Why We Expect Ann’s EBITDA Margins To Decline No Further

Ann (NYSE:ANN) saw its EBITDA (earnings before interest tax depreciation and amortization) margins decline from 22.1% in 2010 to 21% in 2011, due to a sudden rise in cotton prices, which in turn pushed the cost of production up. Floods in major cotton producing areas in Pakistan and a drought in Hubei province of China were responsible for the increase. Additionally, an inventory hangover during the holidays of 2011 forced the company to churn out massive promotions, which impacted the margins further. Despite the improvement in cotton prices in 2012, margins remained low due to higher expenses related to expansion and higher SG&A expenses. In 2013, margins declined further owing to the highly promotional environment, which continued in 2014 as well, when margins were at 18.4%.

Going ahead, however, we expect the margins to improve slightly despite the prevalent highly promotional environment in the U.S. apparel industry. We believe that Ann will leverage its firm inventory management to reduce the intensity of promotional activities and reduce the cost of goods and services by moving production away from China.

Our current price estimate for the company stands at $42, implying a discount of about 15% to the market price.

See our complete analysis for ANN

Strong Inventory Control

Proper inventory management enables a retailer to launch trend- and season-relevant inventory in a timely manner.  This, in turn, helps it operate without unnecessary markdowns, thus helping gross margins. A significant portion of Ann’s products is developed in-house exclusively by its product development and design teams. The merchandising group determines the inventory needs of the upcoming season, passes on the requirements to the design team, and plans a merchandise flow system for different manufacturers. Apart from a few merchandise goof ups, Ann has mostly been on top of its inventory management. With its ongoing omni-channel efforts, this should only get better. Hence, the company is in a good position to improve its margins in the future.

Production Moving Away From China

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 2014, about 35% of Ann’s merchandise units came from China, which made up about 38% of its merchandise cost. On the other hand, merchandise sourced from Vietnam accounted for just 10% of the cost but 16% of the total units. This clearly indicates that per unit cost of production for Ann in China is much higher than its other sourcing locations such as Vietnam, Indonesia, Cambodia, etc. Labor wages in China are three times that of Indonesia, four times that of Vietnam, five times that of Cambodia and ten times that of Bangladesh. Monthly minimum wages in India range from half to one-fourth of China’s minimum wages. In 2009, Ann only sourced 6%, 12% and 10% of its merchandise units from Vietnam, Indonesia and India, respectively. These figures increased to 16%, 19% and 13% in 2014. As rising labor costs in China continue to trouble Ann, we expect these figures to go up in the future, which will have a positive impact on the retailer’s gross margins.

Balanced Pricing Strategy and Product Specific Promotions

In order to attract different customer demographics, Ann employs a balanced pricing strategy and product specific promotions. This approach is aimed at increasing the product variety at the opening price tier and subsequently focusing on promotional discounts on specific products rather than store-wide promotions. Increasing the product variety at opening price tiers will push the merchandise mix towards cheaper products, which have relatively lower margins. On the flip side, product specific promotions will positively impact Ann Taylor stores’ margins.

Lower Expenses

During its Q4 fiscal 2013 earnings call, Ann stated that it is looking to amplify its savings by more effectively planning its expenses. The company is optimizing its cost structure, which is expected to result in $25 million in annualized savings. About two-third of the savings are likely to come from SG&A expenses and the remaining from gross profits. To lessen its SG&A expenses and as part of its ongoing omni-channel realignment, Ann has reduced its corporate workforce by 100.

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