Ann Improves Gross Margins By Shifting Production Away From China

by Trefis Team
-1.19%
Downside
37.08
Market
36.64
Trefis
ANN
ANN
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Ann (NYSE:ANN) is one of the largest specialty retailers for women’s merchandise in the U.S. which offers its products at better and upper moderate prices. Due to the premium price points, the retailer garners higher gross margins (55%) than other players such as American Eagle Outfitters (NYSE:AEO) (40%) and Guess (NYSE:GES) (40%).

Barring 2011, when the margins declined due a sudden rise in cotton prices, Ann’s gross margins have increased steadily over the past five years. This can be attributed to the retailer’s balanced pricing strategy and decreasing dependence on China for merchandise. China no longer remains a low cost destination for foreign retailers as the region’s labor costs have been rising rapidly. As a result, a number of retailers are shifting their manufacturing activities from China to other neighboring countries with low labor costs.

Ann has been steadily cutting its merchandise sourcing from China over the past four years and is likely to continue doing this in the future. As the retailer moves to other low cost destinations such as Vietnam and Indonesia, it can lower its production costs and subsequently improve its gross margins.

See our complete analysis for ANN

How Have Ann’s Gross Margins Trended?

Ann’s gross margins grew steadily from 48.1% in 2008 to 55.8% in 2010 due to a strong market position which allowed the retailer to operate with fewer discounts. Ann follows a balanced pricing strategy in which it offers products across three different price points - good, better and best – and subsequently targets promotions to a fewer products. In 2011, the retailer’s gross margins declined to 54.6% due to a sudden rise in cotton prices, which resulted in higher production costs. From $0.84 per pound in July 2010, cotton prices rose to $2.30 per pound in March 2011. [1] The major factor behind this increase was the drought in Hubei province of China, a major cotton producing area. [2] Government restrictions on exporting cotton out of India and a devastating flood in Pakistan further contributed to the supply shortage. [3] [4] Ann’s margins improved slightly to 54.8% in 2012 as cotton prices declined. Apart from the aforementioned factors, its lower dependence on China for merchandise also helped to increase margins.

Why China Is Becoming Less Attractive For Outsourcing Production

Due to labor shortages, an aging 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 is preventing migration to urban areas, resulting in fewer workers and more expensive labor. Moreover, about 243 million Chinese are expected to be above the age of 60 by 2020, which will further add to the labor shortage. [5]

The Chinese government’s regulations require minimum wages to be raised every two years. [6] Back in 2001, the minimum wage in China was about $58 cents per hour and has increased by almost 20% annually for a decade. [7] Therefore, China no longer remains a low cost destination for Ann and hence, the retailer is looking towards other low cost destinations such as Vietnam.

Ann Is Gradually Moving Away From China

Back in 2009, Ann sourced about 50% of its merchandise units from China, which accounted for more than half of its overall merchandise cost. However, with rising labor costs, the retailer gradually lowered its dependence on the region. At the end of fiscal 2012, about 39% of Ann’s merchandise units came from China, which made up about 43% of its merchandise cost. [8] Going forward, if labor costs continue to rise, we expect the company to continue with this trend and increase its reliance on other countries such as Vietnam, Indonesia, and India. Labor costs in these regions are significantly lower than in China, which makes them viable destinations for Ann.

Currently, Vietnam’s labor costs are about half of those of China’s. [9] Monthly minimum wages in India range from half to one-fourth of China’s minimum wages. [10] Although minimum wages in Indonesia are on the rise, they still remain well below the wages in China. [11]

In 2009, Ann only sourced 6%, 12% and 10% of its merchandise units from Vietnam, Indonesia and India respectively. These figures increased to 16%, 15% and 15% in 2012. Vietnam is emerging as an important region for Ann as it accounts for just 9% of total merchandise cost despite a 16% unit contribution. [8] On the other hand, China’s merchandise cost proportion (43%) is higher than its units proportion (39%). Going forward, as the retailer continues to shift from China to other low cost countries in Asia, its production cost can come down. Ultimately, this will help its gross margins provided that cotton prices don’t fluctuate substantially.

Our price estimate for ANN stands at $39, implying a premium of about 10% to the market price.

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Notes:
  1. Cotton Monthly Prices, Index Mundi []
  2. Cotton Gains on Reports of Chinese Drought; Orange Juice Falls, Bloomberg, May 19 2011 []
  3. Cotton Prices Jump As India Bans Export, FT, March 6 2012 []
  4. Losses Loom As Pakistan Flood Hits Cotton Crop, FT, Aug 19 2010 []
  5. China’s bid to provide care systems for elderly faces hurdles, warn experts, South China Morning Post, Sept 4 2013 []
  6. China Initiates New Rounds Of Minimum Wage Increases, China Briefing, Jan 4 2013 []
  7. China Manufactures Survive by Moving to Asian Neighbors, The Wall Street Journal, May 1 2013 []
  8. Ann’s SEC filings [] []
  9. China Labor Cost Rise To Boost Rivals In Asia, CNBC, Jan 17 2013 []
  10. Comparison: Minimum wages in China and India, Asia Briefing, Jul 18 2013 []
  11. Indonesia Mulls Minimum Wage Boost Amid Protest: Southeast Asia, Bloomberg, Nov 13 2012 []
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