US core retail sales rose a solid 0.4% in October1. Sales have risen for the second consecutive month, suggesting that consumers are spending at a modest pace, fueled by steady job gains and mild wage increases2. Home improvement and garden store sales increased 1%, the most since May, likely boosted by storm-related home repairs and preparations3. Sales at clothing stores gained 0.5% after climbing 0.8% in September. Sales at nonstore retailers rose 0.4% in October after rising 1.3% in the prior month. Receipts at electronics and appliance store rose 0.7%4.
Clearly, holiday fervor has arrived, and industry trends are finally looking up for retail. But is the good cheer hiding something that could take a big mouthful out of profitability? At a time when agility is critical to success, retailers can scarcely afford to make mistakes in streamlining operations. However, a few quarters of sustained revenue growth can quickly mask inefficiencies, and one large potential pitfall is inventory discipline. Yes, consumers are hungry for instant gratification, but stockpiling inventory is a short-sighted solution to that problem.
Retailers have benefitted from the improving business conditions, with sales comparables increasing over the last two years. Data from a group of 35 public specialty apparel and department stores shows that these companies have enjoyed an average of 3.9% same store sales comp increase since the beginning of 2017 (see figure 1).
Something tastes bitter
But, it appears there is an unintended consequence of chasing sales growth: lowered operational discipline. Inventory levels have risen by 2.4% in total for H1 2018 vs. 2017 for the retail cohort in question. And as many as a fifth of the group saw inventory levels rise while turnovers fell at the same time (see figure 2). Simply put – retailers have a larger backlog of merchandise that is not selling as quickly.
If industry trends take a dip again and sales slow down, retailers will be sitting on a heap of unproductive inventory, facing increased markdown exposure and profit risk. The most common relief to inventory buildup is offseason promotions and markdowns, which will eventually lead to lower gross margins.
And these actions are not taken in solitude. Any price cuts that a retailer makes to resolve the inventory problem will create a ripple effect that forces others in the market to respond accordingly to stay competitive. This is not good for either the affected retailer or its rivals. When one seller takes markdowns and promotions to run through increased inventory, everyone suffers in today's world of price matching and transparency.
Find the right recipe
Can your P&L afford to absorb additional markdowns from the excess inventory you've purchased? Here's what retailers can do to avoid both having to take additional promotions and having less working capital flexibility, which is another consequence of buying more inventory:
While the past few quarters have come with profitable gains, retailers that don't keep their inventory in check will face a dilemma that could damage profitability in the upcoming season while causing pricing disruptions throughout the market. It doesn't take long for feast to turn into famine.