An aberrational margin lever turning a 180 should expose the ‘play nice’ posturing we’re seeing among apparel companies today for what it is – smoke in mirrors. We’re more bearish today on the Global Apparel Supply Chain and its components than we were just one week ago. Favorite names on the short side remain CRI and JCP.
Not a conversation goes by without an investor asking about cotton. Most notably, at conferences this week management teams across the board largely downplayed the impact of higher prices on their bottom line. We’re seeing wholesalers (CRI), Retailers (JCP, KSS) and Sourcing companies (Li&Fung) all acknowledge the price pressure, but the consensus amongst them is that the consumer will ultimately pay a higher price.
There are several reasons why this absolutely will not happen. History shows how the industry has coped with circumstances like this in the past. But this time, history is history.
a) We religiously track product spreads at the consumer level vs. import cost level. Like it or not, the positive spread between the two (due to tight inventories and low input costs) has given the industry meaningful pricing power. We are just coming off an event where input cost margin impact was 3 Standard Deviations above the mean. That’s about $10+bn up for grabs in a $280bn industry. Most CEOs don’t acknowledge this (due to no Macro process) even though they unknowingly live it every day.
b) While we’re talking 3-SD moves, look at the recent move in cotton. Yes, the recent spike puts it into the ‘statistical aberration’ bucket. Anomalies or not, it is an economic reality, and a 50% boost in the industry’s biggest cost input must be dealt with.
c) What kind of numbers? As we highlighted in our note where we outlined the bear case on CRI, the recent boost in input costs suggests that a $10 item ultimately needs to sell at retail for closer to $11.50 to keep margins for everyone even. No way that’s gonna happen.
d) Elasticity works both ways. One thing that people often do not realize is that there’s a sea change in the basic economics of this industry. I know that ‘sea change’ sounds sensationalistic, but numbers and facts are tough to exaggerate. Consider this…
- This industry works in a highly elastic pricing model. As price comes down, velocity goes up. I know… that’s common sense.
- With few exceptions, virtually ALL of the units imported into this country are ultimately bought. It might be at a 90% discount 6 months after they hit the initially hit the floor, but they all sell.
- In 1992, 50% of apparel we consumer was made in this country. At that time the average American consumer 42 units per capita.
- In 2008, the percent of consumption that was imported hit 99%. By that time Americans purchased 64 units per capita.
- What does this tell us? Over nearly 2 decades, savings from outsourcing and offshoring were passed through to the consumer, and we ‘bought more stuff at lower prices.’ When demand eased, the industry still had a $3-$4bn safety net of sourcing savings to pad margin pain. This allowed the velocity to remain high without degrading margins.
- Now there’s no more kitty – in fact with the rise in input costs there’s a big deficit. Ideally, the industry would be controlled and rational, and would all take down orders in unison by 5-10% to maintain price. But in an industry that has thousands of brands and millions of SKUs – this would a near-impossible expectation.
e) One of the more common themes I've heard from those in attendance at this week's conferences is that management was much more benign about cost increases than expected. Not a surprise, actually. Seriously... Are talking heads from all facets of the supply chain going to gather at an investor conference and turn it into a battle royale as to which of their peers are going to pick up the tab on the margin deficit? No. They’ll flash their pearly whites and stand largely as a united front. The battle royale starts when the CEOs don't have to look one another square in the eye. They'll be unified until the first player with any power flinches. Then everyone else reacts.
So what have we got? An aberrational margin lever turns a complete 180. Companies are playing nice in the sandbox today, but their behavior is not genuine. We’re more bearish today on the Global Apparel Supply Chain and its components than we were just one week ago. Favorite names on the short side remain CRI and JCP.
WHAT’s DRIVING COTTON?
While demand from Chinese, American, and European consumers grows for cotton, the core driver to cotton nearing $1.00 per pound is supply (though the fact that just about every commodity is on fire is a big contributing factor). We all heard management teams talk about how they were hoping August and September crops were going to be wrong, but hope is not an investment process. Here are the issues over the last month that has kept supply well behind demand:
- Crop quality and quantity has been negatively affected by weather across the globe
- Low temperature and excess rain in China is dimming the prospects of a strong September harvest
- Longer monsoon period is causing delays in Indian picking period
- Floods and landslides destroyed Chinese crops in July and August
- Mexican cotton output was reduced from fungus killing the crop from excess rain
- Pakistan floods destroyed nearly 30% of the cotton crop and derailed infrastructure
- Political/legislative pressures limiting cotton production and exports
- India halted cotton exports in April to cool domestic prices and bolster supplies but has continued to push back the resumption of exports from September to October
Aside from the supply-demand balance we are seeing two other major issues: higher energy and wage costs for cotton production and higher shipping rates to transport finished product to consumption destinations. Cotton inputs of land rent and value of seed increased 17% since 2007 while labor costs are increasing in China and India with those inflating economies. The shipping industry is experiencing the same supply-demand imbalance driving freight higher and higher as we've heard on numerous conferences calls in 1H 2010.
Here’s an overview of the general flow of cotton from production, to manufacture, to end market.