How to Trade Retail's Rising Costs

NEW YORK ( TheStreet) -- As though retailers don't have enough to contend with, the one area of their businesses that has actually been an almost constant positive for the sector may now begin to put pressure on stocks.

After enjoying a decade of a favorable sourcing environment, production costs are now on the rise. Prices for cotton have nearly doubled over the past year, capacity in China is drying up and freight costs are starting to increase. This leaves retailers, who have just barely regained their footing, in the unenviable position of having to decide whether they should attempt to hike prices and pass along some of these costs to consumers, take a hit on profitability or lower the quality of their product.

A recent survey of executives from private consumer, industrial and technology companies found conducted by Credit Suisse found that nearly 40% had seen costs for China-sourced goods increase at least 6% from last year.

While the logical answer to this problem would be to increase prices, consumers' unwillingness to purchase goods at full-price makes that easier said than done. The question now being debated is should retailers raise prices and risk losing customers or take the hit on their bottom line?

Retail Picks for Sourcing Pressures: China Watch

This triple headwind will force retailers to reconsider how they produce merchandise and could permanently alter relationships with China. The takeaway for investors: be skeptical of those retailers that are not working to diversify their production portfolios.

Cotton Tale

Cotton, of course, has been the most watched headline. This isn't surprising, given cotton can represent anywhere from 55% (denim) to 90% (tops) of a garment's total production cost. With cotton prices up 50% year-over-year, this could translate into a 5% increase in the cost of raw materials for retailers, according to UBS estimates.

The bulk of the world's cotton comes from China, India and the U.S. Over the past year production in all of these regions has declined due to the closure of factories, poor weather in China and a ban on raw cotton exports from India. Flooding in China, alone, could reduce cotton output between 5% and 10%, according to UBS.

On top of this, now Pakistan, which is the fourth-largest cotton producer, is experiencing the worst flooding in decades. With a chunk of its cotton drowning, the floods are estimates to have destroyed nearly 30% of Pakistan's cotton crop.

The U.S. Department of Agriculture forecasts world cotton consumption will rise by 1.2 million bales over the next year to 120.9 million, potentially leaving a shortage of 4 million bales between production and consumption.

  Which Retail Stocks Can Withstand Sourcing Pressure?
  Which Retail Stocks Will Be Hurt By Higher Sourcing Costs?

But a bumper crop in the U.S., and India resuming exports in October, could help rebuild some global inventory.

Cotton prices are expected to have only a modest impact on the second half of the year, but should become a more meaningful issue in 2011.

"Given the low supply, factories are willing to pay more to get cotton sooner so that they can fill retailers' orders, which are continuing to drive up prices," UBS wrote in a note.

The teen sector is the most exposed to rising cotton costs and must now try to balance the heavy promotional environment with the potential need to slightly increase ticket prices to offset these costs.

It is also worth noting that other raw materials, such as silk, are seeing price increases as well, though much smaller than that of cotton.

Factory Facts

Chinese manufacturers are finally getting the upper hand after decades of being under the control of retailers. Given that China is the source of most retail production, this may end up being an even bigger issue that cotton costs.

Labor shortages and wage increases are expected to drive up costs between 15% and 20% at least through the first-half of 2011, according to UBS. These increases are being driven by fewer people entering the labor force as the Chinese economy grows, and a shrinking surplus in labor due to years of the government's "one child only" policy.

Phoenix Institutional Equities analyst Robert Samuels is also hearing that the new class of factory workers along the coast is not willing to put in overtime hours like their parents once did.

Currently, the average Chinese worker earns $3,900 a year, up from $1,900 in 2009 and $1,000 in 2000, according to Credit Suisse. The firm found that 40% of executives are "very worried" or "extremely worried" about wage pressure in China.

Aside from costs, there is an added risk that labor shortages could result in late and unfulfilled orders, as well as quality control issues. UBS warns that many retailers may find it difficult to get 100% of their fourth-quarter orders delivered.

In light of this, look to those retailers that anticipated these labor issues and proactively shifted production outside of China over the past several years, UBS advises. These companies will have a significant advantages over those who are now scrambling to find other markets for production.

  Which Retail Stocks Can Withstand Sourcing Pressure?
  Which Retail Stocks Will Be Hurt By Higher Sourcing Costs?

Relocating manufacturing to other markets is not a painless process. Nearly one-half of respondents in Credit Suisse's survey said it is "not easy at all" to move sourcing out of China.

Tertiary Asian countries are already at, or over, capacity. The Middle East needs more time to develop its infrastructure, and there is talk of building new factories in Africa, but that will take time and therefore fails to offer a viable a short-term solution, according to UBS. Latin America is one of the only regions that still has some wiggle room and is being under-utilized.

To The Sea

Even if retailers are able to mitigate cotton and labor costs, they'll still have to face rising freight costs. Trans-Pacific ocean freight costs bottomed last year, but this tailwind is now turning into yet another headwind.

As inventory levels fell throughout 2009, containership fleets cut capacity and raised prices. At one point as much as 10% of the global containership fleet was laid up and idled in Asian waters. Now, as retailers rebuild inventory levels, much of the merchandise is left sitting on the ocean.

Also, as a side effect of China's labor shortage, retailers may be turning to air freight to get merchandise into the U.S. in time for the holiday season, which is significantly more expensive than boat transportation.

Samuels heard from one footwear retailer that prices have gone up to $10 from $6 to ship one pair of shoes via air plane.

Still, while freight costs are up substantially year-over-year, they are about normal compared with historical levels.

How To Invest

No retailer is really safe from these threats, and anyone who discusses "strong partnerships" with their manufactures are most likely alluding to longer-term aspects, not negotiations on near-term pricing increases or changing vendors, UBS warns.

There's a sliding scale to determine which retailers will be affected by which pressures. The more basic the product a retailer produces, the more raw material costs account for total product costs, while the more sophisticated the product, with intricate detailing, the more labor costs will come into play.

Taking this into account, UBS says teen retailers will have the highest exposure to raw materials while women's retailers that cater to a higher-income consumer will have merchandise that is more labor intensive.

There are some companies that will be able to better handle these headwinds. Read on to see which retailers can withstand price increases and which retailers will most likely buckle under the pressure.

  Which Retail Stocks Can Withstand Sourcing Pressure?
  Which Retail Stocks Will Be Hurt By Higher Sourcing Costs?

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--Written by Jeanine Poggi in New York.

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