Here’s How Much Walmart’s Inventory Situation Really Improved Last Quarter

walmartit is (WMT 1.51%) the inventory problems of the beginning of the year are easing. In any case, this is the result of the company’s recent earnings call. Shares rose more than 6% after CEO Doug McMillion said “we’ve made good progress in improving our inventory position” and then went on to illustrate how. And to be fair, the world’s largest brick-and-mortar retailer seems to have a better handle on its aging and increasingly unsalable merchandise than it did just a few quarters ago.

But if you think the company’s inventory situation is no longer a glaring handicap, think again. The case could further boost Walmart shares.

Walmart is always well stocked – maybe too well

Walmart (like many other retailers) aggressively restocked store shelves late last year and early this year, anticipating a resurgence of post-pandemic consumerism that never quite met the expectations. This is a problem simply because so much of its merchandise is seasonal. The longer it sits on a shelf, the harder it becomes to sell…even at a discount. Moreover, not only do these goods occupy valuable space, but they also represent money that could otherwise be used to buy new, more marketable goods. This is one of the main reasons why Walmart’s profit margin rates have been declining lately.

But the company reports making progress on that front. last quarter. In addition to McMillon’s aforementioned comment, the company’s official third quarter report notes, “We significantly improved our inventory position in the third quarter, and we will continue to improve as the year ends.”

The market takes McMillon at his word. But don’t be too quick to embrace optimism. While Walmart is likely taking every action it says it is and successfully addressing its inventory bloat, it still has a lot of issues to deal with.

The image below tells the story. Last quarter revenue increased 8.8% year over year. Inventory levels, meanwhile, rose 12.2%. Indeed, the $64.7 billion in merchandise the company is currently sitting on is not only a new record, but its current inventory-to-sales ratio of 42.7% is the second highest in several years. The highest is 43.6% in the first quarter, when the retailer began to increase pressure to eliminate excess inventory.

Data source: Walmart Inc. Graph by author. Dollar figures are in the billions.

There are three main footnotes to add here. First of all, know that almost all retailers strengthen inventory levels in the third quarter in preparation for the holiday shopping season, so while the magnitude of the increase is significant, it is not entirely irrelevant.

Second, much of Walmart’s sky-high inventory levels at the start of this year were the result of goods being trapped in the retailer’s supply chain and not in stores where they could be sold. And third, inflation increases Walmart’s wholesale costs, thereby inflating the gross value of its inventory.

Nonetheless, the company’s inventory levels are still unusually high relative to sales, and they’re unusually high at a time when consumers may not be as keen to buy as some suggest. Walmart Rival Target just recalled its holiday sales outlook, while Amazon published a disappointing fourth quarter income advice late last month.

More than a small short-term risk

Don’t read the message wrong. Walmart is not doomed. He will correct his inventory errors sooner or later. It’s currently making progress towards that end, in fact, if the retailer’s understanding of its challenges is any indication.

As an example, Walmart merchants know to navigate carefully when purchasing future merchandise with long delivery times, especially if imported. He also knows he has $1 billion worth of spring seasonal products that are nearly unsellable now, especially with spring 2023 products coming soon. It’s a problem, sure, but knowing the near-exact depth of the problem is a good start to solving it.

The thing is, Walmart probably still has a lot more inventory in its stores than it would like right now. This poses a significant threat to its profitability, as significant markdowns and discounts on this merchandise reduce gross margins.

The image below puts this question into perspective. While its gross margin rate of 23.7% in the third quarter is slightly higher than in the second quarter, the broader trend is pointing downwards in the fourth quarter. And note that fourth-quarter gross margins are typically the lowest of the year, as the retailer focuses more on volume and less on protecting its margins.

Chart showing Walmart's gross margin decline since mid-2021.

Data source: Walmart Inc. Graph by author.

Given this trend above profitability already in sharp decline in a context of uncertainty consumer power, Walmart’s fourth-quarter net income could prove particularly disappointing. Unless you’re really committing to the long term, now may not be the time to get into the stock at all.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a board member of The Motley Fool. James Brumley has no position in the stocks mentioned. The Motley Fool holds positions and endorses Amazon, Target, and Walmart Inc. The Motley Fool has a disclosure policy.