Retail Winners & Losers: The Finance Professor

By now, earnings season has wound down for the second quarter of 2009. As always, there were positive surprises, disappointments and investor reactions of both the anticipated and counterintuitive variety.

Going into the season, uncertainty was greatest for the retail sector. As retailers reported their earnings, it became increasingly apparent that the industry was experiencing a wide dispersion of results, ranging from failure to success.

In this week's installment of The Finance Professor, I am going to take a more detailed look at some of the critical factors that determined success or failure in the retail industry and point out a few examples of good, bad and ugly quarterly earnings. I've divided my analysis into three sections, representing the three factors most responsible for separating the winners from the losers in the retail industry this past quarter. Following that, I go into a specific example, using Home Depot(HD) and Lowe's(LOW).

Inventories

Capacity utilization, the ratio of actual output to the installed base of potential output, has decreased tremendously. Whether with automobiles, clothing, washing machines, furniture or even some prepared foods, there has been a common trend in this recession: inventory reduction. We are making and buying fewer things than we used to. Lower demand has been met with decreased supply. The challenge for retailers was to shrink inventories in order to monetize their balance sheets while still having product to sell to customers.

Just several months ago, retailers' shelves and showrooms were flush with inventory. Now you can walk into a Wal-Mart(WMT) or a Sears(SHLD) or a Best Buy(BBY) and find empty spaces on shelves. Simply put, retailers were content to sell off merchandise and were in no rush to replenish their inventories. If a retailer was caught with too much inventory and had to mark down products to empty the shelves, then these actions adversely impacted gross margins and earnings.