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As Commodity Costs Rise, Companies Try to Preserve Profits

With the cost of materials, transportation, and labor rising—and the U.S. economy still limping toward recovery—manufacturers of everything from clothing to food are struggling to preserve profitability.

Despite recent pullbacks, a rally in commodity prices is pressuring corporate profits. That rally will probably continue, says Standard & Poor's (MHP) analyst Alec Young, aided by the Federal Reserve's goal of keeping interest rates near zero. Most commodities are denominated in U.S. dollars, which is likely to decline as the Fed prints money to finance bond purchases. The Thomson Reuters/Jefferies CRB Index of 19 raw materials climbed 15.3 percent in the past five months, led by agriculture commodities, but has pulled back 6.6 percent in the past week and a half on concerns that China will raise interest rates and slow economic growth. Corn futures for March delivery rose 56 percent from June 30 to peak at $6.04 per bushel on Nov. 4, before slipping 12.3 percent, to $5.29 per bushel, on Nov. 22. Since June, wheat futures have spiked 28.3 percent, sugar prices have increased 60.0 percent, and cotton futures for March delivery have surged 51.6 percent. Crude oil has risen 5.2 percent and copper has jumped 26.4 percent in the past five months.

Companies with strong brand recognition—such as General Mills (GIS)—or truly differentiated products, such as Crocs (CROX) shoes, are likely to raise prices in 2011, analysts say. For others who find themselves unable to pass along higher costs, the alternatives consist largely of forcing suppliers to eat costs, switching to higher margin materials, or cutting labor costs.

Loss of Pricing Power

The holiday sales outlook is better than it has been in several years, but cash-strapped shoppers are still hunting for bargains, says Robert Plaza, a consumer staples and discretionary analyst at Key Private Bank in Cleveland. "No industry has pricing power," he says. "Even the aspiring type of consumer is still going to be a little cost conscious because of what's happened over the past few years. Nobody's going to start spending money they don't have to."

Many large-cap apparel vendors recognize how little room they have to raise consumer prices. To date, V.F. Corp. (VFC), Nike (NKE), Polo Ralph Lauren (RL), and Phillips-Van Heusen (PVH) have successfully squeezed suppliers by refusing to absorb the full impact of higher costs, Plaza says. Retailers that serve middle-income consumers will try to sell more higher-margin products, such as clothing made with rayon or polyester instead of pure cotton. Despite rising prices for crude oil, from which synthetic fibers are derived, those have not risen as much as cotton, he adds. Some retailers sourcing for their own labels likely won't have the same leverage. Gap (GPS) and J.C. Penney (JCP) may have to pay Chinese suppliers up to 30 percent more due to surging cotton costs, Bloomberg News reported on Nov. 15. Children's apparel retailer Gymboree (GYMB), which is being sold to buyout firm Bain Capital, said last week that its gross margins may be squeezed by high cotton prices.

Attempts by apparel and footwear retailers to boost prices will be especially difficult after a decade of falling prices. Even as overall retail prices jumped nearly 28 percent from 1998 to 2008, clothing and footwear prices declined 10 percent and 4 percent, respectively, during the same period, due to tighter competition among manufacturers and the opening of several new retail channels that forced aggressive pricing, says Nate Herman, vice-president for international trade at the American Apparel and Footwear Assn. Although demand has dropped, supply has fallen more dramatically, thanks largely to the shutdown of more than 20,000 apparel and footwear factories in China over the past two years, he says. That has led many manufacturers to conclude they'll need to raise prices starting next spring, since "there's just not any room left to take it in margin," Herman says. He expects mid-single-digit price hikes in clothing and shoes in 2011.

Leather Lags Cotton

Rising material costs are less of a burden for footwear manufacturers than for apparel vendors, since leather prices haven't climbed nearly as much as cotton prices, says Camilo Lyon, an analyst at Wedbush Securities. Still, faced with rising labor costs in China, specialty shoe vendor Steven Madden (SHOO) is shifting some production from southern China to lower-cost areas in northern China and Mexico. The company is also fighting margin compression by opening more outlet stores, which generate higher margins, Lyon says. Such vendors as Family Dollar Stores (FDO) that serve more price-sensitive customers can switch suppliers or pit one against another to try to get them to eat costs, says Plaza. Or they'll leave price alone and reduce volume, hoping consumers don't notice. "In that case, you are passing along higher costs to the consumer, but you're doing it in a different way," he said.

Jones Apparel Group (JNY) on Oct. 27 said its margins fell 2.1 percent from a year ago and blamed its third-quarter earnings miss on aggressive pricing by discount retailers and larger-than-expected increases in freight and capacity costs. In a Nov. 5 research note, Morgan Stanley (MS) trimmed its 2011 earnings forecast for Jones to $1.61 per share, or flat with projected 2010 earnings, and forecast a one percentage-point decline in Jones' gross margin in 2011. "Retailers seem to be gaining in this balance of power struggle today, making it more difficult for vendors of all types to pass costs along," says Jeff Edelman, director of retail and consumer products advisory services for RSM McGladrey, an accounting and business consulting firm. Only a few high-end brands, such as Coach (COH) and the upper end of Ralph Lauren, are able to "style around higher costs and translate that into higher margins," he said. "If you can create the uniqueness the consumer wants, you'll be able to get to [a higher] price."

Food Fights

Consumers should also brace for higher grocery bills. Corn is trading at a 36 percent premium to the average price of $4 per bushel over the past four years, which itself was substantially above the average price of $2.35 from 1974 through 2006, says David Maloni, a principal at the American Restaurant Assn., a food commodity research, forecasting, consulting, and contract risk management firm in Sarasota, Fla. Faced with spikes in feed grain costs, chicken, pork, and beef producers are expected to cut production to fight narrowing margins, as they did after feedstock costs soared in 2007, he says. The beef industry has combated higher beef prices by developing lower-cost products. "Flank steaks, skirt steaks, top sirloin—all the less expensive beef cuts are now predominant in meat counters," Maloni says. Top sirloin is about $2 per pound at wholesale and can be sold at retail for $5.99 to $6.99. A wholesale price of almost $6 per pound for New York strip steaks and rib-eyes leaves much less margin to play with. "It's hard to move product at $8.99, $9.99, $10.99," says Maloni.

Expanding their offerings of private-label packaged foods has helped grocery chains maintain and even boost profitability in the face of rising costs. Margins are generally 30 percent higher on private-label goods than on national brands, says John Baumgartner, a packaged food analyst at the Telsey Advisory Group in New York. He sees General Mills (GIS) and Kellogg (K) as "strong brand managers" whose cereal products are less vulnerable to growing competition from private labels than a company such as Kraft (KFT), whose cheese is a less differentiated food category. But Kraft has been fighting to build brand recognition through more advertising and promotion over the past three years. The company's cheese prices were 8.4 percent higher in the third quarter than a year earlier. Kraft generally hedges raw material costs three to six months into the future but won't disclose what portion of its production is hedged, spokesman John Simley says.

Despite a range of cost-saving measures, retail margins may suffer this holiday season because inventories are higher in all product categories and seem more in line with sales expectations than in 2009. Last year, retailers cut inventories to the bone, which reduced the need for markdowns and boosted sell-through, says Edelman. "We can reasonably expect that markdowns will move up to more normal levels, so margins will be under pressure," he says. "Whether or not your sales increase can offset erosion of your gross margin remains to be seen."

Bogoslaw is a reporter for Bloomberg Businessweek's Finance channel.

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