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Sourcing costs for soft-goods retailers have been on the rise for a number of reasons. Expenses for raw commodities have increased due to higher demand from developing regions and better global economic fundamentals. The price of cotton has jumped over the past year, and oil and gas prices have crept up, increasing transportation costs for many textile-based operators. While these factors remain a concern, there are even more prominent cost issues that are not likely to subside anytime soon. Namely, it is upward pressure on labor wages that may crimp profitability for much of the sector over the next few years.

For decades, the retail and manufacturing industries have gained a competitive advantage by making products in low wage communities. To this day, most apparel retailers source their goods in Asia and Latin America, where wages are still below domestic levels. This model has worked because the cost of living in these areas is generally so low. For instance, China, which has historically been one of the largest producers of retail goods, has an average wage of roughly $400 a month, compared to about $3,500 in the United States. While the figure in China is still modest, it has been growing. A prospering industrial economy and high growth have contributed to elevated inflation levels recently. The result has been more wage hikes and even higher minimum wages. In April, the mayor of Shanghai, China’s largest city, instituted a 14% increase in the minimum wage.

The impact of rising wages has started to show up in the retail industry. The challenge has now become how the sector can weather these inflated sourcing expenses. The first response is typically to increase selling prices and pass the additional costs onto the consumer. This could present issues for a number of companies. Specialty retailer Abercrombie & Fitch (ANF) has recently been cutting prices to better position itself within the clothing industry. A rise in selling prices would probably be a setback to recent sales and market share gains. At the same time, more upscale retailers, such as Nordstrom (JWN) and Saks (SKS), face similar pressures in lifting selling prices, as these brands have experienced a large portion of their success from their lower-priced outlet chains (The Rack and Off 5th).

At the other end of the spectrum, discount retailers may face even larger problems. Companies such as Aeropostale (ARO) and DSW (DSW), which specialize in low-priced merchandise, will have to make the decision to increase prices or reduce margins. Since they already have little pricing wiggle room to begin with, these companies are likely to absorb most of the upward labor cost pressures, which will probably take a toll on their bottom lines. Meanwhile, broad-line retailer Wal-Mart (WMT - Free Wal-Mart Stock Report) may experience a degree of margin pressure due to its low price structure. However, Wal-Mart’s particularly strong leverage over its suppliers may force it to shoulder much of the burden, easing the strain on the giant retailer.

Areas that are less likely to be affected include businesses that have higher selling prices and have been less inclined to operate in a low-cost environment. This gives them more flexibility in adjusting to these pressures. Some of these companies include Urban Outfitters (URBN) and J. Crew, where labor costs make up a smaller portion of total operating expenses.

Despite inflationary pressures, most of the soft-goods retailers experienced relatively high gross margins in 2010. This was due to strong demand from consumers, very tight inventory management from retailers, and historically low discounting. This is a reason to be somewhat cautious about the sector in the coming year, as fundamentals may have peaked and conditions could be positioned to soften. Added cost pressure from commodities and wages may only amplify the sector’s concerns moving forward.

 

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.