<May 5, 2022>
A year ago, we wrote about the investment case for buying things. We opined that with so many companies announcing price increases, buying things before inflation hit the shelves made sense. In effect, it was a good time to increase inventories and hold them for inventory gains. In hindsight, this turned out to be a profitable strategy, as the price of many consumer necessities and durable goods have increased meaningfully over the past year.
Based on our review of many of the companies on our possible buy list, it appears that corporate America is currently implementing a similar strategy of stockpiling things. In fact, during a recent visit to Home Depot, I noticed something I hadn’t seen in a long time—lots and lots of inventory! Instead of empty shelves, merchandise was stacked high and tight.
Out of curiosity, when I returned home, I read Home Depot’s latest 10-Q and conference call. Sure enough, there it was in black and white: inventory was up 32% from last year. Management commented that they had been “working like crazy to build inventory” and while inventory turns declined during the current quarter, they weren’t concerned.
Home Depot isn’t alone. After being caught short for most of last year, many of the companies we follow have been investing in inventory. For example, a vendor to Home Depot, Scotts Miracle-Gro (ticker: SMG), has been aggressively building inventory heading into the spring selling season, with inventories up $600 million from a year ago.
Management explained, “On the inventory side, if you're basically looking at cash, if you look at the inventory side, it's a pretty significant increase. I don't know, maybe $600 million, is roughly the number. But I think you probably could take $200 million or $300 million and say, if we had that last year, we would have been a lot happier.”
Similar to Home Depot, Scotts did not seem alarmed about the rise, stating they are “pretty happy” with current inventories and that “there's no indication there's any sort of inventory at retail or with us that's an issue.”
A portion of the increase in Scotts’ inventory is a result of inflation and the rising cost to replenish. Management noted, “About 25% of this increase [in inventory] is due to the higher input costs we've been experiencing over the past year.”
Rising inventory costs are being passed on to the consumer, which increases the risk of moving higher priced goods. Scotts' management discussed the price increases, stating, “But it is a lot of pricing. I don't know if you add it all up, but it's probably in the teens compared to last year.” They also acknowledged the risk of moving higher priced inventory, stating, “That doesn't say that there's no risk based on this.” [On a side note, one of the items I bought last year to get ahead of price increases was Scotts Bonus S Weed and Feed. To date, my stockpiling has resulted in a 15% inventory gain and should meet my fertilizer needs for the next three years 😊.]
Similar to Scotts, Fastenal (ticker: FAST) also commented on the higher cost of replacing inventory, stating, “Inventories were up 22.6%. Inflation accounted for roughly two-thirds of the total increase.”
Supply chain shortages that left many companies with insufficient goods is another reason companies have been investing in inventory. TreeHouse Foods (ticker: THS) summed up its “inventory regret” well, saying, “Quite frankly, I wish we had put a little more of that cash into inventory. So, it's great to build cash, but I'd rather have some of that in my warehouses right now.”
Oil-Dri Corp of America (ticker: ODC) also discussed having higher inventories to meet demand and to improve customer service, stating, “In the near term, we're supporting our growth through inventory builds. We're investing more in inventory, as both prices go up and as we increase our inventory levels in order to better serve our customers.”
Oil-Dri also discussed the rising uncertainty many businesses are experiencing, which is contributing to the desire to hold more inventory. Oil-Dri’s CEO explained, “I can tell you, no one has been prepared with what we're all dealing with. Literally, it goes back to '79 and '80 for inflation. But when you factor in the global pandemic, the supply chain crunch that's going on, labor shortages and then a war, I mean, other than that, how did you like the play, Mrs. Lincoln?”
Higher inventory in-transit is another theme we’ve been documenting. In effect, a large portion of inventory is on the way and has yet to reach store shelves. Big Lots (ticker: BIG) discussed this trend in their last call: “Total ending inventory was up 32% from last year to $1.238 billion and up 34% from 2019 due to higher in-transit inventory, particularly seasonal. The increase versus prior years includes a significant unit cost component.”
Sketchers (ticker: SKX) had similar comments on inventory in-transit, stating, “Total inventory was $1.47 billion, an increase of 45% or $454.2 million from December 31, 2020. However, as previously noted, this balance reflects an increase of $325.1 million in in-transit inventory, attributable mainly to supply chain disruptions.”
Rising inventory is an investment that requires capital and is a drain on cash flow. Pinnacle Financial Partners (ticker: PNFP) commented on the capital requirements of its customers and the use of credit lines to fund inventories: “We did see some uptick in commercial line utilization this quarter, first time that's happened in quite a while, and we have some reason to believe that increases could continue this year as borrowers look to lock in inventories at current price levels.” As interest rates rise on credit lines and other funding sources, the cost to hold inventory is also growing.
Determining the optimal level of inventory is never easy and has likely never been this difficult. Some companies will get it right, but given the wide swings in inventory over the past year, we suspect many will get it wrong. With stress on consumer discretionary companies building—inflation, lack of stimulus, difficult comparisons, negative real wages, and declining stock and bond prices—bulging inventory is another threat facing upcoming quarterly results. Given the current backdrop, we believe there is a growing risk that revenue growth slows just as inventory spikes, placing pressure on profit margins and inventory valuations. We will be monitoring inventory turns closely!
In November 2020, we wrote a post called “Locking It In,” arguing depressed energy prices were beneficial to the energy industry’s prospects and would not last. At the time we added to our energy positions in the portfolio. In our opinion, valuations of energy stocks are no longer nearly as attractive as they were in late 2020 when investing in energy felt much lonelier. With The Great Inventory Build in full swing, we believe we are getting closer to a point when rotating out of energy stocks and into beaten down consumer discretionary stocks will make sense. While we haven’t acted meaningfully to date, our list of potential consumer discretionary buy candidates is growing, along with the potential for inventory miscalculations and investment opportunities.
Eric Cinnamond
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Definitions:
Inventory turns: A financial ratio showing how many times a company has sold and replaced inventory during a certain period.
S&P Consumer Discretionary Index: Stock cap-weighted index of S&P 500 that includes auto, household durables, apparel, leisure equipment, hotels, restaurants, and consume retailing.
S&P Energy Index: Stock cap-weighted index of the companies in the S&P 500 that are classified as members of the GICS® energy sector.