This is a very interesting article from RBC Capital Markets about the current status of the apparel industry in relation to different variables impacting the value chain, specially the ones affecting COGS and OpEx (March 06, 2023 RBC Elements™: European General Retail Profit is sanity…). Great article for anyone interested in retail and strategy: economics, society, trade…
Following my long-term collaboration with RBC, I take the opportunity to inform that I will be talking next May about Supply Chain trends to RBC’s Retail Director, Richard Chamberlain.
Gross margin outlook – challenging near term, looking better for H2 2023/H1 2024. The lagged effect of USD strength versus the GBP and the EUR will be a headwind for apparel retailers near term. However, the GBP and the EUR have strengthened versus the USD since October and, as such, we expect FX to be a gross margin tailwind for retailers heading into 2024. Lower freight rates should also become a material tailwind for the sector later this year. Freight rates made up c.3-4% of a typical apparel retailer’s COGS pre-pandemic but were a much higher proportion (c.6-7%) in 2022. Raw material costs overall have stabilised. For apparel retailers cotton prices have fallen significantly over the past 9 months, albeit still remain ahead of pre-pandemic levels. Polyester prices have been relatively stable in recent months. Lumber prices, which are important for retailers in the home improvement space, were falling for much of 2022. Although prices have risen year to date, we note that these are still well below the early 2022 peak. In apparel, over the last two decades retail supply chains have been shifting towards Asia, first into China and then other regions (e.g. Bangladesh, Cambodia) given lower labour costs which allow for cheaper production. Now, given USD and wage pressures, we expect a further pivot, to cheaper areas in existing markets (often driven by Chinese suppliers), and to more near-shoring to improve speed to market.
Opex outlook – labour cost a major headwind, but helpful for top line. Labour tends to be the largest element of operating cost for retailers, with property/rental costs second most important. We note that high minimum wage inflation has been a significant pressure in recent years, in a number of markets, most notably the UK, the US and France. We have seen a tight labour market here in the UK although this is beginning to ease now, with more people entering the workforce and some redundancies. The rental market remains favourable for retailers, given weaker occupier demand for retail space as well as increased risk of tenant failure, with relatively high levels of vacancy. Furthermore, several store- based retailers will be seeing a net reduction in business rates from April, due to the removal of downward transitional relief, even after netting off warehouse rate increases. In general, energy costs tend to be only a small proportion of operating costs for the average retailer, at c.1-2% of sales, although they are more relevant for certain retailers – e.g. M&S and ABF.
Raw materials have stabilised
For a typical apparel retailer, raw materials are generally one of the larger components of garment manufacturing cost (on average c.40%). Of this proportion of raw materials, typically c.40-50% is from cotton and cotton-related materials (e.g. denim).
Generally, retailers at the upper end of the market use a slightly lower proportion of cotton as they use more expensive materials, such as wool, silk and leather. We see that cotton prices, which steadily rose through the COVID-19 pandemic and peaked sharply in June 2022, have come down significantly over the past 9 months, albeit still remain ahead of pre- pandemic levels. We believe that this has already become a gross margin tailwind for some retailers and should continue to be a benefit through 2023. Synthetic materials, such as polyester and viscose, typically make up c.40-45% of raw materials usage.
Polyester prices have been relatively stable in recent months, albeit we note that these were higher pre- pandemic. In general, we see that a higher oil price tends to cause an uptick in the price of oil-related materials such as polyester. Lumber is an important raw material for retailers in the home and home improvement space (e.g. Kingfisher). Lumber prices were falling for much of 2022, after an initial strong start. Although prices have risen ytd, we note that these are still well below the 2022 peak.
Labour and Freight
For apparel retailers, labour is the second major component of garment production cost (c.30%).
At the upper end of the market, labour is the largest proportion of cost, whereas at the lower end, labour and raw materials are more evenly split. Although there have been some extra admin costs for suppliers, we note that in recent years minimum wages in Asia have been more stable compared to a few years ago. However, we note that pressure from unions in key sourcing regions (e.g. Bangladesh) may result in wage inflation across 2023, with some regions (e.g. Vietnam, Cambodia) having already raised wages for this year.
Over the last decade we note retail supply chains have been shifting towards Asia, first into China and then other regions (e.g. Bangladesh, Cambodia) given lower labour costs which allow for cheaper production. Now, given USD and wage pressures, we expect a further pivot, into cheaper locations and also to near-shoring areas to improve fashion response times.
Labour rates in major sourcing markets (USD/month)
Source: Government websites, Trading Economics, RBC Capital Markets
Freight rates typically made up c.3-4% of an apparel retailer’s COGS pre-pandemic but were a higher proportion of COGS for hardlines retailers. Freight costs were relatively stable pre-pandemic but rose sharply across 2021. These have been falling steadily for the past year and are now close to pre- pandemic levels. As such, we expect that freight should be a yoy tailwind for most retailers in H2 2023.
Source: Drewry, Bloomberg, RBC Capital Markets
FX – USD a transactional headwind this year, H2 outlook better
We note that a major element of cost pressure for European retailers heading through 2023 will likely be the higher cost of sourcing product from Asia, paid for in USD. We note that the lagged effect of the relatively stronger USD vs the GBP and the EUR has already become a headwind for a number of retailers and we expect this to continue to be the case near term.
That being said, we note that the GBP and the EUR have been strengthening against the USD since October and, as such, we expect FX to be a gross margin tailwind for retailers heading into 2024. In terms of top line, the stronger USD has been a translational benefit to retailers with US exposure in 2022, notably JD Sports (c.30%), WH Smith (c.25%) and BOSS (c.20%), Dufry (c.20%) and Inditex (c.10%). We expect this effect to ease off in 2023.
The stronger EUR versus the GBP is a benefit for UK retailers selling in Europe but a negative for European retailers selling in the UK. We note that the SEK has been weakening versus the EUR in recent months, which should be a benefit for H&M. The SEK has strengthened vs the USD over the last few months, but is still considerably weaker on a yoy basis, so this should remain a benefit in early 2023.
Currency exchange rates relevant to the European General Retail sector
Source: Datastream, RBC Capital Markets
Labour cost pressure but starting to ease
Staff costs to be the largest element of operating cost for retailers, with property/rental costs second more important. We note that high minimum wage inflation has been a significant pressure in recent years in a number of markets – e.g. in the UK, the US and France. Post-pandemic, we believe that a very tight labour market in a number of key selling markets meant that some retailers have struggled with capacity constraints and were forced to re-hire at much higher rates across 2022.
Although capacity pressures have eased in recent months, we expect labour pressures to remain a headwind as retailers annualise re-hirings and given ongoing minimum wage increases. For example, the UK National Living Wage rose by c.6.7% in April 2022 and is set to rise by a further c.9.7% in April 2023. However, we think that some UK retailers may not see the full effect of this second round of wage inflation, as they chose to raise salaries by more than c.6.7% in 2022 in order to retain talent and, as such, are already paying colleagues more than the National Living Wage.
In general, we note that the most labour-intensive element of running stores tends to be around point of sale. As such, we note that digital initiatives, such as the roll-out of self-checkouts should, in time, help to lower the labour requirement and, as such, the cost burden.
Source: Government websites, Eurostat, RBC Capital Markets
Rental market still fairly benign
In general, rent tends to be the second largest element of a retailer’s operating cost base. We believe that retailers have been benefiting in recent years from rental cost reductions, with double-digit reductions seen across the pandemic. We think that this has been higher for the High Street, and to a lesser degree for the more desirable, out-of-town, retail park locations.
We believe that rental reductions have stabilised somewhat now, with retailers still seeing some reductions, but to a smaller degree. We see that rates are still falling somewhat in the UK, but have broadly stabilised in France and in Germany. In Spain, rates were stable for much for 2022, but rose in Q4. Additionally, we believe that increasingly, rental terms are moving in favour of retailers, towards shorter lease lengths and more flexible terms (e.g. break clauses).
Generally, we think the retailers in our coverage are taking more care when choosing new locations and would rather wait for the right site to become available at a good price. Space reductions, which were a theme in the sector in the years leading up to the pandemic, have now more or less stabilised.
Source: Datastream, Bloomberg, Government websites, Savills, Collliers
Energy cost pressures easing
In general, energy costs tend to be only a small proportion of operating costs for the average retailer, at c.1-2% of sales. In our General Retail coverage, the exceptions to this would be: 1) ABF, which has high energy requirements in its Food business, particularly in Sugar, given that sugar production tends to be energy intensive; 2) M&S, given the cost of refrigeration in its Food business.
We note that a reduction in energy costs should be a benefit for operating margins, albeit we expect this to come through in the latter part of 2023/early 2024, given a number of retailers have already bought a significant proportion of their 2023 energy requirement in advance. We believe that the larger benefit of energy cost reduction is likely the impact on consumer balance sheets and spending power. Although UK energy rates remain high, these have been falling for c.6 months now and, as such, we believe that the outlook for consumers looks better now, from H2 2023. In Europe, electricity prices have fallen somewhat in recent months, and household gas prices remain high but are set to fall later this year.
Source: Energie-Control Austria, MEKH, VaasaETT, RBC Capital Markets
Financial resuts and forecast – Apparel Retailers in Europe
Source: Company reports, RBC CM estimates, Reuters
Read and compare data from May-July 2022: Fashion Industry Update Q4 2022