Motley Fool Hidden Gems Investing - Retail's Inventory Problem

Episode Date: May 18, 2022

"We got the inventory wrong." That's basically what Target CEO Brian Cornell said about his company's latest results. (0:30) Bill Mann discusses: - Why Cornell and Walmart CEO Doug McMillon should have warned investors sooner about their latest quarterly numbers - The inventory glut major these retailers will have to work through - Lowe's benefitting from the residential home environment - Whether Target's stock is more attractive after today's drop (13:11) Tim Beyers talks with Arista Networks CEO Jayshree Ullal about how her company is diversifying its revenue stream and one thing investors often get wrong about Arista. Stocks discussed: TGT, WMT, LOW, HD, ANET, MSFT, FB Host: Chris Hill Guests: Bill Mann, Tim Beyers, Jayshree Ullal Producer: Ricky Mulvey Engineers: Dan Boyd, Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

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Because we have your number. Chris Hill. We've got retail, home improvement, and a closer look at a growing cloud networking company. Motley Fool Money starts now. I'm Chris Hill, joined by Motley Fool Senior Analyst Bill Mann. Thanks for being here. Bill Mann. Hey, Chris. What do you want to talk about today? Same thing as yesterday, let's talk some retail. You and I are going to figure out what is happening with America's biggest retailers, because I feel like we are one level down from just saying, supply chain issues. Yeah. Look, it's not funny.

We have Walmart lost a huge amount of market cap a couple of days ago. It's Target's turn today, their stock is down as much as it has been on any single trading session since the great crash of 1987, back when it was Dayton-Hudson and not Target. Lowe's is down pretty sharply today as well. I think the thing that's been interesting to me this earning season is you had Visa, for example, came out and said, hey, spending is strong, the consumer is doing great. And Amazon came out and said, the consumer is doing great. And then suddenly, you've got one after another after another. They're like, no, no, no, no, no, no, no. It is bad out there. And we have inventory issues that are harming our results. And we don't really know what's

coming up next. So yesterday, part of the story with Walmart was people spending a greater percentage of their ticket on groceries and the impulse items were not moving off the shelves. Today, Brian Cornell, the CEO of Target, basically came out and said, we got the inventory wrong. I give him points for honesty. It's a little surprising because Cornell and his team have been so good for so long on their merchandise mix, particularly apparel, but there is a degree to which they blew this. We're seeing this in the stock price movement, which is in the same way that Walmart, which rarely makes big moves, it's surprising to see it down 11% on Tuesday. Target makes bigger moves falling 24%, holy cow. Yeah, that's the technical term,

actually, too. It's holy cow. I don't know what more you can say. Now, I will say this, We do need to give companies a little bit of leeway because we are dealing with an incredible supply chain issue. And Target, like most retailers, values its inventory on something called last in, first out. So, the most expensive inventory is that which goes into their cost of goods sold. So, it may not be as financially bad as it seems. We also have to remember that coming out of COVID, and I hope we're coming out of COVID, but I think that we can, let's just, without making predictions, say that the consumer behaved differently in the first quarter of 2022 than the average consumer behaved in the first quarter of 2021, was really hard to predict.

So, I think that we will see Target level set. I am a little disappointed if you're going to play the quarterly guidance game, Target has known for a while that they had a problem. And I'm really surprised that they did not get out ahead of this and wait all the way until earnings to surprise people. I am as well. You and I are not alone in thinking that about Target, and for that matter, about Walmart and Doug McMillan and his team. So, I mean, that's part of what is surprising here. Is it safe to assume this is going to, and by this I'm referring to the inventory glut that now exists at both of these retailers, it's going to take three to six months to work this through, assuming they manage it correctly?

Maybe. But think about it this way. If you are still in a supply chain, if you don't have security in your supply chain, if some supplier offers you a six-month supply of some good that you know that you can sell, you're going to take it. You should. You should get it in, even if there is a cost to the short-term in the meantime, because that component, we could talk about the war in Ukraine, we could talk about some of the food insecurity issues that are coming down the pike. And both Target and Walmart have sufficient food components to their business. All of this are things that the companies themselves have to figure out how to operate in. And I think it's probably a bigger disaster for a Target and a Walmart to have

empty shelves than to have a stockroom full of things that they can't sell right away. So, I don't expect this to get better anytime soon. The Target said that they believe that their costs are going to be about a billion dollars higher this year in the form of both labor and what they pay for products. So, it's not great. It's not great. I just don't understand, if you're going to play the quarterly guidance game, why we got to this point before they bothered to mention it. Hopefully, both of these large, important retailers are going to ramp up their communications because three months from now, not only do we get the next earnings report from both Walmart and Target, we're also going to get

color on what is the second most important season of the year for retailers, which is back-to-school shopping, and the earliest bit of guidance on holiday, which is the most important part. Hopefully, both of them take that. I'm assuming both CEOs are listening to this podcast. Big fans of the show. Brian Cornell, big fan of the show. Lowe's first quarter, not as good as what we saw on Tuesday from Home Depot, which is a little surprising only because for a a while now, these two have sort of moved together in terms of the general direction of their results. Lowe's first quarter profits a little bit higher than Wall Street was expecting.

Revenue was the tiniest bit lower. Look, there's been a cold spring, and if you want to look at revenue missing by 0.4%, which is what the expectation was, look, Lowe's isn't blaming the weather, but it's not unreasonable to think, yeah, that's probably worth half a point. Yeah. Yeah. Entirely different issue. And it bears remembering that both Lowe's and Home Depot fabulously run companies. So, what I'm about to say should not be seen as pejorative at all. But they have benefited mightily from people staying at home, people renovating their houses, people doing things like building in-home offices. And at some point, that is going to ramp down some. They have also benefited really from various parts of the new housing market, plenty. And

that's something that is under threat. It hasn't really happened yet in most markets, although realtors are seeing a lot less foot traffic. In a rising interest rate environment, one of the first things that is sensitive to that is home purchases. So, I think maybe what you're seeing from Lowe's and the stock is, the stock's off about 4% as we record this, which means it'll land anywhere from up to down 30 by the time it comes out. I mean, who knows, it's 2022. But at this point in time, it's a bad-ish day. Maybe down 4% is the 2022 version of up. Well, here's a positive if you're a Lowe's shareholder, which I am. They didn't lower their guidance. Part of what was surprising about Home Depot on Tuesday was they actually

raised guidance for the full fiscal year. Lowe's didn't raise it, but they maintained it. To your point, Marvin Ellison, the CEO at Lowe's, made some comments basically echoing what you were saying. I'm paraphrasing here, but he basically said, look, it's not that the macroeconomic stuff in terms of inflation, in terms of Russia invading Ukraine, it's not that these things don't matter, it's just that there's not at the moment a material impact on the home improvement industry. He talked a little bit about the things that are working in their favor in terms of residential housing. One more reason to like Marvin Ellison. He's just like, yeah, no, we're absolutely benefiting from the current environment. Yeah. That's why I mentioned earlier what

I was saying was not meant as a knock under any circumstances. Now, the thing that you pointed to early, and I do want to point this out, why did Home Depot do okay, but Lowe's not do as well? That really comes down to, they feel like they are the same exact type of experience. Home Depot does have much more of its revenue coming from the professional services part of the market. Home Depot is much more heavily levered to the do-it-yourselfers, the weekend warrior types, the you and me types. The decidedly unprofessional teams. That's right. I'm here to say that I do have some projects, so Lowe's is going to benefit from me. But in general, do-it-yourselfers have pulled back a little bit. They're not

looking for projects to do in the same way that the professional services, they're still working through much more of a backlog. Let's end on the dramatic stock movement of Target. When you look at everything we've talked about, the comments from Cornell, etc., and you look at the stock down 24% in a single day, do you view that as a buying opportunity for people who have thought to themselves for a while, well, yeah, on balance, that's a solid business, I'm just looking for an opportunity, because that's kind of what it it seems like. Yeah, I actually would. It is noteworthy that their gross margin for the quarter dipped and dipped a lot. It went from 30% to 25%. I think what you're looking at now is,

I don't want to use the word transitory, but there is always a transition when you go from a steady state, which we have done at super low interest rates, money coming out in the form of direct payments from government to the people in this country, to a time in which suddenly our dollars have to be stretched farther. But consumers have always and will once again adjust to the new normal. This is a super well-run company, one of the best performing stocks in the world over the last 30 years. A 25% down day, again, who knows by the time the end of the day ends, I would view as being a pretty substantial overreaction. Bill Mann, always great talking to you. Thanks for being here.

Thanks, Chris. Enough of retail and home improvement, it's time for a closer look at Arista Networks, a $33 billion cloud networking company. Arista helps connect computers, servers, and devices for companies like Microsoft and Meta Platforms. It's infrastructure that you rely on, but you probably aren't thinking about. Tim Beyers caught up with CEO Jayshree Ullal to talk about how Arista is diversifying its revenue stream and one thing investors often get wrong about this company. For those who don't really know the networking business that well, can you do this kind of simply? What is this? Why are we upgrading and what's driving this?

Well, you might have heard the old saying from Sun Microsystems, the network is the computer. And I think the vision of that is in full reality in Arista's implementation. And so when you look at what's driving it, there are so many users, so many subscribers, and every one of us is running with lots and lots of devices, right? One user doesn't equal one device anymore, right? So there's a proliferation of devices, proliferation of workloads, which can be virtual machines, containers or physical machines and you and i just talked about the proliferation of applications so when you look at this you go oh my god you you could have every user generating

10 megabit or even one gigabit of bandwidth by virtue of all the applications and users they're doing aggregate that and you now need terabits of capacity and that's why the cloud titans build regions that are megawatt and gigawatt because they're aggregating it across multiple tenants and multiple users. So in the past, when networking was a nice-to-have or an occasional connection, it was never overloaded. Today, the network can be the bottleneck because all those compute and storage cycles

are putting pressure on it. That's why you're seeing that 10 gigabit, when Arista first started, really took 10 years to materialize. 100 gigabit has taken half the time to materialize, and Arista's emerged as the number one market leader in 100 gigabit. I think 200 and 400 gigabit will continue to interleave with 100 gigabit. It's not going to be either or. You might need some tributaries for lower speeds. I

hate to call 100 gig lower speeds, but it can be for some people, depending on the users you have. And some others may need much higher capacity in the spine or aggregation of gaming or video or streaming applications. So my belief is the next decade is rich for the combination of 100, 200, and 400 gigabit. And by the way, don't forget, 800 gigabit and terabit Ethernet will be in the horizon in that timeframe. So, it's not quite either or, but really a lot of interleaving of these architectures. Okay. Is it fair to think about it as a little bit like the internet, I'm sorry, the interstate highway system, not the internet, or maybe the internet highway system, if you had data packets as cars. And there's so many that we're building this out

and creating a more expansive system where we can move things where we couldn't before. We had just a lot of congested areas, and now we're opening up new ways to get data where it needs to be. I think that's a great analogy. And you have to open up the ramps, too. You can't just have fast freeways, you need a lot of fast ramps as well to the freeway. Yeah. Hence, more opportunity for Arista. Let's talk a little bit about the CloudTitans. You've done a really good job diversifying revenue outside of the CloudTitans. If I read the filings right, Microsoft was at over 20%. It's now down to 15% of revenue, last I looked. Meta is now under 10%. So, clearly, the cloud titans are important, but not the massive driver

of revenue that they once were. Talk to us a little bit about what you're doing to diversify revenue, and what do you expect looking forward? Well, I'm very proud of the cloud titans, and I hope they continue to be a large part of our lives. You might have seen in the announcement that Microsoft gave us a ringing endorsement and continues to view us over the last decade and hopefully the next decade as a strategic partner, not only for the cloud, but also increasingly for the intelligent edge.

Our development with Meta, that we do a lot of joint products together with them as well. So both of them are alive and well, and I think will be a very strategic part of our growth this year and for years beyond. But having said that, we want to take the lessons learned from that

and those cloud principles and apply them to other customer sectors. So they may not be as large with other customers, but still the principles apply. The principles of scale, performance, quality, automation, throughput, latency, AI principles, security principles. So this is what has led to the diversification where the cloud titans can still be 30,

maybe even 40% of our business or more in a given year. But the enterprise and financials are doing extremely well and they can be literally neck-to-neck with these cloud titans. And then we have a third sector, what we call the provider sector, where the service providers and the specialty clouds, these are folks that may not be as large as the cloud titans, but are still building their own database cloud or clouds that are special to their applications,

hosting cloud, content cloud, you name it. So what's nice is I think we've developed a nice end-by-end matrix where we have diversification of our customers and we have diversification of our product line as well. Our core data center products are still very much north of 60% of our business, but we're expanding into adjacencies such as routing and campus, as well as, as we discussed earlier, software and services and renewals. So increasingly over time, our core business will be 60%,

but another 40% comes from adjacencies and new markets as well. Okay, that's really good to hear. Last question. This is a little bit more, I would call this a foolish question, because at The Motley Fool, we're really interested in the way that teams work. You've been at this since 2008, and you have a really long history in this industry. You're not a founder of Arista, but I almost think of you as founder adjacent, because you've been with this company for so long. So I wonder, how do you work with that? You mentioned Andy Bechtolsheim. There's a whole bunch of founders that are still involved in technical development at Arista. Can you talk

us a little bit through how products get stood up and how you work together as a team on new ideas? I'm so glad you asked the question. I think the CEO gets too much credit or debit. it. And really, I want to give a huge shout out to the team who's, along with me, led this and seen us through many highs and lows. And we are a family. We are the Arista family and nothing could make me more proud. When I came here, we were 30 employees, primarily engineers. And there is Ken Duda, one of the key founders who led our software mission. And I shared an office, right? And I remember those days fondly. Maybe he doesn't because I spoke on the phone too loudly and interrupted all his coding time.

But, however, I remember it fondly because I really embraced his culture, culture for teamwork, culture for getting software right and building the right foundation, and culture for quality. And he, in turn, really embraced my customer-driven principles and the desire to not just innovate for the sake of innovation, but to bring that innovation to the context of a customer and drive it from a business point of view. So I think this is really important that you call me founder adjacent. It's a great way to say it. That really, while Arista has key founders like Andy and Ken, we also have a founding team of leaders who have brought us into this journey. You know, Hugh Holbrook and Adam Sweeney in engineering, Anshul Sadana, our COO, you know, Chris Schmidt, Ashwin Kohli, Doug Orley on the sales side, you know, Mark Taxei, you know, on the finance and legal side, John McCool, who drives our manufacturing. Many of us have worked together for not just years, but decades. So the ability to argue, debate, and yet align is so important between founders and founding teams.

So very proud of the leadership team, very proud of upholding the Arista way. And from time to time, we've had to change and adapt to the situation the way it is, rather than the way we'd like it to be. But we don't have this separation between founders and non-founders. We're one team. I love that. Let me ask one question and let you go. What is something that the market, the general public, people who have heard the name Arista

the networks, get wrong about your company? Something that's just a misconception. Well, I think they associate us too much with the cloud and cloud titans. I know there are some companies who would be dying to get in the cloud, and we're very proud of that heritage. But they sort of define us on only one angle or one spectrum when we're really so multidimensional. So if there's one thing I'd like to see them get right,

it's, you know, really understand the diversification. We're proud of our cloud heritage and we're proud of diversifying from it too. Great. All right. Well, thank you very much. I hope we'll do this again. I look forward to it. Thanks again. That's all for today, but coming up later in the week, we'll have a conversation with the one and only Michael Lewis. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill, thanks for listening, we'll see you tomorrow.