4 Retail Stock Losers: Rising Costs Victims

Retail stocks are poised to be hurt by rising production costs. Here are the stocks that could feel the most pressure.
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NEW YORK (

TheStreet

) -- After a brief reprieve, the woes of the retail sector are back, this time with the focus on rising sourcing costs.

After a decade of a favorable sourcing environment, the costs of cotton, labor and freight are rising, leaving some retailers scrambling to fend off these headwinds.

Here's a look at which retailers are most likely to crack under the pressure of rising costs...

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Abercrombie & Fitch

Abercrombie & Fitch

(ANF) - Get Report

is taking some of the bells and whistles out of select merchandise to cut costs. How this will sit with shoppers, who already have shunned the brand unless it's on the sales rack, remains to be seen.

The teen retailer has said it expects headwinds from cotton and labor increases in the second-half of the year, specifically in the fourth quarter. With 45% of its sourcing coming from China and a 75% exposure to cotton, according to UBS, there's no doubt it will be one of the more pressured retailers.

Still, Abercrombie believes it will offset some of these costs through its process initiatives and sees an opportunity to further cut average unit costs. During its second-quarter earnings call, management said it expects to hold product costs flat for spring 2011.

Analysts also expect Abercrombie, as well as most teen retailers, to get away with lowering the quality of its merchandise given the current deflationary environment.

Abercrombie, in particular, has been struggling to attract shoppers, resorting to deep markdowns to boost its top line. As a result, its margins have taken a beating, falling 150 basis points during the second quarter. Abercrombie also said inventory levels were up 47% at the end of the quarter, more than analysts expected, which could lead to further discounting heading into fall.

These factors, combined with sourcing woes, don't bode well for the company.

Dollar Tree

Dollar Tree's

(DLTR) - Get Report

$1 pricing strategy will limit its ability to pass along any additional costs to shoppers, which will most likely result in a margin squeeze.

J.P. Morgan cut its rating on Dollar Tree last week to underweight from neutral, saying tailwinds over the last couple of years are starting to turn into headwinds, including cheaper sourcing and freight costs. These low levels allowed Dollar Tree to improve its gross margin by 122 basis points last year, but that growth will surely wane.

Morningstar analyst Zoe Tan estimates operating margin just north of 10% for the year, despite the 170 basis-point increase in the year-to-date period.

Dollar Tree sources about 40% of its goods from China, according to Credit Suisse.

The discounter does, however, have the ability to offset some costs through changing its merchandise selection due to its "treasure hunt" format. "In other words, where it can't offer an item for the $1 price point, Dollar Tree could drop it in favor of carrying another item that can meet its price limit," UBS wrote in a note.

As of the first quarter, Dollar Tree said it had visibility into pricing through spring 2011 and made purchases on a large majority of its imports through Easter 2011.

Wall Street estimates 2011 earnings of $3.35 a share, but in a worst-case scenario, where costs rise 20%, that could fall to $2.24, Credit Suisse predicts, and that's assuming Dollar Tree's pricing power. Without that ability, earnings may be as low as $1.67 a share.

Target

Target's

(TGT) - Get Report

bigger selection in softline categories like apparel and home furnishings could make it more susceptible to rising sourcing and cotton costs than other discounters.

"As Target tends to convey a more fashion-forward selection in apparel and home versus basic assortments at its discounter peers, its input costs may therefore be more heavily impacted by increased global raw material costs and higher Chinese labor prices," UBS wrote in a note.

Target has indicated that a large portion of its merchandise is sourced outside the U.S., with China as the largest single source.

If costs rose 20%, Credit Suisse estimates that Target could take a whopping 40% hit to its 2011 earnings.

"Based on our discussions with Target management, we expect the company to pass on input cost increases, although economies of scale may represent a beneficial offset in limiting the magnitude of the pass through," UBS wrote. "Target management has stated to us that it feels better prepared than most, given its well developed sourcing platform and its nimbleness in

its ability to change inputs/ornamentation."

Coach

Despite

Coach's

(COH)

efforts to expand its manufacturing into new markets, its exposure to China remains high.

As a result, the handbag and accessories retailer foresees headwinds on higher raw materials and labor costs. This will make it increasingly difficult to replicate the gross margin expansion it posted in the first-half of the year.

To Coach's credit, it is working quickly to move sourcing to lower-cost regions like Vietnam and India. The company said it is on track to have 7% of its merchandise produced in Vietnam by the end of fiscal 2011.

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>>How To Trade Retails' Rising Costs

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>>Retails' Regional Sourcing Exposure

--Written by Jeanine Poggi in New York.

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