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U.S. Apparel Profits Facing Some Risks

Higher input costs, weak demand could slow operating profit growth to between 6 and 8 percent this year, Moody’s says.

The headwinds are blowing harder than the tailwinds.

Moody’s Investors Service this week issued a report tamping down its expectations for earnings and sales among apparel and footwear vendors for the year. But the downward pressure on earnings isn’t coming as much from weak demand, which has some signs of strengthening recently, as much as it is the threat of higher costs.

Just as consumers are still facing rising gasoline prices and the prospects for higher prices at the supermarket after weathering higher home-heating costs during the winter, apparel vendors know that they could be dealing with higher production and raw-material costs, as well as higher energy prices that could further lift manufacturing and distribution expenses.

Companies with strong brand franchises are seen as having a far better ability to pass on those costs to their customers than those selling unbranded merchandise or less recognizable brands.

Moody’s vice president and senior credit officer Scott Tuhy originally expected operating income in the apparel and footwear sector to grow between 7 and 9 percent this year, but brought the forecast down a point to growth of between 6 and 8 percent.

He also lowered revenue expectations for the year, to a range of between 4 and 6 percent from earlier expectations of between 5 and 7 percent.

In 2015, he expects the rise in profits to slip to between 4 and 6 percent with revenues growing at the same pace.

While maintaining its “positive” outlook for the U.S. apparel industry, Moody’s said it could change that rating to “stable” should the prospects for operating profit growth fall below current expectations and into the range of 2 to 6 percent.

“This would most likely occur if revenue growth was subdued or if input costs or other pressures suggested that operating margins could erode,” the report said.

Tuhy told WWD that he views better managed inventories and expansion of e-commerce and international operations as providing opportunities for companies to outperform general expectations.

“Companies essentially have two levers to get help on margins,” he said. “One is pricing, for the companies that have the power to influence it, and the other is managing inventories at better levels. Last year, inventories were a little higher across the industry and there was a lot of promotional pressure. Better alignment with demand could help ease the markdown pressures.”

He noted that many consumers remain reluctant to spend. “People still have to pay their heating bills from the winter that is allegedly ending and there has not been a lot of wage growth,” he noted. “We’ve seen some good numbers for auto and home sales as those purchases can only be deferred so long, but once consumers make them, they’re going to have payments for the next few years. That puts more of a stretch on the wallet for items like apparel and footwear.”

Although apparel suppliers have offset the impact of higher wages in China by shifting production to markets like Vietnam and Bangladesh in some cases, they will still be confronted in all likelihood by higher input costs for raw materials.

“We’re not talking about anything like what happened when cotton went above $2 a pound, but we are expecting rising prices in the back half of the year,” he said.

Cotton sold for a low of about 75 cents a pound in late 2013 but has moved to 88 cents a pound recently.

Wages in China have been increasing at a rate of about 10 percent a year and labor generally accounts for about 20 percent of the cost of manufactured goods.

Earlier this week, Richard Noll, chairman and chief executive officer of Hanesbrands Inc., told The Barclays Retail and Consumer Discretionary Conference that, even with occasional peaks of more than 90 cents a pound, he expected the average price for cotton this year to remain about the same as last. “There’s speculation that China has been hoarding and now they’ll release it to the market,” Noll said. “That may actually put downward pressure” on prices.

Craig Johnson, president of Customer Growth Partners, is among those who believes that pressures on disposable income will keep retailers in a defensive posture for the foreseeable future. “What we see in the malls, and off mall, is not retail in balance, but actively decelerating, well worse than economists and some others believe,” he said. “The much-touted April-Easter rebound was more of a dead-cat bounce and weakness continues in all areas but part of luxury, but notably in apparel, general merchandise, sports and toys, and home.”

There are some hopeful signs, however. Economists and analysts were encouraged Thursday by the Commerce Department’s report that consumer spending rose 0.9 percent in March and that the February increase in spending, originally recorded as 0.3 percent, was revised upward to 0.5 percent. And whatever its implications for people’s retirements and preparation for rainy days, a drop in the savings rate, to 3.8 percent in March from 4.2 percent in the prior month, was perceived as a hopeful sign for retail spending going forward.

“It is clear that many Americans headed out to the shopping mall and automobile dealership in March after staying home and cranking up the heat for the first two months of the year,” commented Chris Christopher Jr., director of consumer economics at IHS Global Insight.

What isn’t clear is what share of these liberated dollars will flow to apparel stores and broadlines retailers who stock apparel.

“A lot of the strength we’re seeing in first-quarter spending trends isn’t really coming from the discretionary categories,” he told WWD. “It’s coming from health care and natural gas. Even looking at apparel, when the cold weather hit and stuck, that took care of a lot of cold-weather categories, but didn’t do much for the rest of apparel.”

He noted that luxury apparel continues to do well “because economic equality is up and the stock market’s doing well,” with the Dow Jones Industrial Average recording its highest close ever on Wednesday.

“But there’s great bifurcation,” he added, as less affluent consumers deal with higher fuel and grocery prices and some with reductions in food stamps and the loss of unemployment benefits.