Ann's (NYSE:ANN) EBITDA (earnings before interest tax depreciation and amortization) margins were low at 15.7% in 2008 but improved to 22.1% in 2010, despite the impact of the economic downturn. However, in 2011, the figure declined to 21% due to a sudden rise in cotton prices, which resulted in higher production costs. From $0.84 per pound in July 2010, cotton prices rose to $2.30 per pound in March 2011. Ann’s margins remained flat in 2012 and declined slightly to 20.6% in 2013, due to the extreme promotional environment in the U.S. apparel industry.
Going forward, we expect Ann’s EBITDA margins to improve gradually, backed by fewer promotional activities, reduced dependence on China for sourcing of goods and the retailer’s plans to lower its operating costs. Being one of the most popular apparel brands in the U.S., Ann is at liberty to operate with a higher number of full-price sales. Since the brand’s salient feature is its designs, buyers are less concerned about the prices. Over the years, Ann has improved its gross margins by gradually shifting its sourcing from China to its low labor cost neighbors. We expect this trend to continue in the future. In addition, the retailer is working hard to reduce its operating costs, which should have a slight positive impact on its EBITDA margins.
Our price estimate for ANN stands at $41.31, which is roughly inline with the current market price.
Delivering Popular Merchandise To Operate With Fewer Markdowns
While several U.S. retailers have lost their customers to fast-fashion brands such as Zara, Forever 21 and H&M lately, Ann has managed to hold on to its brand loyal customers by consistently delivering popular merchandise. Its comparable store sales growth remained strong throughout last year and buyers responded very well to its offerings during the holiday quarter, despite the industry slump. Ann Taylor’s entire product range of holiday fashion offerings garnered significant customer attention, including its special collections, wedding collections, special occasion dresses, as well as handbags, jewelry, and shoes. LOFT also exhibited tremendous resilience against the edgy retail environment with its enticing product mix, strong core categories and the relaunch of LOFT lounge under the Lou & Grey brand name. The brand’s client base registered double digit growth in 2013 driven by its extensive marketing and appealing product range.
A good customer response amid a sluggish economic environment and cutthroat competition indicates Ann’s strong market position and its ability to operate with fewer markdowns. While several players in the market have seen their gross margins shrink due to heavy traffic-driving promotional activities, Ann appears to be in a better position to shield its margins. The retailer’s gross margins declined just marginally to 53.87% in 2013 from 54.82% in 2012 even though the entire industry was highly promotional during the year.
Gradually Shifting Production Away From China
Back in 2009, Ann sourced about 50% of its merchandise units from China, which accounted for more than half of its overall merchandise cost. However, with rising labor costs, the retailer gradually lowered its dependence on the region. At the end of fiscal 2013, about 37% of Ann’s merchandise units came from China, which made up about 40% of its merchandise cost. On the other hand, merchandise sourced from Vietnam accounted for just 7% of the cost but 13% of the total units. This clearly indicates that per unit cost of production for Ann in China is much higher than its other sourcing locations such as Vietnam, Indonesia, Cambodia, etc.
Labor wages in China are three times that of Indonesia, four times that of Vietnam, five times that of Cambodia and ten times that of Bangladesh.  Monthly minimum wages in India range from half to one-fourth of China’s minimum wages.  In 2009, Ann only sourced 6%, 12% and 10% of its merchandise units from Vietnam, Indonesia and India, respectively. These figures increased to 13%, 17% and 15% in 2013. As rising labor costs in China continue to trouble Ann, we expect these figures to go up in the future, which will have a positive impact on the retailer’s gross margins.
Reducing Operating Costs
During its Q4 fiscal 2013 earnings call, Ann stated that it is looking to amplify its savings by more effectively planning its expenses. The company is optimizing its cost structure, which is expected to result in $25 million in annualized savings. About two-third of the savings are likely to come from SG&A expenses and the remaining from gross profits. To lessen its SG&A expenses and as part of its ongoing omni-channel realignment, Ann is planning to reduce its corporate workforce by 100.
How Significant Are Ann’s EBITDA Margins For Its Stock?
We currently estimate Ann’s EBITDA margins to gradually recover from 20.6% in 2013 to 21% over the next three-four years and remain stable afterwards. However, if the company maintains its strong market position, sources a significant portion of its goods from low labor cost countries and effectively executes its cost saving plans, its margins can improve at a faster pace. If the figure reaches 22.5% by the end of our forecast period, there can be about 10% upside to our price estimate for Ann. On the contrary, if the margins remain at the current levels, there can be about 5% downside to our price estimate.
- Even as Wages Rise, China Exports Grow, The New York Times, Jan 9 2014
- Comparison: Minimum wages in China and India, Asia Briefing, Jul 18 2013
Disclosure: No positions