The apparel supply chain is being squeezed from both ends. Depressed demand and increased costs have farmers and retailers alike scrutinizing strategies.
On the materials end, cheap man-made fibers and new competition are further pressuring cotton prices, which continue to be weak. Against this backdrop, the cotton industry faces not only economic headwinds but also the challenge of ensuring natural fibers are valued appropriately agains the environmental impacts of synthetics.
For retailers, the story isn’t much brighter. The industry’s reliance on Southeast Asia means there’s only so much merchants can do to mitigate tariff impacts. Couple that with the loss of de minimis, and the outlook for the next round of quarterly reports is in question. Thus far, retailers have managed to shield consumers from much of the disruption, but that may not last long.
Below, Jon Devine, Senior Economist for Cotton Incorporated; Jess Dankert Vice President, Supply Chain for the Retail Industry Leaders Association (RILA); and John Kernan, Managing Director at TD Cowen, share their insights into what players upstream and downstream are doing to manage through the latest disruptions and what the industry can expect in Q4 and beyond.
This article is an excerpt from the HGI Supply Chain Outlook call on October 22. Watch the full Call here to dig more into logistics pressures, supply chain shifts and changing consumer habits.
Raw Materials Outlook
Edward Hertzman: What are the current headwinds and outlook for the cotton market, and how does how does U.S. cotton compare?
Jon Devine: Of course, top of the list is going to be uncertainty. It’s not just the speed of change, but also the magnitude and breadth of the change. In the cotton sector, of course, we’re pretty dependent on trade. Starting at the fiber level, we export about 85 percent of all the cotton grown in the U.S. every year. And then downstream about 98-plus percent of all the apparel sold to consumers in the U.S. is imported as well. So, there’s no lack of exposure throughout the supply chain to changes in trade policy, and trying to digest those changes, it certainly is a big factor.
Another challenge U.S. growers are facing relative to pricing is that we have seen some changes in terms of where cotton has been produced and where cotton exports are available. And a big story on that front has been the rise of Brazil over the past couple of years, with them shipping about three times as much cotton as they did about 10 years ago. So, on top of all the trade policy issues, we have all this additional cotton, and that’s creating some competition, and that’s all contributing to some of the weakness that we’ve seen in prices here over the past year.
EH: With the price of cotton so depressed, what impact does this have on farmers’ decisions on whether or not to plant cotton or switch to another crop? And what does this mean as we look a year or two out as it relates to pricing and supply?
Devine: An unfortunate thing in the agricultural sector right now is that all prices are down. So, if you are a producer, there’s nowhere to hide. Corn prices are down. Soybean prices are down a little bit, and, of course, cotton prices are down as well. On top of all that, we’ve got the uncertainty of trade policy affecting these markets and the outlook. So, there’s a lot of questions out there, but no easy answers. I think a lot of our producers will probably look to rotational issues, trying to keep their soil health up, and probably let that guide their acreage decisions, but generally not expecting increases in acreage given these low prices we have for cotton right now.
“The cotton industry would like to see some of these man-made, petroleum-based fibers priced accordingly to their environmental costs, which I don’t think are adequately incorporated.”
—Jon Devine, Cotton Incorporated
EH: To add pain to this, we’re seeing man-made fiber costs continue to decrease and the capacities are going up. Is this impacting cotton demand at all?
Devine: We’re all swimming in the same sea to a certain extent. So global fiber demand is affected by global apparel demand. Global apparel demand is affected by the economic situation, which is being affected by uncertainty in the trade policy. All that’s putting some headwinds out there in terms of demand for all fibers. But of course, there is fiber price competition. And something that we would like to see in the cotton industry as natural fibers, that some of these man-made, petroleum-based fibers are priced accordingly to their environmental costs as well, which I don’t think are adequately incorporated into the price of those fibers.
Retail Margins
EH: John Kernan, what is really happening behind closed doors as relates to the sourcing map for brands or retailers? Are they setting up production in new countries? Are they moving to different regions?
John Kernan: There’s unprecedented uncertainty on costs and pricing. Our companies in U.S. retail—the retailers, the vendors, the apparel manufacturers, the footwear manufacturers—they’re all extremely levered to Southeast Asia, and there is no change in strategy around that. We’re not hearing of any nearshoring. Right now, the strategy is to attempt to mitigate as much of the tariff cost as possible. Some of that comes with the factory partners eating some of it. Some of it’s going to be the consumer. Some of it’s going to be the companies. But it’s an unprecedented cost headwind. The biggest company in our space is Nike. They face a $1.5 billion gross tariff impact hit this year. That’s a lot of money.
This is an industry that’s become so embedded in Southeast Asia and the low-cost labor in that region right now, there really isn’t an alternative. And you’re seeing a lot of innovation in the supply chain around some of the factory direct-to-consumer models but it’s all emanating out of Asia. Southeast Asia is where the supply chain starts and ends, and we really haven’t heard much of anything in terms of strategy shifts around that.
EH: Jess, are you seeing a lot of diversification or changing in the supply chain? Are they planning their sourcing, their inventory, their logistics strategies any different?
Jess Dankert: Leading retailers are always evaluating that. It’s not something that just started on January 20 of this year. Retailers have really focused on that North Star of the shopper experience, and ensuring that, regardless of whatever upstream disruptions may happen, what the guest wants is on the shelf or on their doorstep, when and how they want it. So, they’ve been remarkably able to insulate the end consumer from a lot of these shocks that we’ve seen, these ebbs and flows and wild whiplashes in global supply chain picture. There hasn’t been a significant effect on store shelves, and that’s a testament to not just the retailers, but the entire ecosystem to insulate that. But the longer this uncertainty continues, it’s in an open question of how long it’s possible to continue to do that.
“There hasn’t been a significant effect on store shelves, and that’s a testament to the entire ecosystem. But the longer this uncertainty continues, it’s in an open question of how long it’s possible to continue to do that.”
—Jess Dankert, RILA
EH: John, you called me after the quarterly earning calls a couple months ago, and you were surprised at how exposed so many companies were to de minimis. Now, with this being phased out, what does this mean for margin?
Kernan: The most visible hit from the de minimis exemption going away, was Shein and Temu took a big hit. But a lot of their e-commerce, traffic and digital engagement numbers are still very strong. The most recent public company that spoke about the hit from de minimis was Lululemon. They’re obviously a Canadian company that almost 50% of their mix is done online. They were shipping a lot of their goods from their huge Canadian [distribution center] into the U.S., directly to consumers. Roughly $2 to $2.5 billion dollar duty free business; the hit to that is tremendous. I mean, it was roughly a 200 to 250 basis point hit to their gross margin, and that P&L is not coming back. I don’t think you can price around that in this environment. There are other companies that have taken the hits as well. You’re going to hear a few more companies talk about de minimis. And I don’t know if the hits will be quite as large as the one we saw from Lululemon, but there’s certainly still a lot of DCs in Mexico, a lot of DCs in Canada that were taking advantage of the duty-free treatment.
EH: Has there been any indication from management if there’s going to be a deprioritization of some e-commerce, trying to drive people more into brick-and-mortar as strategies change?
Kernan: I don’t think management teams are making wholesale changes. They certainly have to take the cost hit of not being duty free anymore, and there’s not much they can do about that. That’s a permanent hit to their margin structure. And I think a lot of folks in the investment community were surprised at the size of some of these duty-free businesses. And I don’t think they’re planning to adjust price significantly to offset this. The consumer is probably not going to know in a lot of cases, certainly with the Shein and Temus of the world and the factory direct consumer models. Prices have risen there, and it’s visible when you go from a $6 blouse to an $8 blouse. But again, it’s all about value. The consumer is very conscious of value. They’re comparing prices constantly online, and there’s not much you can do from a pricing standpoint to offset the de minimis hit. And certainly companies are reinvesting in DCs and supply chain. We see a lot of CapEx dollars being spent this year on the supply chain across retail. They’re building bigger DCs, more automated DCs, and they’re increasing their DC capacity here in the U.S., and they have to get faster. And that’s what you’re going to see. You’re going to see a shift away from some of those foreign-led DCs, and probably some more distribution center investments here in the U.S.
