The New Science of Retailing: How Analytics are Transforming the Supply Chain and Improving Performance

Marshall Fisher is the UPS Professor of Operations and Information Management at the Wharton School of the University of Pennsylvania and codirector of the Fishman-Davidson Center for Service and Operations Management. Ananth Raman is UPS Foundation Professor of Business Administration at the Harvard Business School and specializes in supply chain management. They cofounded 4R Systems, Inc., which provides analytic services and software to retail supply chains.

Chapter 1

Retail Valuation: How Investors Value Product Availability and Inventory Management

For years we have heard from managers responsible for operations and supply chain management that they could not get their CEOs and other senior executives excited about operational issues. A common explanation for the CEOs’ lack of interest in operations was because operational issues did not seem to get attention from investors. Frequently, managers have complained to us that investors in their firms do not pay attention to operational metrics like inventory turns. Moreover, they also complain that quarterly pressure to meet short-term earnings precludes their firms from investing in longer leadtime operational-improvement projects, such as improving store operations and customer service. Clearly, investors’ inability or unwillingness to reward operational improvement or investment in operational improvement could be a barrier to implementing rocket-science in retailing.
The good news for managers seeking to improve operational capabilities is that the situation is changing now. In our experience, Wall Street led by a few fund managers and analysts is becoming increasingly savvier about evaluating operational performance and capabilities. For example, as we argue in this chapter, we see inventory becoming increasingly important to retailer valuation, and we have interacted with some investors who watch retailers’ inventory very closely for early signs of good or bad news. Such attention from investors is likely to translate to attention from senior executives within the company as well and could be a blessing for operations managers who have craved such attention for a long time. On the other hand, some other operating managers and retailers might be unprepared for this attention from senior executives and investors.
This chapter examines the relationship between retailers’ stock-market valuation and inventory management capabilities. The chapter first explores how inventory affects a retailer’s economics (and therefore should affect the retailer stock price) before looking closely at the inventory turns metric. It then identifies how the metric needs to be modified to control for the impact of other operational variables that are correlated with turns. Finally, we provide evidence that valuation is in fact a function of inventory performance once these other variables are controlled for or some missing performance metrics are revealed.

Inventory Management and Valuation
How should a retailer’s inventory level and inventory management capabilities affect its stock market valuation? A look at a typical retailer’s financial statements highlights the importance of inventory to retailer financial performance. Inventory is a significant portion of most retailers’ assets, and the cost of financing and warehousing inventory can be substantial relative to a retailer’s profit. Moreover, inventory has associated markdown and obsolescence costs and the lack of inventory when consumers want to purchase the product can also be expensive. Include the added bankruptcy risk that additional inventory imposes upon the retailer, and it would lead us to conclude that savvy investors and financial analysts should have a good understanding of the relationship between inventory and stock market valuation and incorporate this understanding in valuing retail companies. However, the relationship between a firm’s inventory management performance and its stock market valuation is not well understood and according to some industry observers often ignored even by otherwise careful investors. Wall Street does not get it [the relationship between a retailer’s stock market valuation and its inventory level],” David Berman, a hedge-fund manager specializing in retail stocks who looks at inventory turns very closely . Numerous retail executives have echoed the sentiment too; some have even bemoaned the fact that the lack of Wall Street attention implies insufficient senior management attention to this problem. This, we argue, is likely to change soon inventory management is going to be a vital piece of retailer valuation in the near future.
Inventory levels on a retailer’s balance sheet -- do not get the weight that one would expect them to get in retailer valuation because investors lack appropriate metrics to reward a firm for managing its inventory well. Retailers should carry an optimum amount of inventory and deviations from this optimum in either direction can be expensive; too little inventory results in additional stockouts and poor customer service while too much inventory leads to additional financing, storage and obsolescence costs. It is hard for an observer external to the firm (such as a financial analyst or an investor) to identify the optimum inventory level for a retailer, let alone to know if a given retailer is at their optimum level. The commonly used metric for evaluating the appropriate level of inventory at a firm namely, inventory turns varies widely across even similar” firms and over time for a single firm. Moreover, the nature of the variation is not well-understood. Consequently in the absence of knowing the appropriate level of inventory-- it is difficult for investors to evaluate and hence, reward good inventory management performance. Moreover, recent academic research also shows that to reward good inventory management, investors will have to control for the effects of other operational variables (such as gross margins, service levels, and proportion of inventory that is obsolete), some of which can be obtained from public financial statements and others that become apparent only periodically. When investors are able either to control for some of these operational variables, such as gross margin, and when some of these other variables become known (e.g., when a firm marks down inventory), we notice a clear correlation between stock market valuation and inventory levels.

How should Inventory Levels affect a Retailer’s Economics and its Valuation?
Should a retailer’s stock market valuation be a function of its inventory level if investors are able to project future sales and inventory for the retailer perfectly?

To understand the impact of inventory levels on a retailer’s valuation, we can examine the relationship between inventory levels and a firm’s earnings and also how inventory levels can affect the firm’s expected future cash flows. We consider each of these in sequence.

Impact on Earnings: Even a casual glance at a typical retailer’s financial statements shows the importance of inventory productivity to a retailer’s earnings. Not only does inventory impose substantial costs, including obsolescence and markdown, retailers lose sales and gross margins when they do not have the appropriate inventory. Moreover, inventory increases the risk of bankruptcy at a retailer.

We can illustrate the cost of carrying inventory with a simple example. Just as an example, consider a retailer whose inventory (valued at cost) is around 11% of sales . Assuming (conservatively) that the cost of financing and warehousing this inventory amounts to even 10% per year, the inventory carrying cost amounts to 1.1% of sales, substantial even for well-run retailers like Gap and Staples, where profit before taxes are typically between 5 and 10% of sales. In addition to financing and warehousing, the inventory also incurs markdown and obsolescence costs. These costs have been growing relative to sales for most retailers; for US department stores for example, markdowns have risen from roughly 8% of sales in 1970 to roughly 25% of sales in the mid 1990s.
What is often forgotten --in being concerned with the costs of having too much inventory-- is that the costs of insufficient inventory or stockouts can often be much higher. Assume for example that 90% of the consumers looking for a particular product find it in stock while the others (i.e., those that do not find the product in stock), choose not to purchase anything or purchase the product they want at another retailer. By not having inventory of the product when the consumer wanted to purchase it, the retailer loses sales and gross margins (on the lost sales), which would have flowed directly to the bottom line. In our example, if the retailer operated with 50% gross margin (a reasonable estimate for retailers for many segments, including apparel and footwear), the lost gross margin (and also net margin) would be 5% of sales. In our experience working with retailers, the cost of stockouts typically exceeds the cost associated with markdowns and financing and storing inventory.
In addition to the impact on earnings shown above, retailers also face higher risk of bankruptcy when carrying additional inventory. Retailers face a high risk of bankruptcy; the problem arises because they need to build assets (stores and inventory) in anticipation of sales. When sales are smaller than expected, a retailer’s cash flow can become negative quite easily.

Impact on Future Cash Flows: Some professional investors believe that the relationship between a retailer’s inventory levels and future cash flow is huge.” We illustrate this relationship with a simple numerical example (consisting of a sequence of scenarios) before explaining briefly the views of David Berman, the hedge-fund manager mentioned earlier. Throughout this numerical example, which consists of a sequence of numerical scenarios, we will make an unrealistic assumption that the investor can project the retailer’s future sales and inventory perfectly.
Scenario 1
Consider an investor seeking to value two apparel retailers, A and B, whose projected performance is summarized in the following table. Gross margins are expected to be 40% of sales at both retailers; SG&A (selling, general and administrative expenses) will be $180 Million per year. Sales at both firms in the first year are expected to be $500 Million. While firm A is NOT expected to grow or decline in sales, firm B is expected to grow at 3% per year; all of the growth is expected to stem from comp-store sales growth.” In other words, neither firm is expected to add stores in the next few years. As stated earlier, we assume that the projections are accurate for both retailers.

Financial Metric Retailer A Retailer B
Sales 500M 500M
Gross Margin 40% 40%
Net Margin (current year) 4% ($20 Mn) 4% ($20 MN)
Sales Growth (1 year) 0% 3%
Comp Store Sales Growth (1 year) 0% 3%

Table 1: Scenario 1

To evaluate the two firms, we can use albeit with many simplifying assumptions a discounted cash flow model. In such models, a firm’s value is equivalent to the present value of its future cash flows. For simplicity in analysis and exposition, we ignore taxes, depreciation, and capital expenses. Moreover, we project cash flows for 25 years and assume that at the end of year 25, the terminal value of the firm and the inventory is zero. Finally, we assume that the discounting rate is 10% per year.

Firm A
Gross Margin% 40%
Firm A
Year 1 2 25
Sales 500 500 500
GM 200 200 200
SG&A 180 180 180
Net Margin 20 20 20
Cash Flow 20 20
20

Table 2: Sample Cash Flow Projections
Our discounted cash flow analysis valued retailer A at $182 Million; an annual cash flow of $20 Million for 25 years discounted at 10% per year. Retailer B, on the other hand, was valued at $625 Million. The growth rate has a substantial and favorable impact on cash flow because the gross margin from the additional sale accrues to the company’s bottom-line. In year 2, for example, firm B has sales of $515 Million, gross margins of $206 Million, and net earnings and cash flow of $26 Million. This example highlights the importance of comp-store sales growth, and illustrates why analysts often pay close attention to a retailer’s projected growth.

Scenario 2
Now, assume that in addition to the data shown above, we discover that Retailer A will operate with 182.5 days of inventory while retailer B will operate with 365 days of inventory.

Retailer A Retailer B
Days of Inventory 182.5 days ($150 MN) 365 days ($300 MN)

Table 3: Scenario 2
Inventory level does not affect retailer A’s cash flow or valuation. Retailer B’s cash flow is affected adversely compared to scenario 1; as the retailer grows, it has to devote part of its cash flow to fund the inventory needed for growth. In year 2 for example, retailer B’s inventory grows from $300 Million to $309 Million; cash flows from the firm are consequently reduced by $9 Million, and now amount to $17 Million (as opposed to $26 Million in scenario 1). Consequently, retailer B’s valuation in scenario 2 is only $578 Million.
Scenario 3

In this scenario, retailer B’s inventory is expected to grow at 6% per year, which is higher than the 3% expected growth in sales.

Retailer A Retailer B
Days of Inventory 182.5 days ($150 MN) 365 days ($300 MN)
Inventory Growth Rate 0% 6%

Table 4: Scenario 3
In our discounted cash flow model, the growth in inventory affects future cash flows substantially. In year 2 for example, inventory increases to $318 Million (from $300 Million in year 1), resulting in cash flow being reduced to $8 Million (from $26 Million in scenario 1 and $17 Million in scenario 2). The sharp reduction in cash flow results in firm B having a valuation of $430 Million.

Scenario 4

What would the impact be on valuation if retailer B was also expected to write off some obsolete inventory every year? For example, what would the consequences be if retailer B was expected to write off $10 Million of inventory every year?

Retailer A Retailer B
Days of Inventory 182.5 days ($150 MN) 365 days ($300 MN)
Inventory Growth Rate 0% 6%
Inventory Write off per year 0 $10 Million

Table 5: Scenario 4
Clearly, the inventory write off expected every year would reduce expected cash flow by a corresponding amount. Not surprisingly, our discounted cash flow model values retailer B at $339 Million.

Notice that the four scenarios listed above demonstrate how inventory levels (in scenario 2), inventory growth rate (in scenario 3), inventory write-off (in scenario 4) collectively impact a firm’s cash flow and implied valuation.
The logic embedded in the scenarios described above also summarizes the views of David Berman. The relationship between inventory levels and a firm’s valuation, Berman observes, is ASTOUNDINGLY powerful, but surprisingly few understand why.” Berman’s arguments for the powerful” relationship between stock price and inventory levels are two-fold: One, Berman notes that rising inventory levels are often a function of the retailer failing to take markdowns in a disciplined way. Berman argues, that this game” [of failing to take markdowns on obsolete inventory] cannot be played indefinitely and ultimately the music has to stop.” In other words, Berman is arguing that rising inventory levels are a predictor of likely earnings declines in subsequent years.
Two, Berman argues that sales growth achieved through increasing inventory are probably not as sustainable as growth achieved by greater consumer acceptance of the brand. Investment analysts who typically pay very close attention to same store sales growth” fail to distinguish between these two types of growth and hence, over-value a retailer that is increasing sales by adding inventory. Consider a retailer that has historically suffered from stockouts due to insufficient inventory. When the company adds inventory to its stores, sales will go up. However, Berman notes that such sales growth is less sustainable than growth driven by greater consumer acceptance of the brand. Since analysts incorrectly fail to distinguish the two typ...

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