Market-leading baby and children's apparel company Carter's (NYSE: CRI), perhaps best-known for its popular Oshkosh B'Gosh brand, recently reported earnings that didn't seem to raise any eyebrows. But a further look at the report shows the company may face challenges in the coming quarters.
In its first-quarter 2022 earnings report, the company revealed an all-time high inventory line item on its balance sheet. A slowing U.S. economy or inflationary pressure could make selling its inventory a tall task. Here's how the stock could be riskier than you think.
Lesser of two evils
In late 2020 and throughout 2021, as the U.S. economy recovered from its brief COVID recession, red-hot consumer demand left major retailers scrambling for inventory to stock shelves and fulfill e-commerce orders. At the same time, many of the countries that supply the U.S. market imposed pandemic-related shutdowns, crippling the global supply chain. As a large buyer, Carter's was able to flex its muscles and get the products it wanted.
Image source: Getty Images.
Soon after, the Federal Reserve started raising interest rates to cool demand. But the rate hikes may have come at a perilous time for Carter's. In its Q1 2022 earnings report, the company reiterated its full-year sales outlook but also reported the highest inventory level in its history.
CRI Inventories (Annual) data by YCharts.
Carter's situation may present one of two risks. First, the company may have more items in its inventory than it can sell. To add a little perspective, Carter's Q1 inventory in 2019 was a manageable $520 million. It ended the following quarter with $734 million in sales as it turned Q1 inventory.
In Q1 2022, its all-time-high inventory came in at a surprising $680 million. The company's Q2 guidance is for $750 million to $775 million in sales. At the midpoint, sales should be 3.8% higher than in the same quarter of 2019 as it attempts to turn 30% more inventory. If Carter's has difficulty turning over its record-high inventory, it may need to incur costly write-downs.
The second potential risk is that Carter's lofty inventory number could also be caused by inflation. In other words, Carter's may have the right items in its inventory, but those items could now cost the company significantly more than they have in the past. If that is the case, Carter's could see gross margins contract as the high-cost inventory flows through its income statement. For example, as global inflation leaped during Q1 2022, the company's gross margin fell 440 basis points to 45.4%. The company's high inventory at the end of the quarter could indicate its gross margin may continue to contract.
Now what?
Carter's has been a steady, cash-generative company over the years and could eventually work through potential inventory problems. One solution could be to pass on higher inventory costs to customers in the form of higher prices.
Wholesale customers like Kohl's, Walmart, and Costco make up about a third of Carter's sales. Those low-price sellers won't likely take price increases too kindly. In the same vein, it could raise prices at its retail outlets, which could drive customers to wholesalers or to Amazon.com to get a better price.
With the stock down over 30% for the year and looming inventory risks, investors may find better bargains elsewhere in the swooning stock market.
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BJ Cook has no position in any of the stocks mentioned. The Motley Fool recommends Carter's. The Motley Fool has a disclosure policy.
