Women’s specialty retailer Ann (NYSE:ANN) sources about 40% (as of 2012) of its goods from China, which accounts for close to 43% of its total merchandise cost. On the other hand, merchandise sourced from Vietnam accounts for just 9% of the cost but 16% of the total units. This clearly indicates that per unit cost of production for Ann in China is much higher than its other sourcing locations such as Vietnam, Indonesia, Cambodia, etc. This is attributable to the fact that China, which was once known for its cheap labor, has seen a tremendous rise in labor wages over the past decade. It explains why Ann has been gradually shifting its sourcing from China to its neighboring countries.
However, considering the improving efficiency of China’s manufacturing plants and the region’s highly developed infrastructure, rising labor costs seem less of a threat. Although minimum wages have risen at a rapid pace over the past few years, labor costs per unit have not risen as sharply due to increasing productivity. A number of foreign companies are investing in other countries with low cost of labor, but their relatively less developed infrastructure can actually impact productivity.
Therefore, we believe that even though exploring other low cost destinations is an inevitable move for Ann, it should not be aggressive in this approach. At the moment, China remains the best option for Ann’s merchandise sourcing given that the region hasn’t troubled the retailer in the past. Its gross margins increased steadily during 2008-2012 (except 2011 when margins declined due to a sudden rise in cotton prices), even as China’s labor costs were soaring.
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Our price estimate for ANN stands at $41, implying a premium of about 20% to the market price.
Labor Costs In China Are Rising
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. Also, China’s population is aging and about 243 million Chinese are expected to be above the age of 60 by 2020.  The younger generation is preferring to go to colleges instead of working in factories due to better education awareness and opportunities.  These factors are further adding to the labor shortage. Over the past decade, business owners have seen blue-collar pay increase five- to nine-fold.
The Chinese government’s 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 almost 20% annually for a decade.  This, along with a strengthening Chinese currency, has pushed companies to direct their investments to other low-wage Asian countries.
However, It Is Still A Good Option For Ann
Despite the rising labor wages, China still remains the hub for manufacturing activities for foreign companies. The second largest economy in the world recently reported its highest annual trade surplus since 2008, indicating that rapidly increasing labor costs are not troubling its exports.  U.S. companies such as Ann have been able to buy products at reasonable prices as the efficiency of Chinese manufacturing plants has increased substantially. Several manufactures in China have started automating their factories, thus reducing their labor requirements. As a result, labor costs per unit have not increased as rapidly as minimum wages.  Moreover, with the huge volumes of products China manufactures, it has been able to absorb increasing labor costs to a certain extent.
Labor wages in China are three times that of Indonesia, four times that of Vietnam, five times that of Cambodia and ten times that of Bangladesh. Although these countries appear as attractive sourcing destinations, dealing with their infrastructure issues results in additional costs and low efficiency. For instance, manufactures have to install expensive power back up systems to tackle unexpected power outages. 
Over the past few years, Ann has gradually reduced its dependence on China and has started sourcing more to Vietnam, Indonesia and India due to their labor cost advantages. Ultimately as their infrastructure improves, this might help Ann save more money in the long term. However, China will still remain an important market for manufacturing services. According to Bureau of Labor Statistics data, average prices for U.S. imports from China declined by 0.9% in 2013.  This should encourage U.S. retailers such as Ann to remain focused on China.Notes:
- China’s bid to provide care systems for elderly faces hurdles, warn experts, South China Morning Post, Sept 4 2013 [↩]
- Even as Wages Rise, China Exports Grow, The New York Times, Jan 9 2014 [↩] [↩] [↩] [↩] [↩]
- China Initiates New Rounds Of Minimum Wage Increases, China Briefing, Jan 4 2013 [↩]
- China Manufactures Survive by Moving to Asian Neighbors, The Wall Street Journal, May 1 2013 [↩]