China tariffs would likely increase the cost of goods for US apparel firms – but there could also be ripple effects on the US economy, according to Moodys

China tariffs would likely increase the cost of goods for US apparel firms – but there could also be ripple effects on the US economy, according to Moody's

The threat of tariffs being imposed on all goods imported into the US from China would be a "credit negative" for the US apparel and footwear sector, leading to higher costs and gross margin pressures for up to two years until companies adjust their sourcing patterns.

The prognosis from Moody's Investors Service comes after President Trump last month indicated that he may be willing to impose tariffs on all goods imported from China, including all apparel and footwear.

The implications would be severe for the clothing and footwear sector because China remains the dominant supplier of these products to the US, accounting for 34% of US apparel imports and 56% of US footwear imports in 2017.

A number of possible credit repercussions are noted in the report 'US: Apparel & Footwear: FAQ on potential sector implications from proposed US tariffs on China.'

#1: Tariffs would increase the costs of goods sold for the US divisions of companies that import from China.
If the tariffs happen, companies would likely experience gross margin pressures for around 12 to 24 months because it will take time for most to further diversify operations away from China and/or adjust costs. 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.

Nevertheless, Moody's analysts think companies do have levers they can pull to mitigate at least part of the cost. For example, they can save on costs by adjusting product designs to achieve a desired cost or pricing level, and more broadly, look to cut costs within their organisations.

Smaller apparel companies with high leverage and/or low profits could end up being particularly exposed if their earnings decline relative to debt service costs, or if they experience any disruptions in their supply chains – for instance reduced vender/factor support or ill-timed shipment delays.

However, until the companies adjust, they could see increases in costs of goods sold, the credit ratings agency warns.

#2: More than half the revenues of large US apparel companies could be affected.
Around 58% of combined revenue of large rated US apparel manufacturers is derived in the US and potentially at risk of increased tariffs. The impact would depend on how much of this is sourced in China versus other countries, which varies greatly from company to company. It would also depend on how quickly they can diversify their sourcing, how much pricing flexibility they have to absorb or pass along additional costs, how they might adjust product designs, or how much they can cut costs elsewhere.

#3: Companies that sell a greater percentage of imported Chinese goods in the US would take the biggest profit hit.
Moody's expects these companies to experience more margin and earnings pressure until they can adjust their cost base and sourcing locations, which may take time given their sourcing concentrations in China.

For example, G-III Apparel Group generated around 88% of its 2017 revenue in the US, and purchased around 65% of its 2017 inventory from China. Others that would take a hit include footwear companies Caleres, Payless and Wolverine World Wide. Caleres generated 94% of 2017 sales in the US, while about 68% of the footwear it sourced was from manufacturing facilities in China. Levi Strauss and VF Corp are well positioned from a diversity standpoint, with less than 20% sourced from China.

#4: Most will look to pass at least some of the additional cost on to customers.
This may be the case especially on premium products where the consumer may have less price sensitivity. Larger companies with stronger margins and balance sheets, such as Wolverine and PVH Corp, could decide to absorb higher costs in an effort to gain market share.

Longer-term repercussions?

As Moody's points out, the threat of new tariffs extends well beyond apparel, "which means this isn't just about whether or not these companies will be able to pass just their own higher costs to the US consumer. This is happening across other US sectors and with other countries."

But it also raises the question: What ultimately happens to US consumer spending power?

Also, if China and/or other countries take retaliatory measures and impose tariffs on US exports, then US-based companies could move production out of the US, which could have ripple effects on the US economy.

Revenue growth for US apparel companies could also take a hit if China imposes regulatory or other such impediments on US companies, or if local consumers turn away from US brands. It is important to remember that China remains a key growth market for global apparel companies, report authors warn, noting that Nike Inc reported 18% (constant currency) growth in the country during its latest fiscal year.

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