Black Friday: Retailers finally have the right amount of stock

Black Friday found American shops with tidy shelves, sensible stock levels and hardly any panic clearance sales. Target and Walmart spent eighteen months writing down bloated pandemic inventories and watching margins erode. They have since rebuilt their supply chains, and leaner stockrooms have handed them back some pricing power.

How the glut built up

The trouble began with the supply-chain snarl of 2021. Retailers ordered early and heavily to beat congested ports, and the goods arrived just as Americans switched their spending from televisions and patio furniture back to travel and restaurants. In May 2022 Target's shares lost about a quarter of their value in a single day, their worst drop since the 1987 crash, after it admitted that costs and unsold stock were eating its profits. Within weeks it was cancelling orders and cutting prices to clear its warehouses, and Walmart issued profit warnings of its own.

Economists have a name for what happened, the bullwhip effect. A modest swing in what shoppers want becomes a larger swing in what shops order, and a larger one still in what factories make, because every link in the chain pads its orders when it fears shortages. The same mechanism caught Cisco in 2001, when the network-equipment maker double-ordered components during a shortage and then wrote off $2.25 billion of inventory once telecoms demand collapsed. Retailers in 2021 repeated the error with sofas and garden furniture instead of routers.

The pain was not shared evenly. Walmart gets more than half of its American sales from groceries, which people buy whatever the economy is doing, and its low prices drew in better-off households trading down. Target leans harder on home goods, clothing and electronics, exactly the categories where the glut sat, which is why its margins fell further and why its recovery now looks more dramatic.

Less stock, fatter margins

Target's operating margin recovered to 5.2 per cent in the third quarter, even though sales volumes were sluggish. Retailers ordered cautiously and kept a tight grip on working capital, so they had little left to mark down. Earnings have steadied because companies are running tighter books. Shoppers are spending no more freely than before.

The arithmetic is plain. Every item bought and not sold must be stored, insured, moved and eventually discounted, often below cost, and each of those steps comes straight off the operating line. A retailer that buys close to what it expects to sell avoids most of them and can hold its prices when shoppers hesitate. Cheaper container freight has helped as well. Drewry's composite index of container rates topped $10,000 per forty-foot box in 2021 and has spent most of this year below $2,000, which cuts the cost of landing each item on the shelf.

Lean stock frees cash as well. Inventory is money sitting on shelves, and a retailer that carries less of it needs less short-term borrowing to fund it, which matters now that such borrowing costs several times what it did two years ago. The cash released can go on wages, store upgrades or dividends instead of warehouse rent.

Who carries the risk now

Lean ordering pushes inventory risk up the chain. Manufacturers and importers must either hold the goods that retailers decline to take or make fewer of them, and they bear the cost if demand falters. Asian exporters of furniture, electronics and toys have felt this through the year in weaker orders from American buyers. Shoppers lose in a small way, since fewer panic clearances mean fewer bargains in the week that was built around bargains. If the discipline lasts, the off-price chains that live on other retailers' surplus may also find thinner pickings.

A retailer that orders thin also accepts a different risk: running out. Empty shelves in the week before Christmas cost sales that cannot be recovered, and the shopper who finds nothing at Target may simply buy online from Amazon. The big chains are betting that a lost sale is cheaper than a marked-down one, which was true when their warehouses were overflowing. It is less obviously true if demand surprises on the upside.

Where the recovery is thin

The margin recovery flatters in one respect. Target is comparing this autumn with a period in which it was still clearing its glut, so part of the improvement is the absence of last year's damage. Sales are falling, and a shop with shrinking revenue spreads its rent and wages over fewer tills. Theft is another drag: Target closed nine stores in four states in October, citing organised retail crime among the reasons. Walmart, which reported the day after Target, sounded wary about the consumer, and its shares fell sharply.

Walmart's caution carried a detail worth noting. Its chief executive said that prices of some general merchandise could fall in the months ahead, which is good for shoppers and awkward for sellers. Deflation in goods helps volumes but squeezes margins, because a retailer's wage and rent bills do not fall with the price of a toaster. Lean stock protects a chain from markdowns it chose to make; it offers less protection when the market marks everything down at once.

What to watch after the holidays

The consumer is where the call could break. Student loan repayments resumed in October after a pause of more than three years, the savings households piled up during the pandemic are dwindling, and borrowing costs are the highest in a generation. The government's retail sales figures for December and the retailers' own fourth-quarter reports in the new year will show whether tight stock kept margins intact through a slower season. A rise in the ratio of inventories to sales would be the first sign that the old habit of over-ordering is back.

Retailers have rebuilt margins by buying less, and the discipline should carry them through the holiday quarter. It will not revive sales if consumers keep cutting back, but a weak season no longer has to mean a season of write-downs. Expect fourth-quarter reports in the spring to show margins holding near this autumn's level on flat or falling sales, with the pain landing on suppliers and on off-price chains rather than on the big-box shelves.