6/22/2010
By Brian Sozzi, Research Analyst

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The market sent shares of retailers down a bundle on the Chinese pre-G20 decision on the Yuan, and the move was not an overreaction in my opinion.  As measured by the S&P Retail Index, retail stocks fell 2.3% by the close of trading, though there were some more pronounced declines ranging from 5% to 8% depending on sector of retail.  However, by reading the comments from executives at leading retailers, one would be led to believe the news was the greatest thing since sliced bread.  Check out the following comments from an unnamed CEO whose company is a big cultivator of products from China but not a big seller of goods in the country: "for us, I would say the net is going to either be neutral or positive."  Huh?  So let me get this straight, the currency rises where you source product from, you are not a major brand in China, and yet there will be zero detrimental impact to earnings on the 12-24 month time horizon?

Pardon my tirade, it just irks me to hear this type of comment, which essentially confuses a shareholder base and questions a CEO's integrity.  The fact is fairly straightforward; a higher Yuan will equate to higher product costs, likely starting to creep into discussions on products set to arrive in mid-2011.

The Yuan dynamic now joins the growing list of things retailers did not want to hear at this point in the year.  Consumers may be back in the malls and outlets with money derived from personal asset write -downs and mortgage refinances, and there are signs of demand for products at higher price-points, but the majority of John Q public is still very price sensitive.  Retailers experiencing increases on products readied for sale will try to raise prices to the end consumer, therefore jeopardizing the sales recovery than began late in 2009.

What Retailers were Concerned About Pre Yuan News

Higher cotton prices: Cotton prices are up 55% year to date as supply gets used up to meet the demand snapback that has resulted from improved economic conditions.  This is a serious problem for retailers, and one that will dent gross margins because there is no way merchandise prices can increase by the same amount in a still fragile economic recovery.  To combat the problem, companies such as Gap (GPS) and American Eagle Outfitters (AEO) have had to seek alternative countries for textile production.  The rise in Chinese wage rates is an added negative ingredient to the China manufacturing issue.  The hotspot of sorts for textile production seems to be India, which is the only cotton surplus country (lends to increasingly competitive prices).  Although manufacturers in India are displaying a willingness to eat the higher cotton prices to establish relationships with Western retailers, there are important considerations if you are the Chief Supply Chain Officer of a retailer.  They include:

* Unproven nature of a new supplier.  As a result, retailers are forced to slowly build a relationship by season, creating more supply chain complexity.
* Product quality
* Logistics
* Costs associated with moving production (actual cash costs and time)

Other: Inventory levels starting to creep up by design; cooling demand in May; increased transportation costs; how will investors embrace slowing earnings growth relative to the sharp increase in recovery in mid 2009.

How to Invest into this News...

Ideally, the retailer should be selling goods globally, and by that I mean have stores established in China and elsewhere around the world.  Having stores in China helps the retailer participate in the release of consumer demand that should arise from a stronger currency, while at the same time the global exposure mitigates potential cost increases (economics of scale).  For example, if Company X is a global brand and is a major account of a Chinese manufacturer, that manufacturer is more likely to eat the Yuan appreciation impact on his end than risk losing a client.  Eating a Yuan appreciation of 5%, to me, is less important than potentially losing a client that represents 90% of one's business.  I have indentified Coach (COH) as a logical way to invest into the Yuan news.  The company has a global brand on its hands, luxury no less.  With that luxury brand proposition, it's better positioned to raise prices to recoup higher costs in the supply chain.  Through a mixture of comparable store sales growth and new unit growth, Coach is positioned to grow its sales in China to $250 million annually by the end of calendar 2011, up from $50 million in calendar 2009.  The company's merchandise fetches higher prices in China relative to the U.S. and the brand is still a small percentage of the luxury goods market, suggesting margin killing saturation is not lingering on the horizon.

How Not to Investment in this News

Unless one is inclined to employ a strategy of shorting, I would temporarily avoid shares of apparel manufacturers (until 2Q conference calls in July, where color will be received on the Yuan impact) that are selling commodity type products and have limited store exposure to China.  A name that stands out is Bebe (BEBE), a company that is not a major global brand.  Moreover, its products are strikingly similar to H&M and Forever 21, which simply outperform Bebe on the price/value equation.  Bebe will likely have little leverage with its suppliers, try and raise prices that are already high, and in turn alienate customers.

Brian Sozzi
Wall Street Strategies