As commodity prices continue to surge there’s a pressing yet unanswered question hanging in the air: When will this lead to an aggregate slowdown in companies’ operating margins or an ignition of inflation as retailers attempt to pass on costs to consumers?
Today, Hennes & Mauritz released its first quarter earnings (ending February 28) which showed a decline in sales, primarily related to a surge in the Swedish krona against most export countries’ currencies. More importantly, the company saw a sharp decline in its gross margin; however, this is normal for the company in its first quarter but the decline was the largest since the first quarter of 2009. According to management the effects on gross margin are due to cost inflation in their sourcing markets (primarily Asia) with for example, significantly higher cotton prices, less spare capacity and increased transportation costs due to higher oil prices. Instead of passing on these cost increases to customers, the company has chosen to strengthen its price position. This might prove to be the right tactic, but if margins continue to get hurt shareholders might have a different opinion.
Looking at the chart below, it is very clear that cotton prices are beginning to hurt clothing retailers. Cotton has increased five times since the beginning of 2009 but the main part of that increase has come since summer 2010.
Source: Bloomberg
If you look at Hennes & Mauritz’s gross margin on a quarterly basis it fluctuates quite a bit so it is difficult to analyse the true trend in gross margin. Looking at the trailing twelve months (TTM) gross margin though it is quite clear that the company is experiencing increased pressure on its margins; the gross margin TTM has been falling for three consecutive quarters now, which was unseen during the financial crisis. Interestingly enough, but will the trend continue? We believe it will because it is all about how companies plan their operations – they operate with long-term contracts and not in the spot market.
Source: Bloomberg and own calculations
So why has Hennes & Mauritz’s gross margin not been hit harder? Companies are not planning their operations in the spot market, they sign long-term contracts to hedge and better budget their costs, so most producers of clothing probably had long-term contracts with favourable prices when commodity prices collapsed at the end of 2008. That is why the rising prices in the futures (and spot) markets are slow to filter through the production chain and it also explains why operating margins have spiked at a rate never seen in decades. As these favourable contracts roll-over the new contracts will reflect the rising commodity prices and squeeze Hennes & Mauritz’s and other companies’ gross and operating margins.
Across the pond, Wal-Mart’s CEO Bill Simon expects inflationary impacts in the months ahead on clothing, food and other products. In an interview with USD Today, Simon said “we are seeing cost increases starting to come through at a pretty rapid rate”. It is not only the surge in cotton and other agricultural prices that is hurting retailers; the price of crude oil has also surged since late 2010 pushing transportation and production costs higher. The large retailers have so far been able to insulate consumers from rising commodity prices which are primarily due to companies planning their operations on longer term contracts and not in the spot market; so as these contracts roll over the new and higher prices will filter through the production chain into the shelves of retailers. On an aggregate level, core inflation (excluding food and energy) rose 0.2 percent month-over-month exceeding estimates.
With these indications from Hennes & Mauritz, Wal-Mart and other companies it is only a matter of quarters now before input costs will pose a threat to companies’ profitability and consumers will not remain shielded from these rapidly rising commodity prices. With this in mind, the next couple of earnings seasons will be very interesting to watch.
source from: tradingfloor
No comments:
Post a Comment