Cost increases may reduce profits more than expected

Cotton futures surged last week to a new high after doubling in 2010. Coupled with other hikes in related costs such as labor in China may splurge margins. Some retailers are claiming cost increases in some areas of 15% to 25%. ICE March cotton,

the US benchmark, rose by the 5 cent daily allowable limit to $1.6194 per pound late January, the highest in the 141-year history of the New York exchange and its predecessors.Soaring cotton prices hit fourth-quarter results at H&M last year, just to mention an example. But the pricing pressure doesn't stop there. Labor costs in China, where most apparel is sourced, have risen by 10% to 12% in the past year amid ongoing minimum-wage hikes. Shipping costs are also up.

Retailers, now in the process of booking apparel orders for the fall, should see the impact of these higher costs by midyear as their suppliers pass on a portion of the increase, analysts say. The combination of higher costs will likely hurt retailers' margins this year as they bear the burden of some of the increases, says Ken Perkins, president of Retail Metrics.

Consumers haven't noticed much of an impact so far. Apparel prices, as measured by the consume price index, have been flat for several years and are still down 11.5% from mid-1994 levels.

Many retailers are predicting that they will pass along price increases, but consumers have not shown a willingness to spend at increased levels. Alix Partners predict that retailers will be faced with protecting price points of key programs and balancing that profit hit with price increases on fashion merchandise. Therefore, margin impacts could be larger than expected as consumers will remain in the driver's seat; mid-tier and value players will face the greatest challenges.

"Inflationary pressures have gotten a lot of attention by investors," said Deutsche Bank analyst Bill Dreher. "They might be looking for reasons why retailers will underperform in 2011. But this alone will not be enough to keep our leading retailing stocks from outperforming."

Nevertheless, there is always room for hope and some retailers should be able to offset the effects of cost pressures better than others, as Coach showed lately.

"Higher costs are affecting us marginally, and we are largely able to offset them through counter- sourcing and improving our SG&A spending levels," Coach CEO Lew Frankfort told Investors Business Daily after the company reported Q2 earnings. "We have the highest operating margins and gross margins in the industry. We're looking to maintain our levels of operating margin today."Still, Coach expects inflationary pressures to have a "dampening impact" on gross margins in the back half of fiscal 2011, said CFO Michael Devine on a conference call.