The strong-arming, chest-thumping and browbeating around China’s flood of cheap textile exports to the U.S. could make a direct hit on the wallet of the US small-cap investor – but not in the way that you may think.
As you stand in the checkout line at your favorite big-box outlet to pay more for Chinese-made shirts, socks and trousers, a double whammy awaits you at home when you realize that your small-cap portfolio is the latest casualty of the textile cold war between Beijing and Capitol Hill.
At risk are American small caps in the apparel industry that outsource manufacturing to China. They could see their bottom lines eaten away — causing a potential slide in their stock prices…and your net worth.
The problems gets worse as China is also pressed by the U.S. to unhitch its currency, the yuan, from the dollar. That could further drive up the costs of labor and materials, which would have to be absorbed by the U.S. companies or through an innovative workaround by the Chinese suppliers — or both.
And unless you read the rag trades or sift through the news with a magnifying glass, chances are you missed the latest threat to U.S. small-cap apparel makers: the rise of cotton prices in China. Spot-market prices have increased by nearly 19% since the beginning of the year, with additional hikes expected in the months ahead.
China took a preemptive strike on Friday by boosting some textile export tariffs as much as 40%. By imposing tariffs on its own exports, China hopes to head off more stringent restrictions imposed on it by the U.S. and Europe. The U.S. in particular could be overwhelmed by Chinese textile imports which are expected to surge from the current 22% to as much as 50% in the next two years, according to the World Trade Organization.
China’s new higher tariffs impact 74 textile products and are slated to take effect June 1. Still, the U.S. Commerce Department also said on Friday that it intends to make a formal request by the end of this month to discuss with China safeguards that would apply to items such as men’s knit shirts.
As a result…
Small-cap apparel companies that stand to get hit the hardest in the Sino-American textile war are those that rely on mass-market retailers with a reputation for squeezing every last cent of margin from their suppliers (think Wal-Mart, Sam’s Club and Costco).
It might be easy for small-cap investors with holdings in apparel companies to be lulled into a false sense of security: many of them are reporting great results. But for how much longer?
The top small-cap apparel companies include Hampshire Group, Oxford Industries, Delta Apparel, St.John Knits Intl., Haggar Corp., Cutter & Buck, Ashworth, G-III Apparel Group and Perry Ellis Intl.
Of those leading small caps, G-III Apparel and Perry Ellis are the most vocal about their outsourcing relationships with China. The implication here is that if companies such as G-III and Perry Ellis are touting their China connection, they expect to be rewarded for it through higher valuations, greater institutional holdings and glowing coverage (because they can’t be doing it to win the hearts and minds of the folks in North Carolina).
For example…
The 2005 annual report of G-III Apparel Group, which was issued on April 27, contains a section that refers to the Jan. 1, 2005, World Trade Organization quota removal on apparel and textiles: ‘This would allow retailers, apparel firms and others to import unlimited quantities of apparel and textile items from China, India and other countries where manufacturing costs are low. The effects of this action could lead to lower production costs or allow us to improve the quality of our products at a given cost.’
The report then goes on to say, ‘Litigation and political activity has been initiated by interested parties seeking to reimpose quotas. As a result, we are unable to predict the effects of the lifting of the quota restrictions and related events on our results of operations.’
The timing may be worse than G-III surmises, since it appears to be shifting its offshore center of gravity from Korea to China, where it relocated its Asian offices. According to the annual report, ‘We also anticipate that, in addition to operational efficiencies, the cost to operate these offices will be reduced after we complete the closing of our Korean offices.’
Whether by coincidence or poor decision-making, the shift to China comes during a cycle of declining earnings for supplying clothes and accessories to Cole Haan, Sean John, Classics Sports and others. For the 12-month period ended Jan. 31, 2005, net sales dropped to $214.3 million, from $225.1 million last year — a 4.8% slip. Gross margins were off 11.8%, falling to 24.6% from 27.9%.
Business is certainly better at Perry Ellis, another proponent of Chinese manufacturing. In its preliminary earnings announcement on May 16, the company expected Q1 2005 revenues to be approximately $225 million, up 14% over $197 million from the same period last year. Net income is also expected to grow. Expectations were for $8.5-9 million, representing an increase of 4-10% over the prior year.
Perry Ellis has been in China since 1976. It currently has four offices and a staff of about 60 to manage relationships with local manufacturers. As of 2004, Perry Ellis relied on China for roughly 28% of its purchases. The question remains, though, for how much longer?
Manufacturing capacity at companies like Perry Ellis and G-III Apparel can always be shifted to Pakistan, Mexico, South Korea or dozens of other countries with cheap labor and better relations with the U.S. As it stands, the political friction in this trade battle is heating up as we head into summer. If you insist on holding your small-cap apparel investments, stay vigilant as things get ugly.
By Irwin Greenstein for The Penny Sleut