The Sweet Spot on the Lemon

I’m pretty religious about triangulating the trade off in sales, inventories and margins for most retailers. Yes, it paints an accurate picture as to financial health (or lack thereof) for a company or an industry, but more importantly, it sheds light on how management teams change their respective behaviors when business deviates from plan.

Nine times out of 10, when you can make a case for sales growth outpacing inventories and margins improving, you want to own the stock in question. Today the stars are aligning, but unfortunately we’re faced with a ‘one out of 10’ scenario.

The chart below aggregates results for Macy’s, Kohl’s, JC Penney, and Nordstrom. After six quarters of sheer ugliness, we’re finally at a point where sales growth is outstripping inventories and margins are up. Next quarter I think we’ll see the same. The problem is that we’re seeing such a positive sales/inventory spread because inventory levels are being driven down mid-high single digits in tandem with comp plans of low-mid single digit comps (I won’t elaborate on how poor their track records are for planning comp). Positive sales/inventory spread is nothing to write home about when a retailer simply throws in the towel and orders less inventory.

What does this mean for 2H?
• If demand is in line and the group hits plan, without cutting muscle from its SG&A base (I’ll give them the benefit of the doubt), then we’ll be looking at low-mid single digit earnings decline.
• If demand strengthens, then there will not be enough product to satisfy customer demand. Perhaps discounting is less severe. But overall it will be very, very tough to comp positive when inventories are planned down mid-single. In this scenario, earnings look flat at best.
• If demand weakens further, all bets are off and we’re back to a double digit EPS decline.

Not a very good decision tree, huh? This phenomenon holds us over until holiday and 1Q09 – exactly when I think that sourcing pressures will intensify the most.

If you’re long any of these names, start praying.

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