would you say that inventory management might be, other than advertising, the most important thing that a retailer can do?

Shen: I think, for some of the companies that we'll talk about, it's a huge differentiator for them, and something that has allowed them to win really strong margins, to gain incredible scale. Think of Wal-Mart (NYSE:WMT), for example, who we'll touch on briefly. But before I get into any of that stuff, Sean, don't you have anything to mention for today's show?

O'Reilly: OK. I'm actually going to be stepping back from the consumer goods and the tech shows to focus more exclusively on the energy show. So Vince, you'll be having lots of cool guest stars and everything. People got a taste of what I'm going to be doing with the energy show last week when I had Daniel Sparks on -- not only a Tesla shareholder, but a Tesla owner -- and we talked about their driverless mode, and the future of Tesla, its valuation, and so on. It's exciting. We're continuing to improve Industry Focus, and one of the ways we're doing that is diversifying our contributors. I think it's a good move.

Shen: Sean, I have to say, after over a year of doing IF with you, I'm going to miss you.

O'Reilly: I bet. This is what I was most sad about, like, "Oh, I won't get to hang out with Vince and Dylan now." I'll just have to go to lunch with you guys more, or something.

Shen: And I know you like talking about your energy and industrial companies, but come on... you know the fun stuff is in tech and consumer goods.

O'Reilly: I know! Like inventory management!

Shen: (laughs) 

O'Reilly: So, for the listener who's rolling their eyes right now, not only because of our bad jokes, but also because of the fact that we're about to talk about Inventory management of retailers, can you draw them in a little bit, explain what it is -- maybe jazz it up a little?

Shen: Sure. Broad context, this is the idea that there's a lot involved when you walk down the aisle at a grocery store, a clothing store, or even a big-box store like a Target or a Wal-Mart. There's a lot involved with keeping this shelves stocked with the product you want. There's SKUs, which are essentially the numbers they assign to identify these products. When you have, let's say, a thousand store locations, and each of the store location -- at a big-box store, for example -- has potentially tens of thousands of SKUs. This becomes a huge, huge operational challenge.

When you're looking at a company, and trying to generally identify how well it's managing its inventory, on the investing side, we generally like to use two metrics. The first one of those is inventory turnover. That basically tells us how many times a company will sell-through the inventory it has in a given period. This number is calculated by cost of goods sold over whatever time period you want to use. Traditionally, it's on a trailing 12-month basis. You divide that by its average inventory balance during the period. So you could take Q4 inventory for 2014, and then the ending balance in 2015, average those two numbers, and you'll get essentially five or 10 or 15 times -- basically, how many times they turned through their inventory in that year period, if you're going by trailing 12 months.

Related to this number, you can also calculate their days of inventory outstanding. This number basically tells you how much inventory they have on hand measured by how many days it would take them to sell-through the balance they currently hold. I really like this number because it puts it into perspective how quickly a company can sell-through its inventory, and how much they have. It's all within the metric, days or weeks.

O'Reilly: That's kind of the name of the game in retail. Assuming that items are being sold for a profit, the more quickly you can sell things, the more you can use that money to buy more inventory, and it keeps on spinning.

Shen: I'm really glad you touched on that, because the ultimate idea is that these companies are pouring resources and money into whatever goods they're producing or selling or acquiring from suppliers. The faster they can convert that inventory into revenue and cash, it's very beneficial to them. Being able to optimize, and make its management of inventory as efficient as possible, is really important to the margins and profitability of any company.

For that days-of-inventory outstanding number, a lower number is generally preferred. The idea is, you can sell through it very quickly. At the same time, if it's too low, you run into the issue of potentially leaving money on the table -- if, for example, you don't forecast demand well.

O'Reilly: You're pricing to sell, yeah.

Shen: And, at the same time, if you don't foresee outsized demand, you can't meet that, and you leave money on the table. Another thing to keep in mind with these two metrics is, on their own, they don't tell you quite as much as when you compare them to their peers or their overall industry or sector. That's where you really see, through that comparison, how well they're doing. 

Moving on to our first example, I wanted to talk about Urban Outfitters (NASDAQ:URBN). Recently, I did a lot of research about Urban Outfitters for the Supernova Explorer One mission.

O'Reilly: One of The Motley Fool's awesome newsletter services.

Shen: Exactly. I wanted to look at it for the apparel sector. And we'll get more broad into the bigger department stores like Nordstrom as well. Urban Outfitters operates three primary chains. They have their namesake, Urban Outfitters, Anthropologie, Free People. They also have some ancillary brands.

O'Reilly: Those two satellite brands, I guess, are the ones that are going gangbusters right now, if I recall right.

Shen: Yeah. For some years, they were the ones that were providing most of the growth. Things overall for the company have slowed down. They're in a recovery turnaround phase. But a big focus for the company -- you'll hear multiple times in their different management calls, earnings calls, presentations that they do -- they talk a lot about their weeks of inventory, and managing that number.

I pulled a lot of my calculations from S&P Capital IQ. Urban Outfitters has an inventory turnover for fiscal year 2016 of 6.5 times. Its days of inventory is at about 56.2. If you compare that to competitors -- think Abercrombie & FitchAmerican Eagle, GapExpress -- Urban Outfitters seems to be running a little bit more efficiently. The average for some of those peers is about 4.9 times, or 80 days. It's taking them longer, and they're going through their inventory fewer times in a year. 

So, as I mentioned with the company Urban Outfitters specifically going through this turnaround phase, by managing their inventory better, basically, for them, it reduces the need for them to employ markdowns to sell their goods. And obviously, that has a very direct impact on their margins and profitability. The company has been trying to handle its inventory better by making some strides in the supply chain. For example, going to a single SKU system across all of its channels. All of its products now -- whether you see them in store or online -- they're all identified by that same SKU number.

This is basically fostering the idea of the omni-channel strategy that you hear so many retailers employing now -- the idea that you want to give a shopper or customer the ability to buy whatever it is that you're selling whenever and however they want. Whether they're in your store, at home on their computer, or in your store on the app, which is something that's becoming very common, where a shopper will go to Urban Outfitters and interact quite a bit due to these beacons that the stores employ. They'll ping your phone if you're a participant, and you have the Urban Outfitters shopping app, and it gives you special offers. A lot of people end up shopping online while they're in store. It's really blending all these different channels.

O'Reilly: I'm really curious, since we're talking about inventory management, what inventory days, and how much stores are going to have in inventory in two decades. How many things is Urban Outfitters and Macy's and J.C. Penney and Wal-Mart -- how many things are they going to have on the shelves? You hear all these retailers talking about their omni-channel strategy, and what it's going to entail is having a huge -- I hate to bring them up again, because we talk about them every time we talk about retail -- but Amazon. You're going to have a huge Amazon-like distribution facility that'll filter out to the stores. They're not going to have every size and every color of shirts. They're just not; it's not worth it.

Shen: Another example more specific to the apparel sector... you look at a company like Zara, which is known as this fast fashion, very successful. Something they stress is that they keep inventory levels pretty slim. When they ship out a new collection, for example, to stores, they do so at a very limited basis. This not only allows them to manage inventory very well, but also add some exclusivity to the new products that come out. So there's a bit more elevated demand from shoppers, when they think, "I might not be able to get this next week if the store is sold out, and that's all they're going to have."

Moving on, still within apparel, but also some of the bigger stores, I wanted to talk about Kohl's, J.C. Penney, TJX Companies, Macy's, Nordstrom. Larger chains actually tended to have lower turnover and more inventory on hand. They average about 3.9 times and 104 days. 

O'Reilly: So these things are sitting on the shelves for three months?

Shen: Yeah. Basically it would take them about 104 days to sell through everything they have. It's very interesting that the bigger stores are actually a little-less efficient, you could call it. But not that surprising.

Moving on to another sector, which is on the opposite end of the spectrum from apparel retailers, naturally, as you would expect, the fastest turnover is probably going to come from companies that sell perishable goods. Let's walk down the grocery aisle, for example. Among major chains like Whole Foods MarketKrogerSuperValu, Sprouts Farmers Market, the average for these peers is about 16 times in 27 days of inventory. The organic-food specialists, Whole Foods and Sprouts, tend to outperform the broad industry. But if you look more broadly at the bigger-box stores, like Wal-Mart -- has obviously pushed significantly into the grocery business. 

You get a lesson, really, in how effectively they manage it. They do everything to run their operations as efficiently as possible. Even when they get to their distribution centers that you mentioned, goods get moved from one truck directly onto another truck to go to the stores. It never gets stored in warehouses, or it does as minimally as possible.

O'Reilly: I remember I saw this report or show about Wal-Mart. They literally use supercomputers to manage their inventory and everything. It was amazing to me. It should be like using supercomputers to solve complex problems, and they're doing inventory stuff.

Shen: It is complex. That's another reason why Wal-Mart has been so successful over the decades. Its numbers are a little stronger than a Target or a Best Buy, for example.

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Vince, you were talking about the company that epitomizes great inventory management at the beginning of the show. I'm going to go out on a limb and say it's Amazon.

Shen: I'd say this is generally a company you would discuss on the tech show with Dylan.

O'Reilly: It's not Amazon? What are you talking about?

Shen: This is one where I think their retail stores have become famous worldwide. They're almost like a tourist destination unto themselves. I think there was a fun fact on the board here at Fool HQ that said that more pictures are taken of the Apple (NASDAQ:AAPL) store in Manhattan, I believe the one in Midtown, than are of the... what was it, the Empire State Building?

O'Reilly: It was the Statue of Liberty. I maintain that that's because the Statue of Liberty is harder to get to. But OK... it's Apple.

Shen: It is. Here's the company that has the highest sales per square foot in retail. I think it's almost $5,000.

O'Reilly: It's second only to ... do you know?

Shen: No, it's first. Who do you...

O'Reilly: Per square foot, it's second only to Tiffany.

Shen: Tiffany's is actually number two.

O'Reilly: You're kidding me! Apple beat them out?!

Shen: Yes. 

O'Reilly: Wow. Sorry, Tiffany's.

Shen: In case you're not aware, for some background, before Tim Cook took over as CEO, he had a long tenure in operations for the company. He is known for making major improvements when he joined in 1998 that really changed the ability for Apple to not only manage the huge demand it would have for some of its iPhones and other products, but to do so very profitably. For example, he scrapped all of their in-house warehouses, all of their in-house manufacturing facilities and went to the contract manufacturers that became so famous, like Foxconn, for example. And something that allows them to do is, if you order a phone, it'll likely be shipped directly to you from the manufacturing facilities abroad. Apple never even has to...

O'Reilly: ... do anything.

Shen: ...take possession of them at any time. That's very efficient for them. A really funny quote is, Tim Cook has several times used dairy products as an analogy for inventory, the idea being, "Kind of like the milk in your fridge; the longer it sits, the more likely it is to go bad." He's even gone so far as to describe inventory as "fundamentally evil." That's probably a bit of a stretch, but he believed that inventory in hand would shed about 1%-2% of its value each week in normal conditions -- maybe even more so during a challenging retail environment. So it's really important to be able to turn these very quickly. 

With all that in mind, the numbers here are really impressive. Instead of having billions of dollars of parts, components, and completed product sitting around, they don't have to deal with that nearly as much with the contract manufacturers. Trailing 12 months inventory turnover, as of the most recently reported 2016 second quarter, was 58.6 times.

O'Reilly: Wow!

Shen: Blowing out even a company that sells perishables, like a supermarket. Average inventory balance during the period was only about $2.3 billion. Days of inventory, they can sell through it in about six days.

O'Reilly: I just realized... when I bought my iPhone last spring, it was probably a week old at that point! (laughs) 

Shen: And I think the scale here is what's really so incredible and hard to imagine. Billions and billions of dollars of product, and they're able to maintain a really well-oiled machine. 

O'Reilly: Revenues were $50 billion... yeah.

Shen: With those numbers, Tim Cook taking over, a lot of people complain or argue that he's not quite the visionary in terms of design that Steve Jobs was. But he was also a huge contributor in his time there, both in operations and as CEO, in developing this model and the systems in place that allow Apple to be so profitable, to cut out the costs wherever he can, and to have these numbers ... six days they can turn through their entire inventory.

O'Reilly: And this is on revenues for the fiscal year ending September 26 of last year, of $233 billion. That is just... I can't even conceive of doing things that quickly.

Shen: Beyond some of the other sectors we talked about, that's one I really wanted to touch on, just because it is this gold standard, I think, within retail.

O'Reilly: That's awesome. Thanks for your thoughts, Vince.

Shen: Thank you, Sean.

O'Reilly: Thanks again for being a great partner for the last year.

Shen: I'm going to miss you.

O'Reilly: You bet. That's it for us, folks. If you're a loyal listener and have questions or comments, we would love to hear from you. Just email us at IndustryFocus@Fool.com. Again, that's IndustryFocus@Fool.com. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against those stocks, so don't buy or sell anything based solely on what you hear on this program. For Vincent Shen, I am Sean O'Reilly. Thanks for listening and Fool on!

John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool’s board of directors. Sean O'Reilly has no position in any stocks mentioned. Vincent Shen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Amazon.com, Apple, Tesla Motors, and Whole Foods Market. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. The Motley Fool recommends Nordstrom, Supervalu, and Urban Outfitters. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.