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5 Retail Stocks That Can Withstand Rising Costs

While sourcing costs are expected to put pressure on the entire sector, some retailers are better able to fend off price increases.



) -- As though retailers don't have enough to contend with, the sector is now facing a perfect storm of rising cotton, labor and freight costs.

Even with these troubles surfacing in the second-half of the year and into 2011, there are several retailers that are well positioned to overcome the obstacles of rising costs


a depressed consumer.

Here's a look at which retailers will be able to best withstand the pangs of sourcing pressure...

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long-term relationships with its five main vendors should help protect it against material cost increases.

The teen retailer pro-actively moved a bulk of its sourcing to countries like Mexico and Guatemala to boost speed-to-market and ability to quickly reorder goods, leaving it only about 30% exposed to China, according to UBS.

Aeropostale has also narrowed its fabric choices, which helped to reduce costs, and nearly all of its merchandise is transported via boat, which is significantly cheaper than moving goods by plane.

Unlike many retailers, Aeropostale has not seen a significant increase in sourcing costs for the second half, with back-to-school costs remaining flat and only a slight uptick for the holiday season. This should limit pressure, at least in the remainder of 2010.

Aeropostale's cost break down is 38% raw materials, 36% labor and 26% freight and other expenses, according to UBS estimates.

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"Among the teen retailers, we think Aeropostale has the most ability to raise prices on the margin, given that it is structured to sell goods profitably at lower prices," UBS wrote. "Thus, a small increase in average unit prices like $1 will be less noticeable to customers, but could be a material percent increase to Aeropostale."

Still, by the end of the second quarter Aeropostale's Achilles heel began to reveal itself. While the retailer has traditionally been dubbed the value-priced leader, deep discounts from rivals

American Eagle Outfitters

(AEO) - Get American Eagle Outfitters Inc. Report


Abercrombie & Fitch

(ANF) - Get Abercrombie & Fitch Company Report

, started to eat away at its market share.

As a result, Aeropostale is showing some cracks, issuing third-quarter guidance that fell short of Wall Street's estimates. This could indicate the retailer may not be as successful in passing along cost increases as the market would like to believe.



(CHS) - Get Chico's FAS Inc. Report

began focusing on improving its sourcing strategy in 2009, giving it a head start in dealing with this year's emerging pressures.

The women's apparel retailer hired Ronald Shulman from

J.C. Penney

(JCP) - Get J. C. Penney Company, Inc. Report

to head the sourcing efforts, reporting to CFO Kent Kleeberger, who helped start direct sourcing at

Tween Brands


Chico's also entered into a partnership with

The Connor Group

to improve quality assurance, reduce transportation costs and increase transparency across all cost lines, UBS said. Connor has a strong knowledge base in Asia, which Chico's can also use to its advantage.

This sourcing initiative is expected to contribute about 200 basis points to margins starting in the second-half of 2010. Chico's does not expect significant cost increases.

"While raw materials and labor are expected to increase, this should at least be offset by the company's initiatives: negotiating directly with mills rather than through vendors, consolidating sourcing efforts across three brands, plan to better negotiate transportation costs, will try to fill shipping containers with more units to lower costs," UBS wrote. "Management even indicated that there may be upside opportunity."

But Chico's efforts to diversify out of China, where it has 66% exposure, haven't come without repercussions. In the first half of the year its White House/Black Market chain experienced production issues with skirts and dresses that were assembled in a new factory, UBS analyst Roxanne Meyer made note. "While

the factory is no longer being used, we believe quality

and delivery issues could be related," she wrote.

Limited Brands

Limited Brands


is more focused on getting new merchandise to its stores quickly and as often as possible, rather than reducing costs.

Only about one-third of Victoria's Secret product is sourced out of China, and all of Bath & Body Works is domestically produced, according to UBS. Costs are expected to be flat in the second-half of 2010, but Limited warned it could see some pressure into 2011.

"We believe Limited has the ability to pass on price increases to the customer, particularly when it offers new technology, stylings and features in its bra launches, though less so on some of its core initiates," UBS wrote in a note.

Limited Brands also has the lowest exposure to cotton given that 40% of its business in beauty and a majority of bras are actually not cotton based.

Urban Outfitters

Urban Outfitters

(URBN) - Get Urban Outfitters Inc. Report

realized early on that it would have to contend with higher sourcing costs as a result of less supply and more demand.

Anticipating this, the specialty apparel retailer began implementing strategies to counteract these threats in mid 2009.

Urban Outfitters has added product engineers at each of its brands to find more efficient, cost effective ways to manufacture goods. There is also an initiative to shift to direct sourcing from agent sourcing, which could be 160 basis points margin opportunity over the next several years, UBS said.

Urban Outfitters does not expect to see cost increases in the second half of the year, but admitted it could start to feel some pangs in 2011, negatively impacting margins.

"While there may be pressure on the company's initial mark up rate, management believes that opportunity for further cost reductions remains," Stifel Nicolaus analyst Richard Jaffe wrote in a note.

With its unique merchandise at namesake and Anthropolgie chains, it would be easier for the company than most to pass off some price increases if necessary.



(WMT) - Get Walmart Inc. Report

sheer size gives it an advantage when negotiating with manufacturers. While factories in China may have gained some measure of control recently, they have limited power up against the retail giant.

Over the past year the discounter has ramped up its grocery offerings, forsaking some of its discretionary categories in the process. Wal-Mart has even openly admitted that it has lagged its competitors when it comes to apparel. Ironically enough, this could work in Wal-Mart's favor, as cost increases tend to impact general merchandise categories the most.

While Wal-Mart does not regularly break down its imports, in 2007 China made up $32 billion, or about 11%, of costs of goods sold, according to UBS.

"Our sense from discussions with Wal-Mart management and suppliers is that the company is taking an open-minded approach to prospects for justifiable price increases," the firm wrote in a note.

Since Wal-Mart's emphasis is on "Everyday Low Price," this could constrain its ability to pass along costs to its consumers. However, since Wal-Mart is, no doubt, the price leader, there could be some wiggle room for consumer acceptance if it decides to narrow the price gap with non-discounters.


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>>Retails' Regional Sourcing Exposure

--Written by Jeanine Poggi in New York.

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