Soaring cotton costs are set to weigh heavily on Gaps bottom line

Soaring cotton costs are set to weigh heavily on Gap's bottom line

Specialty clothing retailer Gap Inc has cut its full-year earnings forecast after admitting that escalating sourcing costs not only contributed to a 23% slump in first quarter profit but are also likely to outpace higher ticket prices later in the year.

The San Francisco based firm said soaring costs of raw materials like cotton meant that it had little leverage when it came to placing orders for its autumn ranges, and that unit product costs will be around 20% higher than a year ago.

The impact is likely to hit hardest in its two value channels - Old Navy (the largest of the retailer's chains with 1,185 stores) and the Outlet business - according to the retailer, which operates a total of 3,100 stores around the world.

"While the company anticipated that the cost of goods would increase during the back half of the year, costs are actualising above the initial estimates," explains CEO Glenn Murphy.

It has been well documented that the price of cotton has soared by around 150% during the past 12 months, reaching a record of $2.44/lb in early March. So how could the US' largest specialty clothing retailer have miscalculated so badly?
"We made the assumption that holiday pricing would ease because we were buying fall into what we believed at the time was the peak of cotton," he said on a call with analysts yesterday (19 May). "And it turns out we were just absolutely wrong on that assumption.

"When cotton went above $2 around February and sustained itself for almost 12 full weeks, we were in the midst of negotiations for our holiday product, we didn't have any leverage.

"Holiday got worse, and that costing came in much higher than we expected and higher than fall."

Not surprisingly, Murphy is keen to point out that "we haven't all of a sudden gone brain-dead when it comes to our ability to negotiate."

He also says there's now "a huge amount of pressure on our vendor community because we're disappointed in the numbers they are quoting back to us."

And this includes options to move sourcing from country to country - including Vietnam, Cambodia, India, Bangladesh and Sri Lanka - to mitigate the additional impact of rising wages, particularly in China.

There is less room to manoeuvre, however, when it comes to offset rising input costs by making changes to fabrics and trims.

At Old Navy "we have quality standards. And it's our view that while there were still choices available to us that may have allowed us to mitigate against the 20% in the back half, that would just be crossing the line."

Murphy reserves some optimism for that fact that the retailer still hasn't finished buying its holiday, let alone its spring assortments, and that cotton prices have fallen by around 35% since their peak at the end of April - which means prices for products delivered from October onwards might not be as high as feared.

"It's not down or anywhere near where I think it's going to get eventually, but it has come down substantially," he told investors, adding that he sees higher input costs as "a near-term shift."

He also believes there's going to be some further "demand destruction which maybe will open up some capacity, which would then also have an impact on the wages and the labour line."

Murphy's comments came as the retailer booked a first quarter profit of $233m, a drop of 23% on the $302m reported in the same period last year.

Sales in the three months to 30 April were down 1% to $3.30bn, which was partly blamed on the impact of the March earthquake and tsunami in Japan. Comparable sales fell 3%.

By division, comparable sales fell 3% at Gap North America, slipped 1% at Banana Republic North America, and were down 2% at Old Navy North America. International sales were 6% lower than last year. 

The company lowered its full-year guidance for earnings in the range of $1.40 to $1.50 per share, down from earlier forecasts for $1.88 to $1.93 per share.