Retailers face rising production costs(69774)

The Rising Cost of Retail: Who Will Win?

Retailers have been plagued by issues; some have suffered from product misses, others from deep discounts, and everyone has been hurt by the decline in consumer spending. But one factor that has actually been a positive for the sector may now begin to put pressure on retailers.

After a decade of a favorable sourcing environment, the cost of production is rising. Prices for cotton have nearly doubled over the last year, capacity in China is drying up and freight costs are expected to rise. And retailers, who have finally begun to regain their footing, will now be forced to up their prices to pass along some of the costs to consumers.

All of this comes at a particularly bad time, as retailers are looking to rebuild inventory levels after last year's drastic cuts.

For those retailers that offer unique and compelling merchandise, this might not be an issue, Stifel Nicolaus analyst Richard Jaffe says. Jaffe calls out such names as Urban Outfitters and Kohl's.

"[Higher costs] will likely impact the undifferentiated, low-cost providers most significantly," Jaffe said. "A retailer, competing primarily on price, will be challenged as its main point of differentiation will be undermined."

In other words, while a $2 increase may not be a big deal for a $180 Anthropologie dress, it could well sway shoppers from buying a $10 t-shirt that is now $12.

Gold prices could also put a drain on jewelry retailers, especially Movado. Wall Street Strategies analyst Brian Sozzi predicts the watchmaker will be hurt by gold prices in the fourth quarter.

So far this changing retail landscape is nearly imperceptible. Still, investors can no longer take deflation for granted, as retailers have already begun voicing some concerns for the second-half of the year.

Target said during its first-quarter conference call that rising cotton prices and other higher costs will pressure the bottom line next year.

Abercrombie & Fitch also said rising cotton prices are a "serious problem." For the teen retailer, which has been trying to remain price-competitive to battle rivals like Aeropostale, this could be a major headwind.

Sourcing costs could become too high to sell the merchandise at a deep discount and still make money, Jaffe says.

Lowe's and Home Depot have recently cited higher lumber and copper prices as a growing concern. The price of lumber at the beginning of May was 79% higher than last year, and close to peak prices of 2004, according to the National Association of Home Builders.

As a result, Home Depot has raised prices on products like plywood and electrical wire to offset these costs.

Liz Claiborne lowered its full-year gross margin forecast in May, citing cotton prices, as well as higher labor and transportation costs. "We are starting to see real second-half sourcing inflation," CFO Andrew Warren said on a conference call.

Jones Apparel Group is also facing inflationary pressure, and CEO Wesley Card said this will be even more profound heading into 2011.

Card said during the company's first-quarter conference call that raw material prices are up in the single-to-low double digits and labor costs in China are growing as the economy there rebounds.

AnnTaylor Stores noted that they didn't have increase in sourcing cost this year, but next year could be challenging, Sozzi said.

And Victoria's Secret, which is owned by Limited Brands, has been working with sourcing partners to mitigate the effects of higher cotton prices.

CEO Sharen Turney said during Limited's first-quarter conference call that she doesn't expect to up prices during the second-half of the year. But "what it means for 2011 remains to be seen," she said.

Thus, in order for investors to decide which retailers will outperform in a period of rising costs, they must find companies that have invested capital in technology over the last two years, Sozzi said. The key is finding companies that have a greater technology investment relative to new square-footage growth.

Besides Urban Outfitters, Sozzi also recommends Aeropostale, American Eagle Outfitters, 99 Cents Only Stores and Wal-Mart.

Big companies like Wal-Mart tend to be immune, due to their sheer size and leverage over their supplies base, Sozzi said.

Meanwhile, off-price retailers like TJX and Ross Stores also won't see much of an impact since they buy their merchandise second hand, Jaffe says.

Retailers face rising production costs

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