Weak retail sales may mean earnings surprises

NEW YORK Sun Aug 10, 2008 11:29am EDT

Shoppers manoeuvre their way through the aisle at Costco Warehouse in Arlington, Virginia, May 29, 2008. REUTERS/Molly Riley

Shoppers manoeuvre their way through the aisle at Costco Warehouse in Arlington, Virginia, May 29, 2008.

Credit: Reuters/Molly Riley

NEW YORK (Reuters) - U.S. retailers that just posted disappointing July sales results may come in with better-than-expected earnings in the next few weeks, highlighting the disconnect between sales and profits.

Retailers have taken steps in the past year to slash inventory levels. Although they risk limiting their overall sales potential by stocking fewer goods, the effort is aimed at boosting margins and protecting profits.

Since last year's back-to-school season, retailers have peppered their conference calls with talk of inventory -- how they are taking a "cautious approach to planning" and "managing inventory carefully."

The result of their actions was apparent on Thursday, when many U.S. retailers reported July sales at stores open at least a year, or same-store sales, that were weaker than analysts expected. Yet some of these companies, including Kohl's Corp (KSS.N) and Gap Inc (GPS.N), stood by or even raised their earnings forecasts.

The decision to cut inventory and have fewer goods on hand hindered July sales results, but it also helped retailers avoid being stuck with excess merchandise that would have required profit-crunching clearance sales.

"Our inventory levels in ... clearance and transitional categories were significantly lower than last year, affecting sales results, but leading to improved gross margins," Kohl's Chief Executive Larry Montgomery said in a statement.

Kohl's, which will report second-quarter results on Aug 14, said it was comfortable with the current consensus estimate for the quarter despite posting a 10.4 percent drop in July sales.

Kohl's will be joined by other retailers including J.C. Penney Co Inc (JCP.N), Nordstrom Inc (JWN.N) and Wal-Mart Stores Inc (WMT.N) in reporting earnings results this week.

Retailers are by no means expected to post stellar earnings and some will report a profit drop, but inventory control means the results may not be as dismal as July sales indicated.

"With less product that could, in theory, need to be marked down, you can manage your profits a bit better," said RBC Capital Markets apparel retail analyst Howard Tubin.

"Even if your same-store sales are declining, you can limit the negative impact that has on profits by managing your inventories well."

INVENTORY CUT-BACKS

As U.S. retailers sweated through the back-to-school shopping season last August, a chill began to creep into the prospects for the 2007 winter holiday.

Retailers like Wal-Mart, Target Corp (TGT.N) and Ross Stores Inc (ROST.O) started warning that the second half of 2007 was going to be more difficult than the first as the deteriorating housing market, higher fuel and food costs, and an undulating stock market took a toll on shoppers.

To avoid markdowns and price wars, retailers began to cut inventory levels, but the measures were not always fast enough or deep enough to match the drop in consumer spending.

This year, as shoppers are squeezed by record-high gas prices, a wobbly housing market, a weak job market and tighter access to credit, retailers have made steeper inventory cuts.

A Commerce Department report showed on Friday that the inventory-to-sales ratio, a measure of how long it would take to sell stocks at the current sales pace, dropped to a record low 1.06 months in June.

The interplay between sales, inventory and profits emerged as retailers reported July sales results.

Wal-Mart's U.S. same-store sales rose 3 percent, missing analysts' view for a gain of 3.4 percent. But it said that while same-store sales in home and apparel were negative, "the stores had much cleaner inventory in these areas and therefore, much less clearance than in the same period last year."

Gap, which has struggled with persistently weak sales, posted an 11 percent drop in same-store sales as it cleared through summer goods. But it raised its full-year profit forecast, citing improved merchandise margins.

"We believe Gap's greater inventory controls and improving middle-of-the-road merchandise styles create a reduced fashion risk," wrote CL King & Associates analyst Mark Montagna. "This should make it possible for the company to grow earnings per share year-over-year."

INVENTORY VS SALES VS PROFITS

But retailers need to strike the right balance between reducing inventory to match weak shopper demand while also trying to ensure they will not have empty shelves.

Burt Flickinger III, managing director of consulting firm Strategic Resource Group, said retailers did a good job of reducing inventory in the first half of the year but may have overdone it headed into this holiday season.

"Consumers can't find the depth and range of assortment because the best colors sell first," he said. "The stores have less markdown exposure, but in a way the stores sabotage themselves" because consumers who do not find what they want will go to competitors.

Tubin also said that while retailers may navigate the tough environment now by cutting inventory to protect profits, profits will suffer in the long run if they do not also find ways to spark sales.

"While I think there can be a lot of good expense control and a lot of good inventory management that offsets a soft top line this year, I think those benefits start to wane in 2009 if the sales environment doesn't improve," he said.

(Editing by Braden Reddall)

Comments (0)
This discussion is now closed. We welcome comments on our articles for a limited period after their publication.