Conclusion: We're seeing inflation spreads, which have been a positive margin event for the apparel industry's margins over the past five quarters, revert back to back to more normalized levels as evidenced by the latest datapoints on import and spending data. This has negative implications for makers and sellers of basic apparel that have been printing outsized gross margin improvements due to input cost reductions since 2011. It's still early to step up short exposure here, but the datapoint is not good.
We continue to favor those names that have very defined company-specific growth drivers, such as WWW, RH, FNP, NKE, FL, KORS, and RL. While we still think it's early to put short exposure on in this space, we don't like companies that are more susceptible to easing inflation spreads and/or are meaningfully stepping up capital investment levels, like HBI, DKS, M, PVH, CRI, GPS, and FDO.
By 'inflation cost spreads' we mean the difference in consumer price and retailer cost. They can't be looked at in isolation. For example, the average garment sells for around $10. But it's only about $3.50 to import at cost. In other words, a 10% hike in input costs leads to about a $0.35 deficit to overcome per garment -- or about a 3.5% change in consumer prices.
The good news is that the latest month shows a +$0.17 per garment spread. The bad news is that just one month ago that spread was $0.41, and the average over the past year was +$0.39. In other words, we're definitely looking at a deceleration on the margin. Two-thirds of the slip was driven by consumer prices, while the other third was import cost. On the consumer price side, the weakest prices were in children's apparel. We don't think it's enough for us to make a blanket call-out as it relates to an impact on CRI or PLCE. But it's a datapoint worth noting.
What does this translate to in aggregate? It's often hard to put this math in context. But think of it like this. Last year, the apparel industry imported almost 24bn units of apparel. If we keep units steady on a year/year basis (i.e. making no major assumptions about elasticity) then the change we saw over the past month incrementally accounts for about $5.7bn in pure profit. This is about a $280bn industry. Let's be generous and say that it has 10% margins ($28bn in profit). So we just saw inflation spreads change (negatively) by 20% of the total profit stream of the apparel retail supply chain.
Many people might argue that you can't make macro calls like this and make any money. But once we chart the data against the industry's gross margins (which are at peak levels, mind you), we think we can make a strong arguement otherwise.