Holiday Inventory Backlog: Retailers Accelerate Clearance to Welcome Peak Season

In late September, Nike joined a number of companies in announcing "decisive action" on inventory. The phrase was mentioned twice by Nike CFO Matthew Friend during a call with analysts, in which the word "inventory" appeared 48 times.

Friend echoed similar statements from other executives. For example, Target CEO Brian Cornell mentioned "bold and decisive actions" and a "decisive path" during an August analyst call, in which the word "inventory" appeared even more frequently, at 73 times.

Both executives were talking about price cuts and other measures to clear products that consumers were unwilling to buy, or at least not at the sales volumes and prices the companies had expected.

By the second quarter of 2022, retail inventories had increased 31% year-over-year, according to an analysis by S&P Capital IQ and FTI Consulting. Michael Eisenband, global co-leader of FTI Consulting's corporate finance and restructuring business, recently wrote that excess inventory could be "the most troubling signal of a turning point for retail."

Because of the sensitive timing, Nike's announcement delivered a fresh shock to an industry already unsettled by weak demand since the beginning of the year. Demand for non-essential goods has continued to decline amid soaring prices for gasoline, food, and housing.

"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The goal for these major companies and many others is to free up store and warehouse space, clear out seasonal or outdated merchandise, and restock for the holiday season with products consumers will actually buy.

The big question hanging over the season: Will these efforts work? Have inventories reached a "just right" level, or will the glut persist through the holidays and beyond? And if 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 they're heading into the holiday season with a backlog, and they know the economy is turning," Alexa Driansky, retail director at AlixPartners, said in an interview. "I think the next year is going to be a bloodbath."

"We're still in the thick of it"

In retail, inventories have reached "record" and "peak" levels, as noted by Cowen analysts in a report in early October. The rise in the dollar value of inventory was driven by both higher unit counts and higher procurement costs.

The analysts added that due to inventory levels, "2023 gross margin expectations are too high, as markdown support rises, storage costs rise, high-cost inventory flows into the P&L, and FX headwinds are building."

"I think the next year is going to be a bloodbath."

— Alexa Driansky, retail director at AlixPartners

D.A. Davidson's Baker wrote in September that retailers are "drowning in inventory," with inventory levels up 22% year-over-year, reaching a 10-year high. More importantly, the gap between inventory growth and sales growth has become a chasm in recent quarters. At the time of the report, Baker wrote that margins should be near a "trough."

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

Less than a month later, Adidas followed suit, again lowering its full-year sales and profit guidance, partly due to "a significant increase in inventory, driven by a decline in demand in major Western markets since early September." The company added that the extra inventory may need to be cleared through markdowns 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 inventory buildup.

"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 made the cuts we can, trimmed orders, canceled orders. But the feeling is still there."

No choice

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

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

A KPMG survey of retail executives released in September showed that 56% of respondents expect inventory buildup after the holiday season. Of those, 52% plan to manage excess inventory through clearance sales, 48% plan to cut purchases and reduce inventory, and 41% plan to mark down or return goods to suppliers. Another 24% said they plan 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 have increased promotions as part of their holiday plans. Another 35% said their companies are deeply discounting or taking other measures to clear excess inventory.

"Retailers stuck with excess inventory have no choice but to either clear it with steep discounts and take the profit hit this year, or pack it 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. Garfield noted that this strategy only works for core items (like colored polo shirts or shorts that can sell every year), and it can be costly. Extra warehouse space costs money, for one.

"People always think about the working capital impact, but they often overlook the operational impact. When you're at or above capacity, efficiency drops significantly," Garfield said.

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. Garfield also mentioned that an apparel company he worked with had to pick from off-site storage facilities because of insufficient pick slots at its main distribution center.

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

"When you're at or above capacity, efficiency drops significantly."

— Matt Garfield, managing director at FTI Consulting

The cost and profit hit of holding or clearing inventory isn't the only pain point for retailers and brands. Although supply chain congestion has eased significantly 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 deflation in freight and input costs is 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 therefore shipping less.

All these costs and markdowns explain why Cowen analysts believe margin woes will persist into 2023, and why the market's consensus expectation of an "aggressive" margin recovery for retail may be too optimistic and needs to be revised down.

Will Q4 be clean? Or just "cleaner"?

So, do the "bold" and "decisive" actions taken this year to correct course before the holidays have a chance of working? If Nike and Adidas are any indication, the answer is no, but the overall picture may improve.

"Do we think they'll be clean before the holidays? We think they'll be cleaner than Q2," Baker said. "So when the dust settles and you look at the year-over-year growth rate of inventory... it will still be up, still heavy, but the growth rate will be lower than Q2."

Inna Kuznetsova, CEO of supply chain planning company ToolsGroup, said in emailed comments that as holiday shopping began 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) are a backlog category in the industry, along with home goods, household items, apparel, and fashion, 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 furnishings — where consumers pulled forward a lot of spending in 2021 — as well as footwear and apparel, which are facing difficulties.

"Certain sectors are going to be hit hard, and they won't have a chance to clear this 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: all the discounts could drive revenue growth by attracting consumers to buy more.

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

For brands and manufacturers on the other end of retailers' order cancellations this year, sales will take a hit. "One consistent message we've been hearing is that retailers aren't ordering," Baker said. "So that's bad news for any supplier to retailers."

But even if retailers clear their excess inventory, they face another problem: After multiple seasons of discount shopping, will consumers return to full-price purchases?

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