Although the EBITDA margins (earnings before interest, tax, depreciation and amortization) for Ann‘s (NYSE:AEO) Ann Taylor stores have been on an upward trajectory for the past few years, we expect them to stabilize going forward. From 16% in 2008, the margins increased to 20.7% in 2009 due to an increase in full price sales as a result of better inventory planning and cost savings through the store restructuring program.  The figure further rose to 22.8% in 2010 driven by increased full price and non-full price sales due to improved merchandise mix and effective marketing. However, it dropped to 21.7% in 2011 due to a sudden rise in cotton prices and holiday inventory hangover that forced the company to resort to promotions. The figure remained stable in 2012.
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We expect Ann Taylor’s EBITDA margins to increase slightly in the future and stabilize at around 22-23%. While lower cotton prices, better inventory control and product specific promotions will help, a balanced pricing strategy can act as an offsetting factor. Moreover, the retailer’s over reliance on China for its inventory poses a threat due to rising labor costs in the region.
Lower Cotton Prices Should Have A Positive Impact
From $0.84 per pound in July 2010, cotton prices rose to $2.30 per pound in March 2011.  The major factor behind this price increase was the drought in Hubei province of China, a major cotton producing area.  Government restrictions on exporting cotton out of India and a devastating flood in Pakistan further contributed to the supply shortage.   As cotton is one of the key raw materials for apparel retailers, a sudden spike in cotton prices resulted in an increase in manufacturing costs. However, cotton prices declined to $0.83 per pound by the end of 2012 as China recovered from the drought and India eased its regulation on cotton export. 
With China steadily building up its cotton reserves, we do not expect cotton prices to go up.  Currently the country holds a record cotton inventory of 10 million tons, which has brought the U.S. cotton prices per pound down from 88 cents in 2012 to 71 cents in 2013. With ample cotton reserves and lower prices, retailers such as Ann should be able to reduce their manufacturing costs and sustain margins.
Disciplined Inventory Control Will Result In Fewer Markdowns
The inventory hangover during the latter half of 2011 forced Ann to increase promotional levels on its merchandise, which took a toll on its margins.  This was primarily due to an imbalance in the company’s holiday merchandise that resulted in inventory pile-up. However, with its merchandise design and production strategy, Ann was able to quickly respond to this issue. Its impact was clearly visible in Q4 fiscal 2012 when the retailer reduced the inventory of suits and shoes in the prior quarter, which resulted in fewer markdowns for Ann Taylor. ((Ann’s Q4 fiscal 2012 earnings transcript, Mar 8 2013))
A significant portion of Ann’s products is developed in-house exclusively by its product development and design teams.  The merchandising group determines the inventory needs of the upcoming season, passes on the requirements to the design team, and plans a merchandise flow system for different manufacturers. This strategy enabled the retailer to add a greater depth in color choices, versatility and key fashion trends, which was reflected in its strong performance through the most of last year. The timely launch of refreshing changes such as vibrant colors in tops, dresses, skirts, woven tops and knit dresses helped Ann operate with fewer promotional discounts. As a result, Ann Taylor did well through the spring, summer, fall and even the weak holiday season.  The retailer reported an improvement of 20 basis points in its gross margins in fiscal 2012.  Maintaining discipline in merchandise design and production strategy should enable Ann to further increase its margins.
Balanced Pricing Strategy & Product Specific Prmotions Will Have A Mixed Impact
In order to attract different customer demographics, Ann employs a balanced pricing strategy and product specific promotions. This approach is aimed at increasing the product variety at the opening price tier and subsequently focusing on promotional discounts on specific products rather than store-wide promotions. Increasing the product variety at opening price tiers will push the merchandise mix towards cheaper products, which have relatively lower margins. On the flip side, product specific promotions will positively impact Ann Taylor stores’ margins.
Over Reliance On China Can Increase Manufacturing Costs
Due to a shortage of labor, an aging Chinese population and government regulations, there has been a substantial rise in China’s labor costs. The development of rural areas has encouraged the local population to look for work opportunities in their vicinity. This has prevented the migration to urban areas resulting in less and expensive labor. About 200 million Chinese are expected to be above the age of 60 by 2020, which will further add to the labor shortage.
Additionally, Chinese government regulations require minimum wages to be raised every two years.  Back in 2001, the minimum wage in China was about $58 cents per hour and has increased by about 15%-20% annually.  The rise in labor costs has translated into an increase in production costs, which has hurt a number of retailers. By 2015, the minimum wage is expected to reach $6 per hour and it might become cheaper to manufacture goods for the U.S. market in America itself. 
This is a big threat for Ann as it sources almost 40% of its merchandise from China, which accounts for around 43% of its total merchandise costs.  For safeguarding its margins, the retailer will have to reduce its dependence on China and look for other low cost destinations. The most viable option appears to be Vietnam as currently its labor costs are about half of China’s.  Ann also sources a limited portion of its merchandise (16%) from Vietnam, but it only accounts for 9% of its merchandise costs. 
The Significance For Ann
We currently forecast Ann Taylor’s EBITDA margins to remain stable at 22-23% in the long term. However, if Ann maintains its strong inventory control, it might be able to operate with relatively fewer discounts. Moreover, if the retailer starts shifting its manufacturing activities to other low cost destinations, it can reduce its production costs. If this pushes the margins to 26-27% in the next five-six years, there could be 5-10% upside to our price estimate. On the contrary, if Ann faces another merchandise imbalance and continues to source most of its products from China, its margins may come down. In a scenario where the figure reduces to 18-19%, there could be 5-10% downside to our price estimate.
Our price estimate for Ann at $35, implying a premium of about 20% to the market price.Notes:
- Ann’s SEC filings [↩] [↩] [↩] [↩]
- Cotton Monthly Prices, Index Mundi [↩]
- Cotton Gains on Reports of Chinese Drought; Orange Juice Falls, Bloomberg, May 19 2011 [↩]
- Cotton Prices Jump As India Bans Export, FT, March 6 2012 [↩]
- Losses Loom As Pakistan Flood Hits Cotton Crop, FT, Aug 19 2010 [↩]
- India Eases Restriction On Cotton Exports, Economy Watch, May 1 2012 [↩]
- China’s Cotton Stockpiling Threatens To Devastate American Producers, Fox News, April 12 2013 [↩]
- Ann’s Q4 fiscal 2011 earnings transcript, March 9 2012 [↩]
- Ann’s Q4 fiscal 2012 earnings transcript, Mar 8 2013 [↩] [↩]
- China Initiates New Rounds Of Minimum Wage Increases, China Briefing, Jan 4 2013 [↩]
- Chinese Labor, Cheap No More, The New York Times, Feb 17 2012 [↩]
- As Chinese Wages Rise, US Manufacturers Head Back Home, The Christian Science Monitor, May 10 2012 [↩]
- China Labor Cost Rise To Boost Rivals In Asia, CNBC, Jan 17 2013 [↩]