Retailers say organized theft is biting into profits, but internal issues may really be to blame

• Retailers who have blamed organized theft for lower profits could be overstating the crime's impact to cover up internal flaws such as steep discounting and bloated inventories, experts told CNBC.
• Companies are quick to blame organized theft for shrink losses, but behind closed doors the parallel issues of employee theft and self checkout are their primary focus areas, experts say.
• Foot Locker pointed to organized retail crime in part for slimmer margins in May when the retailer reported dismal quarterly results.

This is part two of a three-part series on organized retail crime. The stories will examine the claims retailers make about how theft is impacting their business and the actions companies and policymakers are taking in response to the issue. Read the first story here and stay tuned for part three.

Retailers who blame organized theft for lower profits could be overstating crime's impact to cover up internal flaws or self-inflicted problems, CNBC has learned.

During recent earnings calls, major companies have blamed disappointing bottom lines or shrinking margins in part on roving bands of organized gangs that ransack their shelves. The issue could come up again as a string of major retailers start to report second-quarter results next week.

But behind closed doors, retailers are facing other issues they can better control, including theft by their own employees, that are contributing to losses, according to two sources who advise major retailers. They spoke on the condition of anonymity because they're not authorized to speak publicly about clients. 

Many retailers have invested in technology to better understand what leads to shrink, or the gap between the inventory a company has and what it sells. Some companies have since identified theft from employees as a major contributor to losses, even as they blame external theft in public, said one of the sources.

Losses from self-checkout theft have also become a major issue, the people said.

While some retailers may be seeing higher rates of shrink because of poor hiring practices and self-checkout machines, others such as Target and Foot Locker could be using retail crime as a crutch to obscure internal challenges, experts told CNBC.

"Shrink has been going up but sometimes it's very difficult to unpack how much is down to theft and how much is down to internal retailer issues and stumbles," Neil Saunders, a retail analyst and the managing director of GlobalData, told CNBC.

"It is a problem, we know that, it does take money off margins, we know that, but there's too much opacity in the way in which it's reported and it is being partly used as an excuse for generally bad performance," Saunders said. 

Theft as an inside job and the curse of self checkout

In the age before shoppers found deodorant and candy bars locked up in drugstores across America, employee theft largely drove shrink, said Patrick Tormey, an adjunct professor at the Lehman College School of Business, who spent more than 40 years in the retail industry. 

The trend may not have changed much, despite what companies say in public, according to experts.

"The theme that comes back the most right now is internal theft … they're realizing that a lot of [losses] come from there," said one of the sources who advises retailers. "If there's an occurrence of external theft they would steal let's say 10 bucks worth of merchandise, but if it's internal theft, it'd be 40 bucks." 

There is no conclusive data to indicate that employees do steal more goods than outsiders, but retailers have gotten better at identifying internal theft, the person said.

Retail workers have access to entire cases of merchandise in backrooms and it's "relatively easy" to take large quantities of goods without anyone noticing, one of the sources said. The theft can also go undetected for a long period of time because it's not as noticeable as a shoplifter who is in public view, the person said. 

Internal theft also happens at warehouses and in aisles where online orders are prepared, one of the people said. In some cases, a worker may know the person receiving the goods and may add extra merchandise into a shipment, one of the people said.

"It's a little bit like organized crime in some way, but not like mafia-style, just a few people [working together]," said the person.

Sonia Lapinsky, a partner and managing director with AlixPartners' retail practice, told CNBC that retailers have struggled to properly staff stores over the last few years. They can't always find the right workers, and some have also felt pressure to lower staffing levels to control costs, she said. 

"Folks are notoriously working multiple jobs these days and just feeling the pressure and having to pick up jobs everywhere," said Lapinsky. "If this is not something that they're necessarily loyal to, or see as a long-term place, then there's probably more risk of theft as well." 

David Johnston, the vice president of asset protection and retail operations at the National Retail Federation, said employee theft has long been the largest contributor to shrink and staff have at times been involved in organized theft rings. However, he thinks internal theft is now "second place" to external theft.

Retailers have another self-made problem that can lead to more stolen goods. Self-checkout machines also increase the risk of theft, and they have become a major source of losses, the two company advisors told CNBC. 

The machines come with increased costs. In some stores with high rates of theft, losses are outweighing the investments companies made in them, the people said.

"You create a problem where there wasn't one," one of the people said.

Shrink references reach a 'fever pitch'

Retailers started to blame organized theft for lower profits as the industry's performance started to suffer.

Janine Stichter, a retail analyst and managing director at BTIG, has been covering the retail industry since 2008. She didn't really hear companies talk about shrink in their earnings calls until about a year and a half ago — right around the time the economy started to soften, she said. 

"It's really kind of hit a fever pitch," said Stichter. 

Home Depot, Best Buy and Walgreens were some of the first retailers to start speaking out about theft. Now a range of companies are saying it has reduced their margins, some for the first time in recent years.

"I think there is a bit of bandwagoning at the moment," said Saunders from GlobalData. "I think one of the things that happens is somebody mentions it and it then becomes a bit of a buzzword and then everyone pays attention to it and it suddenly starts getting called out." 

In May, Target rattled investors when it said it was on pace to lose $1 billion this year from inventory losses driven by stolen goods. Two days later, Foot Locker said "theft-related shrink" contributed to a 4 percentage point drop in its gross margin. 

"This has been a multiyear dynamic in the industry. We are not immune to it. It's increasing. You've heard Target talk about it and others. And so, it's having an increased impact on Foot Locker," CEO Mary Dillon said on a call with analysts. "We've seen a significant increase of theft from stores and usually through this lens of an organized retail crime type of action."

The reference came as Foot Locker reported dismal results for the quarter. It was the first time it called out shrink cutting into its profits in more than 14 years, according to records accessible on FactSet. 

The retailer said its merchandise margins fell 2.5 percentage points because of "higher promotions" and the rise in theft-related shrink.

Three analysts who cover Foot Locker told CNBC the vast majority of that drop likely came from promotions. At the time, the company was grappling with high inventory levels and soft sales, forcing it to rely on discounts to drive revenue.

Foot Locker did not return repeated inquiries from CNBC about how much of its margin hit came from promotions and how much of it was due to shrink. 

Tormey, the Lehman College professor, said retailers have thrown around the words shrink and theft so often, investors "chalk it off as a sign of the times," which can allow companies to use it as a "crutch" for poor merchandising, store design and other internal flaws. 

"It's just a quick aspirin for the headache, so to speak," said Tormey. "It's a lot harder to pin down exact numbers so they can use it and people just kind of nod their head, 'Oh, yeah, it's a shame,' without really [questioning], was it your employees stealing from you? Was it shoplifting? Was it vendor misconduct? You know, are you a sloppy retailer?" 

Over the last two decades, Target had not mentioned shrink hitting its margins during earnings calls until August 2022, when the company and other retailers were buried in inventory they were having trouble unloading, according to FactSet.

At the time, Target's inventories had climbed 36% year over year and its profits had dropped nearly 90% in the quarter ended that July. The company had marked down items significantly to clear out excess merchandise that was no longer in demand. 

When Target explained why its gross margin had fallen nearly 9 percentage points year over year, it blamed higher markdown rates, lower-than-expected discretionary sales and higher shrink. 

By the following quarter, when inventories had begun to moderate but were still up 14%, Target mentioned organized retail theft during an earnings call for the first time in its modern history. It said shrink had contributed to profits plunging by about 50%. 

"As [CEO Brian Cornell] mentioned, this is an industrywide problem that is often driven by criminal networks, and we are collaborating with multiple stakeholders to find industry-wide solutions," Target's finance chief Michael Fiddelke told analysts. "For example, because stolen goods are often sold online, Target strongly supports the passage of legislation to increase accountability and prevent criminals from selling stolen goods through online marketplaces."

While theft has hit Target's bottom line, it also has to contend with high shrink from other parts of its business. Spoiled food from the retailer's grocery aisles and its inventory practices can both weigh on profit.

When companies deal with higher than usual inventories, more items can be lost or damaged. As Target grows its e-commerce business and pickup and delivery options, there's more room for error as merchandise moves around. 

"Target is not always the best at managing its own inventory. It does tend to have a lot of out of stocks at stores, it does tend to have a supply chain that's quite fragmented and it's very easy for things to be misallocated and mis-accounted for within that," said Saunders. "I'm sure bundled in with their number there's a lot of things where Target has just lost stuff, broken stuff, put stuff in the wrong stores, put it in the wrong location, can't find it."

In response, Target said its shrink numbers vary widely by location and do not correlate with inventory levels. The retailer said it sees a relationship between levels of shrink and stores with higher safety and crime incidents, rather than overall levels of inventory in a store.