In my last blog post on inflation, I touched on the fact that most of the inflation we’ve experienced lately results from price increases for services, not goods. Nevertheless, we did experience goods inflation in 2021 and 2022, driven by a range of market forces including government stimulus, excess consumer demand for goods and constrained supply chains.
While it should be clear to most that the price increases we saw were driven by simple supply-demand dynamics, there appears to be a sentiment among some that retailers have played a role in keeping prices artificially high. Let me put that notion to rest.
The retail industry is highly competitive and price sensitive. Consumers can (and often do) switch retailers when prices rise. We saw tremendous growth in dollar store sales at the height of the 2021-2022 inflationary period as consumers traded down to lower priced offerings.
In this day and age, price discovery is almost instant — as is the consumer’s ability to transact and claim the best price available. Retailers operate on tight margins. Unlike many industries with double digit pre-tax margins, most retailers operate with single digit margins and pricing missteps are punished by an informed consumer.
But let’s not take my word for it. Let’s look at the data. The notion that retailers raised prices of their own volition during 2021 and 2022 is obviously a false one. Input prices rose due to increased demand and various supply chain constraints including the Ukraine-Russia war. The chart below plots the Producer Price Index for commodities (essentially wholesale prices) against the Consumer Price Index (the most common gauge for consumer inflation).
As we can see from the chart, wholesale commodity prices rose much faster than retail commodity prices during the inflationary peak. Admittedly, the flow through from PPI into CPI is complex, but there is no doubt that retailers faced much higher prices getting goods onto their shelves — not only from the cost of goods sold, but also from higher wages, electricity and gas prices, storage prices and other inputs.
Given that retailers, like the consumers they serve, were paying more for goods, how did this impact their profitability? Let’s look at gross margins first. Gross margins simply reflect the ratio between the price a business sells its goods for and the price it pays for those same goods. A gross margin of 25% indicates that a business sold its goods for 25% more than it paid for them.
Below, I’ve charted the average gross margin of the top 20 U.S. retailers (based on 2022 U.S. revenues) over the last 31 quarters of financial results. These retailers account for almost $2 trillion in U.S. sales, or approximately 40% of the total U.S. retail market, excluding auto and gas. The reason I use 31 quarters is that this was the longest period for which comparable data was available for the full set of retailers.
As we can see from the chart, gross margins have fluctuated over time, as you would expect for a business operating in a competitive, free market environment. Having a consistent gross margin over time would be more of a concern — indicating that these businesses were able to maintain a consistent margin despite changing input costs.
More importantly, we can see that current gross margins are actually lower than they were for most of the pre-pandemic period from 2015-2019. Additionally, gross margins for the most recent quarter of results are in line with the average for the 31-quarter period. It appears that at a gross margin level, retailers have certainly not benefited in the slightest from the higher prices they’ve had to charge for their goods.
But what about actual profits? Have they been making more profit despite buying and selling goods at a consistent margin? Below is a chart for the same set of retailers showing profit in the form of EBITDA margins. EBITDA is simply gross profit minus the everyday expenses that a business faces in the form of wages, marketing, rent, etc. EBITDA excludes the non-cash expenses of depreciation and amortization as well as interest and tax payments. EBITDA is a measure commonly used in valuing a business because it represents the profitability of a company excluding some of the more volatile expense items on an income statement.
Similar to the gross margin chart, we can see that retailer profitability has fluctuated over the time period. Again though, margins are lower now than for most of the pre-pandemic period and in line with the average profit margin over the period. Clearly, retailers have not been benefiting from higher prices. It appears they have been striving to maintain a degree of profitability in the face of rising input prices and changing customer behavior.
It’s worth noting that, unlike gross margins, EBITDA margins can fluctuate dramatically — in some cases going negative, which can have an extreme impact on the average. To reduce the impact of outliers, I’ve graphed the EBITDA margins using a 10% trimmed mean approach, which excludes the two highest and lowest margins in each quarter, producing an average for the middle 16 values each quarter.
In this scenario, we can see that profit margins are now even lower for this group and the trend over the 31-quarter period is clearly downward, moving from 9.5% down to 8.5% currently.
It’s clear that from a profitability perspective, the retailers featured here have acted more like price-takers than price-makers. Due to the competitive nature of the industry and consumer power, retailers have limited pricing power and face variability in their profitability driven by external factors.
When looking at all the charts, we can see that the pandemic did have some effect on profit margins. There was a rapid decrease in margins at the outset of the pandemic and then an increase in margins toward the latter stages of the pandemic. The drop in profitability is very stark and can be explained by the challenges that retailers faced at the outset of the pandemic — decreases in demand resulting from closed stores and consumer concerns over shopping in person.
The increase in profitability toward the end of the pandemic period was noted by some as a period of profit-taking by retailers. Again, I would posit that this was market forces at work. As demand grew dramatically, with consumers switching from services spending to goods spending, supply chains were strained and inventories were run down. Once again, the simple supply-demand relationship plays out here.
The chart below shows the relationship between gross margins and inventory-to-sales ratios for retailers over the past four years. The inventory-to-sales ratio (calculated by dividing the total dollar value of inventories by the total dollar value of sales) tells a retailer how long its inventory will last at the current level of sales.
There is, understandably, an inverse relationship between inventories and margins. With high inventory levels, retailers have more incentive to discount prices to clear shelves for the goods waiting in warehouses. The inverse holds for when inventories are low — retailers don’t need to discount as heavily or frequently in order to clear their shelves for the next season’s goods.
This phenomenon likely accounts for the very slight, temporary uplift in gross margins during the pandemic period.
The uplift in profit margins during the same period was partly driven by the increased gross margins flowing through to the bottom line, but there were other factors at play. Retail sales increased dramatically during the period from 2020 to 2022. Average annual growth during the 10 years prior to 2020 was 3.6%. From 2020 to 2022, retail sales grew 32% on a nominal basis — almost 10 years of growth in three years.
Consumers switched from spending on services to spending on goods to the tune of approximately $600 billion per year, juiced by trillions of dollars of fiscal and monetary stimulus. Revenues grew faster than the fixed and variable costs incurred by retailers, leading to higher profit margins. The fact that these margins had normalized within a few quarters shows, if anything, that retailers are unable to sustain excess margins over time.
Everything we’ve seen related to retail price fluctuations over the past few years is easily explained by simple market forces. The data quite clearly shows that retailers priced their goods in relation to their fluctuating expenses and inventory levels.
Retailers did not accrue any margin-related benefits as a result of the heightened levels of inflation over the past few years. Any notion that retailers took advantage of high prices to pad their profit margins represents a basic failure to understand the competitive nature of the retail ecosystem and runs contrary to what the data illustrates.
