Consumer Goods: How Retailers Manage their Inventory *** INDUSTRY FOCUS ***

Sean O’Reilly: This episode of Industry Focus is
brought to you by Rocket Mortgage by Quicken Loans. Rocket Mortgage brings the mortgage
process into the 21st century with a fast, easy and completely online process. Check
out Rocket Mortgage today at 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 a little? 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. O’Reilly: This episode of Industry Focus is
brought to you by Rocket Mortgage by Quicken Loans. If you’ve ever bought a home, you already
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Equal housing lender, licensed in all 50 states, number 3030. 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 very quickly. 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. O’Reilly: Wow! 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 [email protected] Again, that’s [email protected] 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!

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