Holiday Inventory 'Hangover': Retailers Accelerate Clearance to Prepare for Peak Season

In late September, Nike joined a growing list of companies announcing that it would take some kind of "decisive action" on inventory. The phrase was mentioned twice by Nike's chief financial officer, Matthew Friend, during a call with analysts in which the word "inventory" appeared 48 times.

Friend's comments echoed those of other executives. Target CEO Brian Cornell also referred to "bold, decisive action" and a "decisive path" during an August analyst call, where the word "inventory" appeared even more frequently, at 73 times.

What both executives were talking about was clearing out goods that consumers didn't want to buy—or at least not at the levels or prices companies had anticipated—through markdowns and other measures.

According to analysis from S&P Capital IQ and FTI Consulting, retail inventories grew 31% in the second quarter of 2022 compared with the same period a year earlier. Michael Eisenband, global co-leader of FTI Consulting's corporate finance and restructuring practice, recently wrote that excess inventory could be "the most troubling signal that the retail industry's fortunes may be reversing."

Because of the timing, Nike's announcement delivered another shock to an industry already unsettled by weak demand for non-essentials since the start of the year, as gasoline, food, and housing prices soared.

"Nike's situation is pretty bad," Michael Baker, senior research analyst at D.A. Davidson, said in an interview. "It's worse than we expected."

The goal for these major companies and many others is to free up store and warehouse space, clear out seasonal or out-of-season merchandise, and restock for the holiday season with items consumers actually want to buy.

The biggest question hanging over the holiday season now: Will their efforts work? Will inventories reach a "just right" level, or will the inventory "hangover" last through the holidays and beyond? And if it's the latter, how bad will it get?

"Retailers have too much inventory, and they're very worried. They placed too many orders when supply chains were challenged. So now they're heading into the holiday season with mountains of inventory, and they know the economy is turning," Alexa Driansky, director in AlixPartners' retail practice, said in an interview. "I think the next year is going to be a bloodbath."

"We're still in the thick of it"

Retail inventories have reached "record" and "peak" levels, according to a report from Cowen analysts in early October. The dollar value of inventories has been driven up by both higher unit counts and higher procurement costs.

Given inventory levels, "2023 gross margin expectations are too high, as markdown support increases, warehousing costs rise, higher-cost inventory flows through the income statement, and foreign exchange headwinds are building," the analysts added.

Baker of D.A. Davidson wrote in September that retailers were "drowning in inventory," with inventory levels up 22% year over year, hitting a ten-year high. More concerning, the gap between inventory growth and sales growth had widened into a chasm in recent quarters. At that time, profit margins should have been near a "trough," Baker wrote in the report.

Since then, Nike reported results that delivered another blow to the market. The sporting goods giant said inventories grew 65% in the quarter ended August 31, while gross margin fell 220 basis points due to markdowns, supply chain costs, and unfavorable currency exchange.

Less than a month later, Adidas followed suit, cutting its full-year sales and profit guidance again, partly due to "significantly higher inventory levels resulting from lower demand in major Western markets since early September." The company added that excess inventory may need to be discounted for the remainder of the year.

Hasbro also took a hit. The company reported in October that operating profit in its consumer products segment fell 31% due to additional costs and markdowns from excess inventory.

"Big brands and department stores have all come out and said, 'Hey, we're still in the thick of it,'" Matt Garfield, managing director at FTI Consulting, said in an interview. "We've done what we can to pull back, cut orders, cancel orders. But that pressure is still there."

No choice

Last year, many companies may have wanted more inventory amid strong demand and widespread supply chain disruptions, but now, with weak demand, high inventory levels offer no benefit.

All response options will erode profits in some way. The most common way to deal with excess inventory is likely markdowns.

A KPMG survey of retail executives released in September found that 56% of respondents expected an inventory "hangover" after the holiday season. Of those, 52% planned to clear excess inventory through clearance sales, 48% planned to cut purchases and gradually reduce inventory, and 41% planned to discount and sell through or return goods to suppliers. Another 24% said they planned to sell inventory to liquidators and discount retailers.

An Accenture survey of retail executives released in October found that nearly all respondents (99%) said they had included increased promotions in their holiday plans. Another 35% said their companies were significantly discounting or taking other measures to clear excess inventory.

"Retailers with excess inventory have no choice but to either discount heavily this year and take the profit hit, or pack the inventory away and hold it for next year," Driansky said.

Garfield worked with an apparel company that set up multiple backup distribution centers to handle excess inventory. He noted that this strategy only works for core basic items—like colored polo shirts or shorts that can sell every year—and can be costly. The extra warehousing space itself costs money.

"People always think about the working capital impact, but they overlook the operational impact," Garfield said. "When you're operating at or above capacity, efficiency takes a big hit."

For example, Garfield noted that when a distribution center is packed with inventory, workers may need to move multiple pallets to find the one they need. He also mentioned an apparel company he worked with that had to pick from an off-site storage facility because the pick slots in its main distribution center were full.

Another option is selling inventory to liquidators, but Garfield said he hasn't seen much of that. "With the level of excess inventory we're seeing, the margin hit from liquidation is too big," Garfield said. "Liquidation makes sense when the excess is a small part of the product mix." But in many cases, it's the "entire category mix" that's affected.

The costs and margin hits from holding or clearing inventory aren't the only pain points retailers and brands face. Although supply chain congestion has eased considerably from last year, companies still face supply chain cost pressures from higher fuel prices, rising wages, and higher warehousing rates.

Still, the Cowen team noted that falling freight and input costs are a "silver lining" in the holiday "gloom"—but the downside is that these cost declines are largely because consumer demand has fallen, retailers are selling less, and thus shipping volumes are down.

All these costs and markdowns explain why Cowen analysts believe margin pressures will persist into 2023, and why the market's consensus expectation of a "strong recovery" in retail margins may be too optimistic and needs to be revised downward.

Clean by Q4? Or just "a little" cleaner?

So, could the "bold" and "decisive" actions taken this year to correct course before the holiday season actually work? If Nike and Adidas are any indication, the answer may be no, but the overall picture may have improved somewhat.

"Do we think inventories will be clean before the holiday season? We think they'll be 'a little' cleaner than in Q2," Baker said. "So when it's all said and done, in terms of year-over-year inventory growth... inventories will still be up, still be high, but the growth rate will be lower than in Q2."

Inna Kuznetsova, CEO of supply chain planning company ToolsGroup, said in emailed comments that as holiday shopping kicked off early in October, "we're already seeing a lot of excess inventory being heavily discounted due to planning mistakes."

Kuznetsova noted that electronics (especially TVs), home goods and home improvement items, apparel, and fashion categories are the excess inventory categories in the industry, while demand for other categories like cosmetics is rising.

FTI's Garfield also noted that some categories are more plagued by excess inventory than others. He mentioned home decor—where consumers pulled forward a lot of spending in 2021—as well as footwear and apparel categories facing difficulties.

"Certain industries are just going to get hit hard, and they won't have a chance to clear out that inventory," Garfield said. "The bigger challenge is how to create freshness and bring in seasonal merchandise while dealing with high inventory."

Despite the margin pressure from markdowns, Baker also pointed to an offsetting effect in retailers' favor: discounts may attract consumers to buy more, boosting revenue.

"We still think volumes will be decent because prices will be more attractive, and consumers do seem to still be spending," Baker said. "But discounts are an offset because retailers are making less money per unit."

For brands and manufacturers on the other end of the massive order cancellations by retailers this year, sales will take a hit. "One consistent message we keep hearing is that retailers aren't placing orders," Baker said. "So that's bad news for any retailer's suppliers."

But even after retailers clear their excess inventory, they face another problem: After several quarters of hunting for and buying discounted goods, will consumers return to paying full price?

As HSBC analysts wrote in a report on Nike's tough year: "Consumers accustomed to paying full price may soon develop bad habits."