What Is Ann Doing For Its Margins In The Wake Of China’s Labor Cost Boom

Ann (NYSE:ANN), among the more popular upscale specialty apparel brands for women in the U.S., positions its quality merchandise at moderately higher prices. Due to these premium price points, the retailer’s gross margins are notably higher than those of some of the other apparel retailers such as American Eagle Outfitters (NYSE:AEO) and Guess (NYSE:GES). While Ann’s gross margins are around 54%, American Eagle and Guess have their gross margins at around 33% and 37%, respectively.

Barring 2011, Ann was able to steadily increase gross margins between the period of 2008 and 2012, by engaging in less promotional activity and lowering production costs. The retailer was able to successfully reduce its reliance on China, where per unit product cost is higher as compared other Asian nations such as India, Indonesia, the Philippines and Vietnam. Although the company’s gross margins declined in 2013, it was mostly attributable to the highly promotional environment in the U.S.

Over the past several years, labor costs in China have increased significantly, which has resulted in a rise in production costs for several U.S. companies. Ann has been steadily cutting its merchandise sourcing from China over the past five years, and is likely to continue doing this in the future. As the retailer moves to other low cost destinations such as Vietnam and Indonesia, it can lower its production costs and subsequently improve its gross margins.

Our price estimate for ANN stands at $36.64, which is just below the current market price.

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Ann’s Gross Margins Trend

Ann’s gross margins grew steadily from 48.1% in 2008 to 55.8% in 2010, on account of its strong market position, which allowed the retailer to operate with fewer discounts. Ann follows a balanced pricing strategy in which it offers products across three different price points — good, better and best — and accordingly limits promotional pricing to fewer products. In 2011, the retailer’s gross margins declined to 54.6% due to a sudden rise in cotton prices, which resulted in higher production costs. From $0.84 per pound in July 2010, cotton prices rose to $2.30 per pound in March 2011. The major factor behind this increase was the drought in Hubei province of China, a major cotton producing area. Government restrictions on exporting cotton out of India and a devastating flood in Pakistan further contributed to the supply shortage. Ann’s margins improved slightly to 54.8% in 2012 as cotton prices declined, and the retailer maintained its control over the level of discounting. Apart from the aforementioned factors, its lower dependence on China for merchandise also helped the margins.

In 2013 however, the retailer’s gross margins decline again to 53.9%, as U.S. buyers spent less on clothing in the wake of increased taxes and slower job growth, which subsequently resulted in heavy traffic driving promotional activities across the industry. U.S. consumer spending remained weak for much of 2014 and buyers visited fewer stores, as they made more purchases online. This intensified the level of promotional activity in 2014, and this trend is likely to persist in the near future. In order to shield its gross margins, the company needs to enhance its focus on lowering its production cost, as selling products at higher prices in the current environment is somewhat unrealistic. Ann is looking to reduce its production cost by slowly shifting its production from China, where labor costs are rising, to other low production cost countries.

China is Turning Into a Less Attractive Outsourcing Destination

Due to labor shortages, an aging population and government regulation, there has been a substantial rise in China’s labor costs over the past several years. Back in 2001, the minimum wage in China was about 58 cents per hour and it increased by almost 20% annually for the next decade. ^[1] In 2013, wages increased by 10.7% and they were expected to go up by another 11% in 2014. ^[2] 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. In addition, the ageing Chinese population and growing education awareness among the younger generation is further adding to the labor shortage. This clearly indicates that with every passing year, skilled labor will keep getting more expensive.

In addition, the Chinese government is looking to discourage manufacturing for foreign companies, with an aim of creating a balanced economic model and curtailing the substantial rise in pollution. Following the global economic downturn, China has realized that its economic growth is extremely dependent on the demand in foreign markets. In order to reduce the vulnerability of its economic model, China is looking to boost the service-sector and high-tech industries, as well as domestic consumption. To this end, the government has consistently increased minimum wages across the country, which in turn has resulted in a rise in production costs.

The Chinese Employment Promotion Plan requires minimum wages to be increased at least once in every two years. The 2011-2015 Five-Year Plan specified an annual increase of 13% in minimum wages. Though the growth has been relatively slower, it still remains significant enough to drive out low-end businesses and force several manufacturing facilities to consider other countries for their operations. ^[3]

Where Is Ann Going ?

Back in 2009, Ann sourced about 50% of its merchandise units from China, which accounted for more than half of its overall merchandise cost. However, with rising labor costs, the retailer gradually lowered its dependence on the region. At the end of fiscal 2013, about 37% of Ann’s merchandise units came from China, which made up about 40% of its merchandise cost. In comparison, the retailer sourced 45% of its merchandise from Indonesia, India and Vietnam, which accounted for 38% of its merchandise cost. This clearly indicates that per unit cost of production for Ann in Indonesia, India and Vietnam is significantly lower than China. This justifies its strategy of gradually moving production away from China to its low cost neighbors. ^[4]

Labor wages in China are three times that of Indonesia, four times that of Vietnam, and India. ^[5] In 2009, Ann only sourced 6%, 12% and 10% of its merchandise units from Vietnam, Indonesia and India respectively. These figures increased to 13%, 17% and 15% in 2013. What’s interesting to note is here that even though these countries have a clear advantage over China in terms of labor costs, Ann hasn’t been too aggressive in shifting its production. This can be attributed to the fact that dealing with infrastructure issues in these countries results in additional costs and low efficiency. For instance, manufactures have to install expensive power back up systems to tackle unexpected power outages. Nevertheless, from long term perspectives, these countries are the way to go for Ann.

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1. China Manufactures Survive by Moving to Asian Neighbors, The Wall Street Journal, May 1 2013 [↩]
2. China Wages Seen Jumping in 2014 Amid Shit to Service, Bloomberg, Jan 6 2014 [↩]
3. China’s Rising Manufacturing Costs: Challenges and Opportunities, China Briefing, July 8 2014 [↩]
4. Ann’s SEC filings [↩]
5. Even as Wages Rise, China Exports Grow, The New York Times, Jan 9 2014 [↩]