A 10% tariff increase on goods imported from China wouldn’t impact apparel and retail companies that much, but a hike to 25% could make investors more bearish on the sector.
Looking at a few what-if scenarios, equities analyst Jay Sole at UBS came to two key conclusions: there’s a possibility that no price increases get passed along, and the industry could see margin erosion from too much discounting as the economy slows and stores shutter.
When it comes to price increases, the analyst said the abundance of goods available from other countries, particularly from online marketplaces, could make it hard for retailers to raise prices. Moreover, there are “far too many ways for consumers to search for cheaper goods online for price increases to hold. We imagine marketplaces like Amazon, eBay [and others] would be full of goods available at ‘regular’ prices,” Sole said. And he noted that the experience at retail with tariffs placed on imported home goods from China “suggest raising prices will be hard.” The analyst also pointed out that even if a company can raise prices, it will run the risk of hurting sales.
But an even bigger issue for companies in the fashion sector could be what happens if economic activity slows.
Watch on FN
Tariffs can be absorbed when the economy is strong and growing, but less so when there’s a contraction.
UBS’ U.S. equity strategist Francois Trahan believes the U.S. economy is about to enter the late stage of a business cycle, a scenario that the strategist said could be bad for stock prices in general. And in a slowing-economy scenario, if the tariff rate is too high, Sole believes it would likely “cause widespread store closures.” And when that happens, promotional activity jumps as closing stores liquidate to clear inventory. What’s more, Sole said job losses are likely to increase, which then “compounds the effect of the tariffs themselves.” Those are the reasons the analyst thinks the tariff “impact would be greater than many realize.”
In a separate report on the impact from a tariff hike earlier this year, the analyst projected that $40 billion in retail sales and 12,000 store closures could be at risk.
In general, most softlines companies already have strategies in place to offset cost increases, whether through consolidation of vendors, reduction in unit orders or manufacturing capacity outside of China. Those initiatives, including agreements with manufacturing partners where they agree to share in the cost increases, help to offset a 10% tariff. Because different companies have different initiatives and arrangements, Sole estimated that a 10% tariff increase on a direct cost basis would likely cause fiscal year 2020 earnings per share estimates to drop 10%. More important, most companies would likely see an earnings recovery by fiscal year 2021.
In contrast, a 25% tariff hike, using the same direct cost basis, would see a corresponding EPS decline by 25%. But the worst case scenario would be a 25% tariff hike while there’s a global recession, and that’s where the apparel and retail sector would see the most impact, including weaker demand, significantly elevated inventory levels and retail bankruptcies. According to Sole, EPS estimates could be lower by as much as 59%, presuming certain variables see little change, like the inability to migrate production out of China.
Looking at the apparel and retail stock in his coverage universe, Sole said Nike, Lululemon and VF Corp. could be “secular winners” in Wall Street parlance since all three are already well positioned, have EPS growth and have brand names that investors would be willing to own.
Those that have weak earnings outlook are deemed “highly cyclical” or “structurally challenged.” According to the UBS analyst, retailers Macy’s and Gap — and maybe Kohl’s — fall into that scenario, mostly because price-earnings ratios are already at or near 20-year lows, and could go lower if EPS falls significantly.
The big question marks are companies like HanesBrands and PVH. That’s because private label companies tend to get hurt since much of what is manufactured is produced in China. That scenario could create market-share opportunity for national brands, particularly if retailers like Walmart and Target bring in more nationally-branded merchandise because of their pricing power. Whether this would actually happen is debatable — Sole acknowledged that there’s little historical precedent to know conclusively whether this scenario would be a component of the investor mindset when they do their analysis for stock picks.
One retail channel that could do well is the off-price channel, although it, too, can get hurt initially and see stock prices drop before rising again.
Sole said retailers in this sector have more exposure to Chinese imports than anyone realizes. What could change investor sentiment after the initial decline in share price is the expectation that off-price “takes very big market share in fiscal year 2021,” which keeps price-earnings ratio high and investors more interested in the stock.
According to companies in his research universe, the UBS analyst pegs off-prices TJX Cos., Ross Stores and Burlington Stores as having 50% of its total manufacturing in China. They are followed by Nordstrom, Kohl’s, Macy’s and Skechers at 40%. American Eagle Outfitters, Ralph Lauren and Under Armour are at 30%, followed by Capri Holdings and Nike at 25%, and Gap at 22%. Limited Brands, Tapestry and VF Corp. are at 20%, followed by PVH at 18%, Lululemon at 10% and HanesBrands at 5%.
It’s hard to tell what the impact will be on companies’ income statements until they report fourth quarter results. Most retailers follow the retail calendar, which means the closing date for their fiscal year is the end of January or very early in February. Earnings reports on how well they did — or not — start to flow in around March.
Editor’s Note: This story was reported by FN’s sister magazine Sourcing Journal. For more, visit Sourcingjournal.com.