Does this retailer have an inventory problem or a margin problem?

As high demand and COVID-19 related shutdowns have hampered the global supply chain, Urban outfitters (NASDAQ: URBN) was able to get the inventory he thought he needed. Today, the company’s inventory is at an all-time high. Inflation or a slowing economy could cause one of two problems for the retail apparel maker. Here’s what that means for investors.

Too much of a good thing

Although the initial onset of the COVID pandemic scared everyone, the Federal Reserve cut interest rates and stimulus checks were sent out to help avoid a financial Armageddon. Additionally, stay-at-home restrictions have left people with extra money that would normally be spent on things like restaurant meals or travel. The situation fueled consumer demand later in 2020 and 2021.

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Spikes in virus cases in countries manufacturing goods to meet feverish US demand prompted shutdowns as US consumers continued to shop. In addition, American truck drivers and warehouse workers did not return quickly enough to meet the demand. These factors have caused serious bottlenecks in the global supply chain.

Greater United States retailers like Urban Outfitters were able to get the items they wanted. For example, the company’s first quarter inventory was by far the highest level in its history. Now, Urban Outfitters’ sky-high inventory—combined with inflation and a potential slowdown in the U.S. economy—could present one of two risks.

First, high inventory could mean the business has too many items. If the U.S. economy slows, as many economists predict, Urban Outfitters could have trouble selling its items, especially if spring fashions go out of fashion as the season shifts to summer. If so, costly write-downs could affect the income statement in the coming quarters.

Having too much inventory isn’t limited to Urban Outfitters. The Retail Juggernaut Target (NYSE: TGT) warned investors in June of a pileup in its inventory. Target CEO Brian Cornell said the company will take drastic measures to get its inventory back on track. In the meantime, he considers his operating margin would fall to 2% in the second quarter against 5.3% in the first quarter.

The second risk is that Urban Outfitters’ sky-high inventory levels could be caused by inflation. In other words, the company has the right items in its inventory, but they cost more than in the past. With inflation at multi-decade highs, that could be the case.

On the positive side, the company’s first quarter earnings press release noted record revenue. In the statement, however, Urban Outfitters CEO Richard Hayne said: “Unfortunately, the impact of inflation on our operating costs has more than offset the benefit of record revenues.” If inflation is the culprit, its operating margin could be hit in future quarters as high-cost inventory moves through the income statement.

Now what?

Statements from Urban Outfitters’ first quarter earnings report could indicate that if Urban Outfitters has an inventory or gross margin problem, it may already be hitting the business. The company has not announced the date of its second quarter results, but the potential risks inherent in the title could be revealed at that time.

Urban Outfitters stock is down 34% year-to-date, matching the SPDR S&P Retail ETF. Beyond retail, stocks in many market sectors are crushed this year. While there are plenty of great stocks at tempting prices, Urban Outfitters might not be one of them.

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BJ Cook has no position in the stocks mentioned. The Motley Fool fills positions and recommends Target. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.