Arthur Peck started 2018 with a problem – and a scapegoat.
A series of "operational missteps" held back Gap, Inc.'s potential in 2017, Peck told investors during a company earnings call last week. Faulty inventory management had led to late deliveries, greater store variance and product on-hand.
By the end of the year, such mistakes had contributed to an unexpected rise of $100 million in operating expenses. Beyond the rise in costs however, the excess inventory would also lead to unwanted markdowns throughout the first half of 2018, hindering the company's margins.
As CEO of the storied retailer, Peck could not let operations continue unchanged. Last week, the company announced Jeff Kirwan would no longer serve as Gap brand's President and CEO and would be temporarily replaced by Gap operations veteran, Brent Hyder.
"Frankly, I have zero patience for a lack of operating discipline," Peck said. "Obviously, we're all over this. We see the fix. It's not a difficult one, but it won't be immediate."
Leadership shifts typically beckon a change in executive strategy. Yet, the above episode paints a deeper picture: Gap's financial strategy has not shifted, but the need to execute it seamlessly has — and that need is raising the stakes for supply chain managers facing a surge in digital sales across the industry.
The problem with booming digital sales
Increases in sales are great, but when revenue growth exceeds expectations, companies must adapt to meet the new demand as soon as possible.
The dynamic is far from new for retail executives. Brick-and-mortar inventory is planned weeks in advance, with data on shopping traffic, consumer spending and marketing efforts informing how much of a product should be stocked in-store. Once a product is in store, additional sale costs tend to be low, yielding favorable margins.
But to this day, retailers are still trying to figure out the right inventory mix or model to meet digital sales growth.
A digital sale may shift various line-items in the balance sheet. In-stock, the product may have to be transported to a store or home, raising sales, general and administrative expenses (SG&A). If an item starts selling far above expectation, it may require new orders, boosting the total cost of goods sold. Add to that the unpredictability of what may be sold, when, and retailers are stuck with higher inventory and storage costs.
"Now the onus is on me to understand what changes in the flow of our supply chain [are necessary]."
Richard Maltsbarger
Chief Operating Officer, Lowe's Companies
Some retailers may boast entering 2018 with a lower inventory count, but often this is a result of liquidating slow-selling inventory, closing stores, or other measures designed to stock only what consumers demand to buy.
J.C. Penney, for example, reported a 3.2% YoY reduction in its inventory, but admitted much of it came from a "reduced inventory position." The company shuttered 141 stores and one distribution center (DC) in 2017 and plans to close another 7 stores and its Wisconsin DC in 2018, resulting in high liquidation rates.
Yet in the same period the company aggressively boosted the product assortment for its digital channel. "In 2017, we increased our online SKU count by 50% with plans to add an additional 600,000 SKUs in 2018," said Marvin Ellison, Chairman and CEO at J.C. Penney during an earnings call last week.
"We're also pleased that today, roughly 80% of the store's existing inventory is eligible for free same-day pickup." He added, "100% of our brick and mortar store network is now being utilized to fulfill online orders and over 40% of our dotcom orders were fulfilled from a brick and mortar store."
As digital sales increase, then, retailers are being forced to discern what inventory to prioritize, and how to get it to the end consumer more efficiently. Doing so provides the opportunity to fulfill the customer promise, according to the J.C. Penney executives.
"Our teams remain committed to effectively manage inventory levels without sacrificing customer availability," Jeff Davis, CFO at J.C. Penney told investors.
The supply chain manager's challenge
The tall order of achieving high availability, speed-to-market and product assortment without excessive shrink rates was not lost on Richard Maltsbarger, Lowe's newly appointed COO.
"Now the onus is on me to understand what changes in the flow of our supply chain, what changes in the interactions between our supply chain and our stores, and what changes in specifically having inventory in a shoppable position for customers when they come in to demand the purchase are necessary to continue to manage at roughly a flat to slightly up inventory that is less than our rate of sales growth in 2018," he told investors last week.
Lowe's 5.5% net sales growth last year came coupled with a 6.24% higher cost of goods sold and 8.94% greater end-of-year inventory, according to the company's fiscal 2018 earnings report. The high expenses led the company to a $0.13 earnings per share miss, according to Seeking Alpha.
Operating costs are rising for retailers
| % change, 2017-2018 | Net Sales | SG&A | COGS | Inventory |
|---|---|---|---|---|
| J.C. Penney | -0.33% | -1.98% | 1.28% | -3.22% |
| Gap | 2.18% | -3.01% | -0.88% | 9.13% |
| Lowe's | 5.54% | 1.63% | 6.24% | 8.94% |
"While we were pleased with our traffic growth, we are actively working to improve conversion and gross margin while better managing inventory," said Maltsbarger.
The home improvement retailer is betting its financial performance can improve with some targeted investments in its operating strategy – and for that, Lowe's executives were thrilled to receive a significant tax benefit from the recent political overhaul.
"We plan to capitalize on this strong macroeconomic environment and see an opportunity to invest much of the incremental cash flow from corporate tax reform to accelerate our strategic priorities, including investments in our people," said Robert Niblock, Lowe's Chairman, President and CEO.
In 2018, the company plans to spend $1.7 billion in capital expenditures, using 45% of that for strategic initiatives. The figure is 55% higher than the $1.1 billion spent in 2017, and triple the amount spent for strategic purposes, according to Marshall Croom, CFO at Lowe's.
The investments will include a new direct fulfillment center, "allowing for the expansion of our online product offering and faster parcel shipping," according to Maltsbarger. "We're also investing in delivery capacity to meet increased demand, and we're advancing our pick-up-in-store experience during Q1."
What makes a solution?
Lowe's is not the only company using the tax windfall for supply chain purposes.
"We expect, particularly given the additional flexibility provided by tax reform, to increase our capital expenditures to $800 million," said Teri List-Stoll, Executive Vice President and CFO at Gap, Inc. "More than half of this spend is related to IT and supply-chain to support our product and digital strategies, with the remainder largely related to store investments."
Independent of the newfound tax money, Gap, Lowe's and J.C. Penney all signaled they intended to build omnichannel capabilities in 2018, pointing to high expected returns.
Last year, Gap piloted a buy-online, pick-up in-store (BOPIS) program in two cities with its high-selling Old Navy brand, to "encouraging" results, according to Peck.
The pilot, he said, was beneficial not just for higher uptake, but also because customers would build baskets around the items they already bought online. Yet an even better benefit was the indirect relief it provided to the supply chain.
"Frankly, I have zero patience for a lack of operating discipline."
Arthur Peck
CEO, Gap, Inc.
"As volume pivots to BOPIS, it does allow us to take some of the pressure off of our direct fulfillment centers," Peck said. "And again, it doesn't drag through fulfillment cost below the line. So it's very attractive from an economic standpoint."
That's a selling point for retailers. To date, the struggle for digital sales lies not just in ensuring top-line growth — but doing so sustainably. It requires a culture of operational excellence to ensure each new sale does not yield a net loss.
"Retail in the U.S. is a multi-trillion dollar industry, and we believe there can be multiple winners," said J.C. Penney's Ellison. "Those retailers who can offer their customers the best in-store and online choices while eliminating friction will be the winners."
