Why Target's inventory strategy is a bad idea

Why Target's inventory strategy is a bad idea

Target Corp.'s earnings and stock have suffered in recent months as the discount retailer has started aggressively dealing with an inventory shortage, leaving investors to wonder why and was it worth it.

Target missed profit expectations due to a wide margin in back-to-back quarters, after a 13 quarter streak of beating forecasts, according to the report of fiscal second-quarter results on Wednesday.

In early-June, the stock TGT has tumbled more than 18% since Target reported first quarter results in mid-May, while the S&P 500 index SPX has gained about 7%.

Considering the consequences, Chief Executive Brian Cornell opened the post-earnings conference call with analysts on Wednesday, with the question whether he still believed the bold effort to right-size inventory was a good idea:

Cornell explained why it was so important to reduce inventory so aggressively.

We could have held onto excess inventory, and tried to deal with it slowly over multiple quarters or even years, Cornell said. It could have reduced the financial impact, but it would have held back our business over time. Since June 7, when Target warned of bold efforts to cut inventory, the stock has rallied 13.0% while the S&P 500 has tacked on 3.1%.

Reduces the ability to increase inventory in categories that are leading to growth, such as food and beverage, beauty and essentials, as well as back-to-school items.

Chief Operating Officer John Mulligan said on the call that Target s distribution centers DCs work best when they are operating at or below 85% of the maximum capacity, as operational difficulties and costs rise significantly when they move above that level.

Mulligan said that the DC network was well over 90% of capacity when the inventory actions were announced in June.

At the end of July, DC capacity utilization was below 80%, meaning that the physical space occupied by DC inventory was 20% lower than the June peak.

Davidson analyst Michael Baker reiterated his buy rating on Target's stock while boosting his price target to $203 from $185, citing progress made in reducing DC space occupied by inventory.

One of the main issues with being over-inventoried is that it clogs up the systems, both physically and financially, Baker wrote in a note to clients.

The stock was down 2.2% in the afternoon on Thursday in the wake of second quarter results, but has gone up 26.5% since closing at a two-year low of $139.30 on June 17. The S&P 500 has advanced 16.7% over the same time.