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AnnTaylor (NYSE:ANN) is a leading specialty retailer of women’s apparel, shoes and accessories in the US. The firm has come out strong from one of the worst economic periods with its stock price increasing 220% over the last year. The company has consistently reported strong earnings resulting primarily from increases in AnnTaylor’s EBITDA margin.

However, an increase in apparel production costs in the future could negatively impact AnnTaylor’s EBITDA margin, resulting in a downside to the $22 Trefis price estimate for AnnTaylor’s stock.

AnnTaylor Rebounds As Apparel Prices Rise

As a luxury brand, AnnTaylor saw its sales decline over the past few years as consumers in the US became increasingly value conscious and cut down on their discretionary spending. The firm had to offer products at discounted prices thereby reducing its EBITDA margins.

Although margins have improved with an increase in consumer spending and their return to full-priced products towards late 2009 and early 2010, a rise in production costs could put downward pressure on AnnTaylor’s margins.

Apparel Production Costs Expected to Rise

1. Most manufacturing already outsourced

Over the last decade, apparel production costs have generally decreased. This was primarily because most of the retailers outsourced manufacturing to countries where labor, raw materials and other costs of production were low compared to the US.

Part of these cost savings were passed on to the end consumers and thus apparel prices declined while the margins of apparel firms increased. However, as most firms now outsource almost their entire manufacturing, additional opportunities to achieve further cost savings through outsourcing are limited.

2. Outsourcing to get costly

Not only are there fewer opportunities to outsource, but outsourced services are becoming more expensive. With growing economies and rising standards of living in the main outsourcing destinations, the cost of production inputs like labor and raw materials are most likely to rise in the future.

For example, in China, which sources nearly 50% of AnnTaylor’s merchandise, producer price inflation hit 7.2% in May. As outsourcing to these locations becomes less lucrative, firms will have to develop their own capacities or outsource merchandise to other countries, both of which offer limited savings over existing production costs.

Potential Impact on AnnTaylor’s Stock

We estimate a 5% increase in AnnTaylor’s cost of goods sold, due to increase in apparel production costs, would result in a 2.3% percent decrease in AnnTaylor EBITDA margins in 2011 and beyond and that such a margin decline over the Trefis forecast period could result in a downside of $6.90 (31%) to the $22 Trefis price estimate for AnnTaylor’s stock.

Importance of Competitive Pricing

While increasing apparel prices seems to be the natural response to rising production costs across the apparel industry, AnnTaylor is likely to avoid that.

The revival of the firm has been driven primarily by increasing sales at factory stores, offering lower priced products, and sales at the moderately priced LOFT brand of stores (owned by AnnTaylor). We estimate that LOFT stores account for about 37% of our price estimate for AnnTaylor’s stock. Since AnnTaylor expects future growth through its LOFT stores, it would want to limit price increases that could harm demand for LOFT products.

You can see our complete analysis for AnnTaylor’s stock here.

Disclosure: No positions

Source: Rising Production Costs Could Impact AnnTaylor's Margins