Retailers Warn Cost Cuts, Shrinking Inventories Are Coming Back

Stores and their customers have something in common this fall: Both are watching their spending.

As retailers wrapped up their third-quarter earnings reports this week, most merchants noted that they're back in cost-control mode, and said they expect to tighten inventories after the holidays. With shoppers still spending cautiously and producer prices on the rise, merchants are aware that profit growth will have to come from squeezing more juice out of their slowly rising sales.

Even Limited Brands (LTD) plans to go easy next year, despite reporting earnings per share eight times larger than last year and announcing both a share repurchase plan and a special dividend. CFO Stuart Burgdoerfer said the parent of Victoria's Secret and Bath & Body Works will continue to handle inventories and expenses conservatively, even though comparable sales (for stores open at least a year) were up 10%.

U.S. consumers are still tightfisted, so after retailers expanded inventories earlier this year to make up for the recessionary cutting they did last year, the pendulum is about to swing back. Abercrombie & Fitch (ANF) -- which managed a 27% increase in net income thanks to strong international sales -- and Gap (GPS) were among the many merchants that had to explain to analysts how domestic store closings and international expansions were skewing their inventory levels.

Recession's Budget Consciousness Lingers

Gap CFO Sabrina Simmons told analysts inventories were rising faster than square footage because the company had stocked up ahead of opening new stores in China. As the stores open and sales increase, inventories will be more in line with square footage, she said.

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Gap managed to increase earnings 9% despite flat sales, thanks to cost controls -- a common theme among many of the retailers reporting earnings. Most chains reported that shoppers remain cautious, and said they don't expect great increases in sales during the holiday season, because shoppers will be looking for promotional items and sales.

"The recession taught them to make and keep budgets, and even after they are shopping with lists," said Cathy Tesija, executive vice president of merchandising at Target (TGT), which reported a 28.5% increase in earnings despite only a 1.6% increase in sales.

Even at the luxury end of the market, Saks (SKS) noted that its units per transaction were flat, even as its total sales rose, reflecting that wealthy shoppers weren't buying more, just paying full price more often. Saks, which has been turning around its sales this year by bringing prices down slightly, posted a 50% increase in third-quarter net income (after accounting adjustments) on a 5.7% increase in sales. The company said the profit growth came from improved profit margins brought on by the full-price sales.

"The environment has really rationalized itself," said Ron Frasch, president of Saks. "Everyone's goal is to push more goods at full price, to control inventories, to control pricing. . . . We see a very normalized marketplace."

So even as shoppers come back to the malls, the retailers expect the coming months to bring more of the same: More shoppers buying less. The "new normal" for retail in 2011 will be more of the cost controls we've seen so far, combined with modest sales increases.