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Cowen: Pack-and-Hold Could Carry Off-Price Through Supply Chain Woes

Off-price retail may be the big beneficiary of the topsy-turvy supply chain that has negatively impacted just about every consumer goods sector in some way—with retail leaders including Marshalls and HomeGoods owner TJX, Burlington and Ross now firmly in a spot to capitalize by storing more SKUs in reserve.

As fears of a recession rise amid the skyrocketing level of inflation over the past year, off-price may have a built-in advantage, according to a recent research note from Cowen.

“In the long run, there is an expectation that the channel will have plenty of buying power as consumer demand tightens and consumer discretionary spend becomes more discerning,” it said. “With their open-to-buy dollars, off-price can rebuild pack-and-hold inventory levels which are typically margin accretive.”

That’s not to say off-price chains won’t face short-term hurdles, particularly as they contend with higher margin pressures from freight and labor cost increases. Their business model poses a challenge, in that it is difficult for a company whose value proposition is offering discounted prices to saddle consumers with higher prices.

The “big three” off-price retailers already have plenty of inventory stockpiled, enabling these competitors to maximize their pack-and-hold capabilities for future seasons.

Burlington’s reserve inventory is up 62 percent over 2019 levels, representing 50 percent of the retailer’s total stock at the end of 2021—up significantly from 33 percent in the two years prior. Reserve inventory includes product being stored for release either later in the season or in a subsequent season.

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TJX said its end-of-year inventory totals were up 22 percent, but total dollars allocated to the inventory budget were up 37 percent on a year-over-year basis.

The TJ Maxx and Marshalls parent is expected to absorb incremental freight costs of 150 basis points (1.5 percentage points) and incremental wage costs of 100 basis points (1 percentage point) in its current fiscal year, representing $1.5 billion in added expenses, which management looks to partially offset through pricing.

And Ross Stores ended 2021 with 23 percent more inventory than the prior year, with packaway merchandise at 40 percent of total inventory—roughly in line with 2019 packaway levels on a dollar basis.

Cowen predicts that in the second half of 2022, consumer sentiment will be highly levered to supply chain and cost inflation dynamics.

Cowen held an expert call on the current state of the supply chain, focusing on where structural changes related to inflation, unit costs and working capital have been most significant.

Edward Hertzman, founder and president, Sourcing Journal and executive vice president of Fairchild Media, as well as Munir Mashooqullah, global supply chain manager of apparel sourcing company Synergies Worldwide, sat in on the call with a team of Cowen’s equity researchers.

Excess inventory could pose margin headwinds

Although Hertzman and Mashooqullah were bullish on the state of off-price, they were less so on the outlook for inventory across the board, largely due to the bad habit of overbuying. While off-price retailers can afford to pack and hold goods for future seasons, other retailers will need to use their inflated inventories to lap last year’s stimulus-induced sales.

“In turn, inventory excess ties up working capital and potentially leads to an increase in markdowns and margin degradation, particularly among inefficient retailers which could then become irrational with promotions,” the note said. “Our experts see continuing confusion on how inventory, payables, and receivables could be accounted for across the sector. We see this as a continuation of non-linear quarterly margin flow from brands and retailers across the space. Given delays across the supply chain, payment terms from vendors and suppliers are not in sync.”

As margins could take more upcoming hits, additional price increases aren’t out of the question. The Cowen report estimates that U.S. consumers could be looking at a 10 to 15 percent change in pricing on generic goods and 20 percent increase in the price for branded goods.

Despite the higher inventory levels, many companies in Cowen’s apparel and footwear coverage expressed near-term plans to raise prices, particularly as inflationary headwinds come into focus.

For companies that provided specifics of their own price increases, the median increase being planned reflects year-over-year pricing growth between mid-single-digits and low-double-digits.

Overall sales-to-inventory ratio growth has sequentially decelerated in 2021, from its peak in the first quarter at 95 percent growth, all the way to a 4 percent fourth-quarter decline.

While a higher ratio may mean a retailer has strong sales or keeps low inventory numbers, a lower ratio usually indicates the opposite, in which the seller has weak sales, too much inventory or sometimes both.

Increasing transportation and input costs have impacted how retailers approach expenses in 2022. Cowen estimates that on average, freight, which includes inbound and outbound freight costs along with distribution center costs/supply chain labor, now falls somewhere between 12 percent to 15 percent of sales at brands and retailers.

Transportation continues to be affected by the heightened lockdowns in China, particularly since that is expected to result in incremental port delays. In the U.S., West Coast ports will be negotiating longshore labor contracts this spring with the International Longshore and Warehouse Union (ILWU) as the current contract is set to expire July 1.

“The prevailing theory among our panelists is that upon contract resolution, costs will likely be higher,” the note said. “On a somewhat positive note, there are signs that the flow of goods in North America is improving though concerns are rising that inventory levels are set to increase into the second half of 2022 as our contacts suggest buyers have built commitments in order books. Port congestion is seeing relief as there is a reduction in the number of boats on the water at the ports of Los Angeles and Long Beach vs. at year-end 2021 (down 30 percent).”

While the costs for transportation and freight remain high, there appears to be a respite for those hoping for a dip in carrier costs, according to the firm’s 1Q22 Cowen Carrier Survey.

Carriers expect a 5.8 percent rate increase in the next six months, down from 6 percent in Cowen’s fourth quarter survey. This was the first sequential decline seen in the survey since the second quarter of 2020, when the Covid-19 pandemic shut down non-essential operations worldwide.

Contracts that carriers renegotiated in the last month averaged a 5.9 percent rate increase, up from a 5.6 percent rate increase in fourth quarter. But spot rates have come down materially in the month of March, and contract rates typically lag spots.

Freight container fees could retreat 20 percent to 30 percent from peak totals, but are unlikely to return to pre-pandemic levels, the report said. Another report from Bank of America analysts indicated that fees are starting to pull back domestically as well, as dry van truckload spot rates excluding fuel surcharges are down 37 percent since December and 27 percent in the past month.

Bank of America’s measure of trucking capacity available to shippers jumped in April to its highest level since June 2020, while its measure of shippers’ outlook for freight rates dropped sharply to the lowest level since July 2020.

Importers may not be able to rejoice at the declining freight rates, but they still have to handle elevated raw materials prices. The cost of raw materials reflects cotton reaching almost double the price per pound it was a year ago, hovering around $1.25 per pound, and oil-based synthetics at multi-year highs due to petroleum reaching $130 per barrel. The oil prices already are hampering wholesale polyester producers, with prices growing more than 30 percent year over year to decade-high levels. The firm expects the true cost of these prices to largely impact the second half of 2022 and 2023.

“We expect unit costs in softlines retail to rise at a mid-single-digit rate in the back half of 2022 as companies begin to source goods for 2023,” Cowen wrote in another research note. “This could represent a 100-basis-point (one-percentage-point) headwind to gross margin.”