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Rise in Inventory Levels Ahead of Tariffs Could Indicate Gross Margin Problem Later

Retailers looking at different ways to mitigate the impact of rising tariffs have been stocking up on inventory to avoid passing along the increase to customers just as sales have been on the decline. And that’s a strategic move that could have at least one unintended consequence.

UBS analyst Jay Sole said inventory growth at U.S. publicly-traded retailers has been outpacing sales gains for the third straight quarter.

He’s concerned about a classic supply-demand imbalance that could be due to rising inventories because of the tariff situation, but it’s a scenario that could have a negative impact on retail balance sheets where gross margins are concerned if the U.S.-China trade dispute gets resolved sooner than expected.

Using a combination of public information and UBS proprietary research data, the retail analyst said there’s an extra $4.4 billion in inventory that’s been built up, or about 11 percent of the current inventory level. Other data points indicate a 70 percent correlation between excess inventory and gross margin declines. And a UBS Evidence Lab’s Softlines Spending Forecast report points to a worsening of the industry’s sales trend on a quarter-over-quarter basis.

According to Sole, his firm’s modeling is pointing to a gross margin contraction of between minus 25 to minus 75 basis points for the second quarter of 2019.

What’s more, the sector’s operating income–which has been declining for the last four quarters–fell 16 percent in the first quarter, while gross margin decreased 55 basis points year-over-year.

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Tariffs, not surprisingly, could make the situation worse.

Some retailers are bringing in goods sooner than later to avoid the tariffs, which could be a wise move if the additional proposed tariffs get enacted. However, Sole said the bigger risk is that the trade dispute gets resolved soon, and that’s where the potential hit on gross margin becomes a concern. Because retailers don’t know how competitors are planning their businesses, they often have to make bets on inventory based on their own outlook and business plans.

“When inventory is growing faster than sales, supply is essentially outpacing demand. To adjust, retailers usually need gross margin-eroding discounts to clear excess inventory,” he said.

The National Retail Federation and Hackett Associates on Friday released its latest monthly Global Port Tracker report, which also indicated that the major retail container ports are expected to grow this summer as retailers stock up on inventory to get ahead of higher tariffs.

Currently, there’s a tariff increase from 10 percent to 25 percent on $200 billion on imported goods from China that arrive in the U.S. after June 15. Then there’s the proposed increase of 25 percent on $300 billion on additional Chinese imports, the removal of India and Turkey from a preferential treatment that allowed for duty-free imports, and the 5 percent tariffs on Mexican imports set to take effect Monday. The NRF-Hackett report does not include any goods that would be part of the escalation of tariffs on Mexican imports, though, since most of those arrive into the U.S. by truck or train.