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Sean O'Reilly: This episode of Industry Focus is brought to you by Rocket Mortgage by Quicken Loans.
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Welcome to Industry Focus, the podcast that dives into a different sector of the stock
market every day. Today is Tuesday, May 17th, so we're talking about consumer goods. I'm
joined by Motley Fool analyst Vincent Shen, who's going to take us to school on that most
exciting of topics, retail inventory management. How's it going, Vince?
Vincent Shen: I'm doing well, Sean. I personally think it's quite exciting, actually.
O'Reilly: Oh man, I didn't even need coffee to do this. I'm so excited.
Shen: (laughs) Realistically, and on a more serious note, this is a really important part
of the business for a lot of retailers. I'll take you through the gamut of some of the
different sectors we think of, how they manage it, and then take you to the gold standard
with a company that has truly outdone many of its competitors.
O'Reilly: Would you say that inventory management might be, other than advertising, the most
important thing that a retailer can do?
Shen: I think, for some of the companies that we'll talk about, it's a huge differentiator
for them, and something that has allowed them to win really strong margins, to gain incredible
scale. Think of Walmart, for example, who we'll touch on briefly. But I get into any
of that stuff, Sean, don't you have anything to mention for today's show?
O'Reilly: OK. I'm actually going to be stepping back from the consumer goods and the tech
shows, to focus more exclusively on the energy show. So Vince, you'll be having lots of cool
guest stars and everything. People got a taste of what I'm going to be doing with the energy
show last week when I had Daniel Sparks on -- not only a Tesla shareholder, but a Tesla
owner -- and we talked about their driverless mode, and the future of Tesla, its valuation,
and so on. It's exciting. We're continuing to improve Industry Focus, and one of the
ways we're doing that is diversifying our contributors. I think it's a good move.
Shen: Sean, I have to say, after over a year of doing IF with you, I'm going to miss you.
O'Reilly: I bet. This is what I was most sad about, like, "Oh, I won't get to hang out
with Vince and Dylan now." I'll just have to go to lunch with you guys more or something.
Shen: And I know you like talking about your energy and industrial companies, but come
on, you know the fun stuff is in tech and consumer goods.
O'Reilly: I know! Like inventory management! Shen: (laughs)
O'Reilly: So, for the listener who's rolling their eyes right now, not only because of
our bad jokes, but also because of the fact that we're about to talk about Inventory management
of retailers, can you draw them in a little bit, explain what it is, maybe jazz it up
Shen: Sure. Broad context, this is the idea that there's a lot involved in when you walk
down the aisle at a grocery store, a clothing store, or even a big box store like a Target
or a Walmart. There's a lot involved with keeping this shelves stocked with the product
you want. There's SKUs, which are essentially the numbers they assign to identify these
products. When you have, let's say, a thousand store locations, and each of the store locations,
at a big box store, for example, has potentially tens of thousands of SKUs. This becomes a
huge, huge operational challenge.
When you're looking at a company and trying to generally identify how well it's managing
its inventory, on the investing side, we generally like to use two metrics. The first one of
those is inventory turnover. That basically tells us how many times a company will sell
through the inventory it has in a given period. This number is calculated by cost of goods
sold over whatever time period you want to use. Traditionally it's on a trailing 12-month
basis. You divide that by its average inventory balance during the period. So you could take
Q4 inventory for 2014, and then the ending balance in 2015, average those two numbers,
and you'll get essentially 5 or 10 or 15 times, basically how many times they turned through
their inventory in that year period, if you're going by trailing 12 months.
Related to this number, you can also calculate their days of inventory outstanding. This
number basically tells you how much inventory they have on hand measured by how many days
it would take them to sell through the balance they currently hold. I really like this number
because it puts it into perspective, how quickly a company can sell through its inventory and
how much they have. It's all within the metric, days or weeks.
O'Reilly: That's kind of the name of the game in retail. Assuming that items are being sold
for a profit, the more quickly you can sell things, the more you can use that money to
buy more inventory, and it keeps on spinning.
Shen: I'm really glad you touched on that, because the ultimate idea is that these companies
are pouring resources and money into whatever goods they're producing or selling or acquiring
from suppliers. The faster they can convert that inventory into revenue and cash, it's
very beneficial to them. Being able to optimize, and make its management of inventory as efficient
as possible, is really important to the margins and profitability of any company.
For that days of inventory outstanding number, a lower number is generally preferred. The
idea is, you can sell through it very quickly. At the same time, if it's too low, you run
into the issue of potentially leaving money on the table if, for example, you don't forecast
demand well-- O'Reilly: You're pricing to sell, yeah.
Shen: And, at the same time, you don't foresee outsized demand, you can't meet that, and
you leave money on the table. Another thing to keep in mind with these two metrics is,
on their own, they don't tell you quite as much as when you compare them to their peers
or their overall industry or sector. That's where you really see, through that comparison,
how well they're doing.
Moving on to our first example, I wanted to talk about Urban Outfitters. Recently, I did
a lot of research about Urban Outfitters for the Supernova Explorer One mission.
O'Reilly: One of The Motley Fool's awesome newsletter services.
Shen: Exactly. I wanted to look at it for the apparel sector. And we'll get more broad
into the bigger department stores like Nordstrom as well. Urban Outfitters operates three primary
chains. They have their namesake, Urban Outfitters, Anthropologie, Free People. They also have
some ancillary brands.
O'Reilly: Those two satellite brands, I guess, are the ones that are going gangbusters right
now, if I recall right.
Shen: Yeah. For some years, they were the ones that were providing most of the growth.
Things overall for the company have slowed down. They're in a recovery turnaround phase.
But a big focus for the company, you'll hear multiple times in their different management
calls, earnings calls, presentations that they do, they talk a lot about their weeks
of inventory and managing that number.
I pulled a lot of my calculations from S&P Capital IQ. Urban Outfitters has an inventory
turnover for fiscal year 2016 of 6.5 times. Its days of inventory is at about 56.2. If
you compare that to competitors, think Abercrombie & Fitch, American Eagle, the GAP, Express,
Urban Outfitters seems to be running a little bit more efficiently. The average for some
of those peers is about 4.9 times, or 80 days. It's taking them longer, and they're going
through their inventory fewer times in a year.
So, as I mentioned with the company Urban Outfitters specifically going through this
turnaround phase, by managing their inventory better, basically, for them, it reduces the
need for them to employ markdowns to sell their goods. And obviously, that has a very
direct impact on their margins and profitability. The company has been trying to handle its
inventory better by making some strides in the supply chain. For example, going to a
single SKU system across all of its channels. All of its products now, whether you see them
in store or online, they're all identified by that same SKU number.
This is basically fostering the idea of the omni-channel strategy that you hear so many
retailers employing now, the idea that you want to give a shopper or customer the ability
to buy whatever it is that you're selling whenever and however they want. Whether they're
in your store, at home on their computer, or in your store on the app, which is something
that's becoming very common, where a shopper will go to Urban Outfitters and interact quite
a bit due to these beacons that the stores employ. They'll ping your phone if you're
a participant, and you have the Urban Outfitters shopping app, and it gives you special offers.
A lot of people end up shopping online while they're in store. It's really blending all
these different channels.
O'Reilly: I'm really curious, since we're talking about inventory management, what inventory
days and how much stores are going to have an inventory in two decades. How many things
is Urban Outfitters and Macy's and JCPenney and Walmart, how many things are they going
to have on the shelves? You hear all these retailers talking about their omni-channel
strategy, and what it's going to entail is having a huge ... I hate to bring them up
again, because we talk about them every time we talk about retail, but Amazon. You're going
to have a huge Amazon-like distribution facility that'll filter out to the stores. They're
not going to have every size and every color of shirts. They're just not, it's not worth it.
Shen: Another example more specific to the apparel sector, you look at a company like
Zara, which is known as this fast fashion, very successful. Something they stress is
that they keep inventory levels pretty slim. When they ship out a new collection, for example,
to stores, they do so at a very limited basis. This not only allows them to manage inventory
very well, but also add some exclusivity to the new products that come out. So there's
a bit more elevated demand from shoppers, when they think, "I might not be able to get
this next week, if the store is sold out and that's all they're going to have."
Moving on, still within apparel, but also some of the bigger stores, I wanted to talk
about Kohl's, JCPenney, TJX Companies, Macy's, Nordstrom. Larger chains actually tended to
have lower turnover and more inventory on hand. They average about 3.9 times and 104 days.
O'Reilly: So these things are sitting on the shelves for three months?
Shen: Yeah. Basically it would take them about 104 days to sell through everything they have.
It's very interesting that the bigger stores are actually a little less efficient, you
could call it. But not that surprising.
Moving on to another sector, which is on the opposite end of the spectrum from apparel
retailers, naturally, as you would expect, the fastest turnover is probably going to
come from companies that sell perishable goods. Let's walk down the grocery aisle, for example.
Among major chains like Whole Foods Market, Kroger, SuperValu, Sprouts Farmers Market,
the average for these peers is about 16 times in 27 days of inventory. The organic food
specialists, Whole Foods and Sprouts tend to out-perform the broad industry. But if
you look more broadly at the bigger box stores, like, Walmart has obviously pushed significantly
into the grocery business.
You get a lesson, really, in how effectively they manage it. They do everything to run
their operations as efficiently as possible. Even when they get to their distribution centers
that you mentioned, goods get moved from one truck directly onto another truck to go to
the stores. It never get stored in warehouses, or it does as minimally as possible.
O'Reilly: I remember I saw this report or show about Walmart. They literally use supercomputers
to manage their inventory and everything. It was amazing to me. It should be like, using
supercomputers to solve complex problems, and they're doing inventory stuff.
Shen: It is complex. That's another reason why Walmart has been so successful over the
decades. Its numbers are a little stronger than a Target or a Best Buy, for example.
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Vince, you were talking about the company that epitomizes great inventory management
at the beginning of the show. I'm going to go out on a limb and say it's Amazon.
Shen: I'd say this is generally a company you would discuss on the tech show with Dylan.
O'Reilly: It's not Amazon? What are you talking about?
Shen: This is one where I think their retail stores have become famous worldwide. They're
almost like a tourist destination unto themselves. I think there was a fun fact on the board
here at Fool HQ that said that more pictures are taken of the Apple store in Manhattan,
I believe the one in Midtown, than are of the ... what was it, the Empire State Building?
O'Reilly: It was the Statue of Liberty. I maintain that that's because the Statue of
Liberty is harder to get to. But, OK, it's Apple.
Shen: It is. Here's the company that has the highest sales per square foot in retail.
I think it's almost $5,000. O'Reilly: It's second only to ... do you know?
Shen: No, it's first. Who do you--
O'Reilly: Per square foot, it's second only to Tiffany's.
Shen: Tiffany's is actually number two.
O'Reilly: You're kidding me! Apple beat them out?!
Shen: Yes. O'Reilly: Wow. Sorry, Tiffany's.
Shen: In case you're not aware, for some background, before Tim Cook took over as CEO, he had a
long tenure in operations for the company. He is known for making major improvements
when he joined in 1998 that really changed the ability for Apple to not only manage the
huge demand it would have for some of its iPhones and other products, but to do so very
profitably. For example, he scrapped all of their in-house warehouses, all of their in-house
manufacturing facilities and went to the contract manufacturers that became so famous, like
Foxconn, for example. And something that allows them to do is, if you order a phone, it'll
likely be shipped directly to you from the manufacturing facilities abroad. Apple never
even has to-- O'Reilly: Do anything.
Shen: --take possession of them at any time. That's very efficient for them. A really funny
quote is, Tim Cook has several times used dairy products as an analogy for inventory,
the idea being, "Kind of like the milk in your fridge, the longer it sits, the more
likely it is to go bad." He's even gone so far as to describe inventory as "fundamentally
evil." That's probably a bit of a stretch, but he believed that inventory in hand would
shed about 1-2% of its value each week in normal conditions, maybe even more so during
a challenging retail environment. So, it's really important to be able to turn these
With all that in mind, the numbers here are really impressive. Instead of having billions
of dollars of parts, components, and completed product sitting around, they don't have to
deal with that nearly as much with the contract manufacturers. Trailing 12 months inventory
turnover, as of the most recently reported 2016 second quarter, 58.6 times.
Shen: Blowing out even a company that sells perishables, like a supermarket. Average inventory
balance during the period was only about $2.3 billion. Days of inventory, they can sell
through it in about six days.
O'Reilly: I just realized, when I bought my iPhone last spring, it was probably a week
old at that point! (laughs)
Shen: And I think the scale here is what's really so incredible and hard to imagine.
Billions and billions of dollars of product, and they're able to maintain a really well-oiled
machine. O'Reilly: Revenues were $50 billion ... yeah.
Shen: With those numbers, Tim Cook taking over, a lot of people complain or argue that
he's not quite the visionary in terms of design that Steve Jobs was. But he was also a huge
contributor in his time there, both in operations and as CEO, in developing this model and the
systems in place that allow Apple to be so profitable, to cut out the costs wherever
he can, and to have these numbers ... six days they can turn through their entire inventory.
O'Reilly: And this is on revenues for the fiscal year ending September 26 of last year
of $233 billion. That is just ... I can't even conceive of doing things that quickly.
Shen: Beyond some of the other sectors we talked about, that's one I really wanted to
touch on, just because it is this gold standard, I think, within retail.
O'Reilly: That's awesome. Thanks for your thoughts, Vince.
Shen: Thank you, Sean.
O'Reilly: Thanks again for being a great partner for the last year.
Shen: I'm going to miss you.
O'Reilly: You bet. That's it for us, folks. If you're a loyal listener and have questions
or comments, we would love to hear from you, just email us at IndustryFocus@Fool.com. Again,
that's IndustryFocus@Fool.com. As always, people on the program may have interests in
the stocks they talk about, and The Motley Fool may have formal recommendations for or
against those stocks, so don't buy or sell anything based solely on what you hear on
this program. For Vincent Shen, I am Sean O'Reilly. Thanks for listening and Fool on!