US apparel brands and retailers may be caught between higher costs and raising prices when it comes to navigating an extra 10% tariff on clothing and footwear imported from China from the beginning of next month – but analysts suggest some are managing to mitigate the potential impacts.
The escalation of trade tensions last week came in a tweet from US President Donald Trump announcing that from 1 September a “small” 10% tariff will be added to the remaining $300bn of goods and products imported from China – also known as Tranche or List 4 tariffs – a move that will increase cost pressures on the US apparel and footwear industry.
The president said this does not include the $250bn in goods from China that are already subject to a 25% tariff. It also comes in below the 25% that had been threatened back in May.
Even so, this latest round means all US goods imported from China will be hit with incremental tariffs on top of the levies already imposed on these products. Until now, core apparel and footwear products were largely excluded from these increases, except for certain accessories such as handbags and leather gloves, textiles and yarns, leathers and cotton.
This is likely because apparel and footwear are already among the highest-taxed US imports – representing 4% of all imports in 2018, yet paying a whopping 30% of all duties collected.
Higher tariffs would increase costs of goods sold for all US companies that import products made in China – at least until they can diversify their sourcing, reduce costs, adjust product designs or obtain vendor and/or government support.
Research commissioned by the NRF in June suggested extra 25% duties on the apparel items in Tranche 4 would increase prices of apparel from China by 22%, and by 2% for products from US suppliers. Overall, US prices for apparel from all sources combined would rise by 5%.
And a recent survey published by the United States Fashion Industry Association (USFIA) found the average price of US apparel imports from Bangladesh, Vietnam and India – the main alternatives to China – rose by more than 20% in the first five months of 2019 as more companies shift their orders to these countries.
And with only a month until the tariff is set to be imposed, time may not be on the side of an industry known for its long, slow and complex global supply chains.
“For most companies, it will take time to materially diversify operations away from China and/or adjust costs,” analysts at Moody’s Investors Service point out. “There are long lead times in the production cycle and it can take time to work through potential limitations in apparel and footwear manufacturing capacity in other countries, including quality control checks.
“Although companies may opt to increase prices, it will be difficult to do so. US consumers, saddled with higher costs, would likely cut back on purchases, which would take a bite out of company revenue and profitability.”
Also compounding this, of course, is that US companies doing business in China could take another hit from any countermeasures taken by China.
Pre-negotiated vendor concessions
A more optimistic view comes from analyst Susan Anderson at B.Riley, who believes that pre-negotiated vendor concessions are likely to bear the brunt of the new tariff – and that its impact lessens as the industry’s sourcing base continues to shift out of China.
“We believe companies in our apparel/footwear coverage have been preparing for additional tariffs and have proactively diversified their sourcing bases, as well as pre-negotiated burden sharing agreements with vendors that should help to mitigate negative impacts from the new tariff.
“We believe many companies in our coverage will be able to fully mitigate the 10% tariff mainly through price concessions from vendors, though a further increase to 25% would be more difficult.”
Anderson points to anecdotal evidence that Chinese vendors would be able to absorb anywhere from 3-10% of tariffs, adding: “The concession amount likely depends on scale.”
For instance, men’s wear retailer Tailored Brands noted on its first-quarter earnings call that various burden sharing agreements had been worked out with vendors that covered the spectrum of 10% tariffs to 25% – and that at the 10% level vendors would be absorbing almost all of the impact. While children’s wear retailer Carter’s has pre-negotiated terms with vendors in case of a List 4 implementation.
“We believe this provides a good blueprint for how most of the companies in our coverage have positioned themselves.”
B.Riley analysts also believe that current stock prices are generally overestimating the impact of tariffs.
Assuming a 10% tariff for the last four months of 2019, but conservatively estimating 7% vendor concessions and a 1% price increase; and 25% tariffs for 2020 but 10% vendor concessions and a 3% price raise, their analysis estimates earnings per share results would be –1% lower in 2019 and another –9% lower in 2020 for a total of –10% over the two years.
They also see the situation “stabilising/improving post-2020 as companies cycle the tariffs and move further out of China.”
China sourcing shrinking
China is by far the US’s top clothing and footwear supplier, accounting for 42% of all apparel and 69% of all shoes imported into the United States in 2018. All other countries combined are ill-equipped to handle the sheer volume of capacity that would be required to move production out of China.
But Anderson and her team say that over the past two years “companies in our coverage universe have been determinedly reducing China sourcing. We estimate that average US import exposure for China-sourced product in our coverage universe was ~29% at the end of 2018, down significantly from ~36% at 2017-end. We expect company exposure to continue dropping, reaching ~24% by the end of this year and ~19% at the end of 2020.”
The most popular destinations for companies to move to include Vietnam, Cambodia, Bangladesh, and India.
“However, finding new sourcing is not without complications. Large shifts are beginning to bump up against capacity limitations in certain countries, particularly Vietnam. Companies need to consider quality and delivery risks, as well as resource availability and political concerns as they diversify their vendor base.”
Capacity constraints in these alternative production bases may also result in higher costs of production in the new countries because of rising demand.
“For this reason we think that higher margin products are more likely to stay in China, even with higher tariffs, in order to maintain reliable quality standards. Though we would also note that companies were already starting to see lower manufacturing prices from China as those plants have been losing a significant amount of capacity to other countries.”
Biggest profit hit
Moody’s analysts add that the companies at risk of the biggest profit hit from increased tariffs are those that sell a greater percentage of imported Chinese goods in the US.
Of the firms they follow, for example, G-III Apparel Group generated around 86% of its revenue in the US during the fiscal year to 31 January 2019, and sourced around 61.5% of its inventory purchases from China. This is down from 65.1% in fiscal 2018 and 72% in fiscal 2017.
G-III, which owns brands such as Donna Karan, DKNY, Vilebrequin and Bass, and also produces licensed and private label brands, said in its first-quarter conference call that it had in-depth conversations with its vendors and retailers, and although there will likely be a short-term disruption, all parties are willing to share in the increased cost.
Others that would take a hit include footwear companies Caleres and Wolverine World Wide. For example, Caleres generated 94% of 2018 net sales in the US, while about 66% of the footwear it sourced was from manufacturing facilities in China (down from 68% on 2017).
Levi Strauss & Co and VF Corporation are better positioned from a diversity standpoint, with less than 20% sourced from China.
Less than 20% of PVH’s production for North America comes from China, whereas three years ago it was over 40%. Production for the US is 17%-18%, or 8%-9% of its total costs of goods sold.
At the other end of the spectrum, innerwear and activewear supplier Hanesbrands is called out for its minimal China sourcing exposure. “HBI manufactures most of their products in Central and South America, and has a minimal amount of sourcing exposure to China, we estimate less than 2%.”
Wider economic impact
The wider implications of the new List 4 tariffs “confirms our view that the two countries [US and China] remain far apart in their expectations and objectives, and that a significant trade deal is not likely this year,” Moody’s notes.
It contends: “The escalation of trade tensions will increasingly weigh on the global economy and supply chains in an environment of already decelerating growth in the US, the euro area and China, with the uncertainty dampening business investment and trade flows.
“Additionally, the risk of a further escalation of the trade dispute and more tariffs and investment restrictions remains high.
“The direct economic effect of the newly announced tariffs will be manageable because the 10% tariffs by themselves will only shave 0.1-0.2 percentage points off global growth over the next year. We expect monetary policy across regions, and fiscal policy in China, to turn more supportive to prevent a rapid deterioration in financial conditions.”
With their focus on “everyday items,” the new tariffs “will be credit negative for retailers in these sectors if they result in lower sales volume or if retailers cannot pass on the increased costs from the tariffs to consumers.”
The analysts also say the tariffs will have the same effect as a tax on the US consumer. “We estimate that they will result in a one-time price increase of around 20 basis points for the average urban consumer basket of goods. Assuming that companies pass on most of the burden to US consumers, at a tariff rate of 10%, the price of US households’ current consumption basket will rise an average of more than $240,” Moody’s notes.
“At the same time, the heightening of trade tensions will make it more likely that the US Federal Reserve will further cut interest rates in an effort to offset a tightening of financial conditions – including the appreciating dollar – and to provide assurances of its continued support for the current economic expansion.”