INVENTORY HANGOVER
Exploring the Early Warning Signs of a Potential Inventory Hangover
June 1, 2022
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RISING INVENTORY + DECELERATING SALES GROWTH = MARGIN DETERIORATION RISK
Lately, it feels like all you read about is shortages for all kinds of products from baby formula to lumber to critical microchips. We see empty shelves when we walk down grocery store aisles. Estimated delivery time when purchasing a laptop can be up to 4-6 months. Supply chains remain extremely strained. But believe it or not, many companies are actually burdened with way too much inventory. Even worse, companies with ballooning inventories are also experiencing rapidly slowing sales growth. See below.
We don’t throw around the word ‘unprecedented’ lightly but the pull forward of demand since COVID has truly been unprecedented. In fact, we would wager good money we’ll never see anything like this again in our lifetimes (knock on wood).
Consumers, armed with freshly printed stimmy checks, hoarded everything they could. After all, why wouldn’t they? There was no guarantee any given item would be in stock the next time they went shopping and, even if it was, inflation running rampant meant it could cost a lot more. Overbuying minimized future uncertainty and, in our view, was perfectly rational behaviour.
Companies responded in their own rational way and engaged in a race to build inventory as fast as they could (the alternative of not doing so was forgone sales). So, as you would expect, companies sourced as much supply for any available product as possible. Eventually, this leads to an inevitable inventory hangover which is just beginning to unfold.
It appears, now that consumers have gotten more selective with their purchases, there is a shortage of necessities people actually need and a surplus of superfluous stuff people don’t want. Empty shelves and bloated inventory levels occurring simultaneously is downright bizarre. This phenomenon is broad based across many sectors and market caps.
Inventory hangovers almost always precede significant margin compression. The more significant the hangover, the more severe the compression. On top of that, most of these companies are already facing various headwinds throughout the rest of their cost structures (labour, commodities, shipping, etc.).
The S&P 500 is down 13% year-to-date at the time of writing this. So far, stocks have primarily been down on a valuation crunch driven by rising interest rates. If there is another leg down (and there may not be), we believe it’ll be driven by downward revisions to earnings expectations. We remain cautious on stocks with exploding inventory levels relative to sales growth, but are generally finding more opportunities today compared to this time last year.