The Music Has Stopped
Earnings impacts of falling inventories
If there’s been a common theme during 2021 and 2022, it was the mad dash to build inventories. Many earnings calls featured companies discussing how to get more inventory, and suppliers and customers wanted the same. Calls were filled with discussions of 90%-completed products that couldn’t be sold due to the absence of a handful of parts. Other companies were finding parts, but from new or more unique sources and were paying brokers to locate them. China opening, closing, then opening again created more issues for some. Still more were complaining about the high price of fuel and shipping to bring in inventories. All of this was wrapped up under the title of “Supply Chain Bottlenecks.” In addition to this, there was commodity inflation, energy inflation, and higher wages being paid.
Many companies sought to curb some of these inflationary and supply-chain issues by purposefully building higher inventories. That would create a cushion for them to meet future demand and not lose out on sales. The higher costs paid for inventory, overtime, delivery, and locating brokers could be passed along via higher pricing as customers were trying to build cushions into their inventory levels too.
Inventory balances contain of all these rising input costs. Thus, when companies were paying fuel surcharges, overnight delivery, overtime to employees, and higher commodity prices – all that boosted the inventory investment. Plus, they added to unit figures too. Now, they all want to lower inventory levels overall and free up cash. But, their customers want to do the same.
This inventory reset has already started. Many companies are going through this and we think investors should focus on an accounting principle introduced around day three in Financial Accounting classes to gauge which companies will see their margins and earnings suffer the most and the least during this transition. That concept is FIFO vs. LIFO Inventory Accounting. Below we will look at the beverage/packaged food segments for examples including Keurig Dr. Pepper (KDP) using FIFO, General Mills (GIS) using 80% LIFO, and Coca-Cola (KO) using both Average Cost and FIFO.