By Teresa Rivas

Tariffs are once again grabbing headlines, hurting markets, and potentially raising prices for consumers -- putting them, understandably, top of mind for retailers and their investors. However, inventories may be the bigger threat to the industry.

Inventories have been a key concern for investors and consumers in recent years. After the early shortages that marked the start of the Covid-19 pandemic, most retailers ordered as much merchandise as they could to meet strong demand. Unfortunately, supply-chain issues meant that many of those items started to hit shelves when inflation was already curbing consumer appetites, particularly for discretionary goods.

The upshot was that big retailers like Walmart and Target saw their stocks tumble in late 2022 after they lowered guidance: A glut of product led to margin-squeezing promotions.

Now history may be repeating itself.

"A storm is brewing in the U.S. consumer discretionary sector as industry inventories are rising for the first time in two years and about to exceed sales growth," warns Jefferies analyst Randal Konik. "Sure, tariffs are a big issue, but inventories...present an even bigger risk if consumer spending trends moderate from robust levels."

That means margins could be at risk again. Konik analyzed 40 publicly traded companies over the past 22 years and found six times when inventory growth outstripped sales. Those led to crunched gross margins, about 26 basis points lower on average per quarter, compared with an average gross margin expansion of 15 basis points when sales exceeded inventory growth.

Not surprisingly, those periods of inventories outpacing sales also coincided with periods of underperformance for retailers' stocks vis-à-vis the S&P 500. They trailed the index by an average of 304 basis points, or 600 basis points when accounting for lags in retail stocks' reaction.

Compounding the issue is that retailers are facing other margin headwinds right now, like a stronger U.S. dollar (for international operators), and higher freight costs.

All of this leads Konik to argue that unless consumer spending remains robust it could be a "messy" year for retailers.

"Looking at recent GDP [gross domestic product data], consumer spending was up over 4%, credit card companies printed high-single-digit% growth in volumes too," he writes. "Great numbers but also more difficult comparisons lie ahead. Don't forget most retailers saw a 53rd week in 2024... yet another headwind."

As for specific stocks, the companies near peak gross margins and whose inventories are at or near an imbalance with sales will be most vulnerable, he notes.

Konik reiterated a Sell rating on Lululemon Athletica, citing peak margins and inventory building for the first time in five quarters, and he also downgraded Brilliant Earth and Ollie's Bargain Outlet Holdings to Hold from Buy.

Still, he doesn't think investors need to avoid the sector all together. He has a Buy rating on Five Below, "where clean inventory, easy comps, undemanding valuations, present an attractive buying opportunity."

He's also bullish on TJX: Although it its gross margins are near peak, he believes the stock will see further upside as it's the "best positioned to capitalize on an inventory buildup."

The potential for a mismatch between consumer appetite and inventory, akin to 2022, remains a real possibility. While 2024's holiday season was a strong one, December retail sales were a touch below expectations. That was largely due to a lower number of auto sales, but big ticket items like that might not see much demand if tariffs make them more expensive.

Tariffs will likely remain a moving target in the near future. But if merchandise isn't moving off shelves quickly enough to keep stockrooms from overflowing, retailers could get hurt either way.

Write to Teresa Rivas at teresa.rivas@barrons.com

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February 04, 2025 15:16 ET (20:16 GMT)

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