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Reading Between the Lines

4/1/2011

Econometric model bests Wall Street analysis

Unfortunately for investors, retail merchandise inventory doesn’t come with a freshness date.

Knowing the age of the inventory is critical when comparing the balance sheets of two retailers that show an identical dollar value of inventory, said Saravanan Kesavan, assistant professor of operations, technology and innovation management.

“It’s important to know how much of that inventory is going to be sold at a price greater than what it was purchased for, and what will have to be discounted or sent to salvage,” Kesavan said. “As an investor, there’s no way to figure out whether a retailer is going to write off that inventory or whether they’re carrying stale inventory on their balance sheet.”

Correctly valuing a public retailer’s inventory affects the company’s share value.

  • Too much inventory and analysts are likely to be overly optimistic about the store’s value.
  • Too little inventory and analysts are likely to undervalue the company, scaring off investors and depressing the share price.

Most Wall Street analysts ignore the very important nuances of inventory, but operations is a leading indicator of financial performance, Kesavan contends. A large inventory could indicate a robust company but holds the potential for a large write-off down the line, whereas a small inventory could be the mark of a struggling company or signal a lean, efficient operation. Arguably, a retailer’s most important asset is merchandise inventory. Managing this critical asset predicts how well the retailer will do financially.

Reading Between the Lines

One hedge-fund manager, a Harvard alumnus who credits his competitive advantage to his ability to value retailers’ inventory better than other Wall Street analysts, hires an army of foot soldiers to visit stores and report back on how much stale inventory the stores appear to carry. But even that’s not a failsafe: The retailer could have stale inventory stored in a warehouse.

Kesavan saved the shoe leather and second-guessing by creating an econometric model that predicts retailers’ sales better than Wall Street analysts. He published the results of his work with Vishal Gaur of Cornell University and Ananth Raman of Harvard University in the article “Do Inventory and Gross Margin Data Improve Sales Forecasts for U.S. Public Retailers?” in Management Science.

Kesavan and his colleagues used publicly available data from public retailers to build the econometric model. He implemented his methodological idea through simultaneous equation models, which have been used in economics for decades, most commonly in supply and demand applications. His model captured the way sales, inventory and margin moved for a given retailer. The result allowed him to accurately predict a company’s sales and diagnose some instances where retailers were carrying too much or too little inventory. Along the way, Kesavan uncovered a systematic bias by equity analysts who did not take the correct valuation of inventory into account.

Retailers have two levers to pull in affecting sales: the amount of inventory they carry in stores and the price they can charge for it. Increasing the amount of inventory in stores could increase sales. Dropping prices also could drive sales. Traditional forecasting models looked at sales trends in the past. But past performance isn’t always a good predictor of future sales. For instance, a retailer who plays short-term gains by boosting inventory or dropping prices to boost sales may not be able to repeat that performance in the next quarter or year without carrying even more inventory or dropping prices even lower.

“There’s only so much leeway you have over inventory and prices,” Kesavan said. “Our model looks not only at past sales but how the sales were generated.”

Kesavan tested his model against the predictions of Wall Street analysts who are highly compensated to provide accurate forecasts of sales, earnings and other financial metrics of retailers. His model matched or outperformed the accuracy of the analysts.

Until Wall Street analysts gain a better understanding of the quality of inventory rather than the quantity, Kesavan recommends that lean, efficient companies with low inventory volunteer more information to analysts than is required by the Securities and Exchange Commission (SEC).

The SEC does not require firms to report the age of inventory, but a company could provide details to show that it has managed its inventory well. Kesavan cautions companies that hold too much inventory. He expects Wall Street will pay increasingly greater attention to inventory. And with growth drying up for many retailers, their profitability has come under increased scrutiny. Examining how retailers manage inventory will be a part of that assessment.

Kesavan got an early start in retail supply chain while working in his father’s bookstore in India. He recommended selections to customers, worked the cash register and picked up shipments from the distributor. He acquired experience in sales, logistics and transportation, albeit on a small scale, before heading off to college. He then spent several years developing supply-chain software for businesses before completing his doctorate in technology and operations management at Harvard Business School.

Kesavan is building on his model. His initial research shows that inventory contains information to predict future earnings per share and that creating portfolios based on inventory levels produces abnormally high returns compared to the market.

“We show that inventory predicts sales, earnings and stock market returns for retailers,” he said. “So, understanding a retailer’s inventory is like gazing into the crystal ball to learn what the future holds for that retailer.”

Key take-aways

  • Balance sheet inventory is subjective and does not tell the whole story. Look beyond past sales to learn how they were generated.
  • Expect Wall Street to increase scrutiny of retailers’ inventory levels. Lack of discipline in managing inventory levels will get penalized.
  • Lean inventory firms should volunteer more information than is required by the SEC to Wall Street until analysts grasp the true value of low-inventory operations.

Saravanan Kesavan is an assistant professor of operations, technology and innovation management at UNC Kenan-Flagler.