By Bridget Weishaar
We think apparel manufacturers have experienced a resurgence in revenue-generating opportunities with the advent of innovative fabrics and designs, the ability to interact directly with consumers, and the chance to expand in growing global markets. Furthermore, additional pricing power through strong brands and a faster, more flexible, and lean manufacturing system has yielded margin expansion possibilities. We think the apparel manufacturing industry is dynamic, quickly growing, and one to watch over the next couple of years.
Given the sectorwide disruptive forces of e-commerce and fast-fashion retailing on apparel manufacturing, we have revisited the attributes that we believe lead apparel manufacturers to garner economic moats. We think modern technologies and consumer preferences demand an entirely different skill set from companies than in the past. In fact, we think current innovations have given companies an unprecedented opportunity to develop direct relationships with their customers to solidify their intangible brand asset, as well as be creative in managing the supply chain to develop unrealized cost efficiencies, both of which are critical to developing an economic moat in this category. In an effort to quantify the opportunity and positioning of our apparel manufacturing universe in regards to economic moats, we have developed a framework with which to view the firms. We look for leadership in five categories when analyzing competitive advantage: product differentiation, direct-to-consumer penetration, geographic reach of the distribution system, manufacturing efficiencies, and an ability to defend against rising costs. Those companies with narrow Morningstar Economic Moat Ratings--Hanesbrands (NYSE:HBI), PVH (NYSE:PVH), and VF (NYSE:VFC)--tend to outperform competition across all categories considered, leading to outsize revenue growth, operating margins, and overall returns on invested capital, while no-moat Gildan Activewear (NYSE:GIL) and Guess (NYSE:GES) trail in a couple of categories.
Technological Disruption Gives Apparel Makers Opportunity to Build Moats
The technological revolution of the past 15 years--including the scaling of e-commerce and the philosophy of quick, cost-efficient manufacturing--has affected almost every aspect of business, and apparel manufacturing has been no exception. Social media, e-commerce, globalization, and manufacturing efficiencies have reshaped the apparel manufacturing landscape, and we think the companies that have adapted to modern times have a real opportunity to develop brand strength (an intangible asset) and cost efficiencies, both sources of an economic moat. Advanced fabrication and construction, seamless integration of the design and production process, more direct-to-consumer opportunities, and efficiencies in manufacturing have given apparel manufacturing companies increased pricing power, a decreased reliance on retail partners, added cost advantages, and ultimately, the opportunity to develop an economic moat versus their peers.
The old method of apparel manufacturing was very simple and linear. Apparel companies designed a fall/winter and spring/summer collection, materials were sourced, products were manufactured, and garments were shipped to a distribution center, where they were delivered to the appropriate retail venues. The entire process required apparel manufacturers to commit approximately six months in advance to the designs for 40%-60% of their seasonal lines. At the start of each season, nearly 80% of that season's inventory was committed, and deliveries to retailers were made about four times a year.
The new manufacturing process is more circular, relying on feedback loops, customization, speed to market, and more frequent inventory turns to increase sell-through of full-priced merchandise. Perhaps one of the best examples of this is apparel retailer Zara, the flagship concept of Inditex (OTCPK:IDEXY). Zara commits six months in advance to only 15%-25% of a season's line and locks in only 50%-60% of the line by the start of the season. Turnaround is quick. The time from design to the garment hitting store shelves can be as short as two weeks. (Sources: Nelson Fraiman's 2010 Zara case study and Seth Stevenson's 2012 Slate.com article, "Polka Dots Are In? Polka Dots It Is!")
A key theme across our coverage universe is the integration of the design, production, and retailing processes to maximize sales and costs. Flexibility and differentiation in design, manufacturing locations, and distribution channels have become paramount to success.
Product Differentiation: A Sure Path to Pricing Power
For many years, apparel designers were forced to work with a fixed array of fabrics and materials. Differentiation among branded products was solely determined by design, color, and use of embellishment. However, advanced research and development processes combined with an educated consumer base that demands attention to functionality and environmental and health issues have quickly changed the universe of fabrication, fit, and design. Smart textiles are being developed to incorporate technology into apparel. Sustainability has become more than a trend, and recycled fibers or other environmentally friendly materials are often favored over synthetics. The activewear category has transformed gym clothes from a uniform of cotton T-shirts and shorts into an array of temperature-controlling, sweat-wicking, performance-enhancing bodywear that is customized for specific activities.
Features like these are valued and differentiated, and companies that have invested in their development have found that they can command a higher price for them. We think certain categories have lent themselves better to differentiation in product. We have seen innerwear, outerwear, and activewear apparel manufacturers command significantly higher margins than more traditional apparel manufacturers.
A look at VF's groups provides us with a relatively clean comparison of this advantage, as all of the product lines are sourced and manufactured through the same parent company. At VF, the outdoor and action sports coalition commands a gross margin that is 4 percentage points above the overall company's gross margin. Hanesbrands provides another example of strength in innovation. Its Innovate to Elevate strategy has had a noticeable impact on operating margins. Innerwear has been executing the strategy for a number of years, and operating margins grew from 14.6% in 2010 to 17% in 2012. The company introduced Hanes ComfortBlend men's underwear in 2012 with a 30% price premium to core products. Gildan has introduced Gildan performance apparel, which provides enhanced performance attributes like moisture management and antimicrobial properties. Its acquisition of the Anvil brand meets demand from eco-conscious consumers. As a result, we highlight these three companies as leaders in this category out of the apparel manufacturers we cover.
Not Just Wholesalers Anymore: Developing Direct Consumer Relationships
Since the brand intangible asset is the single most common source of an economic moat in the apparel sector, one of the things we watch most closely is how well a company protects and nurtures its brands. Traditionally, many apparel brands launched through the wholesale channel with multibrand retail partners. This strategy can give a company instant reach and scale with a much lower investment than opening its own retail outlets. However, the multibrand retailing format started to suffer seismic shifts. Department stores, once the bastion of apparel retail, began to fall from popularity, losing market share to value-focused multibrand stores including T.J. Maxx (NYSE:TJX) and Kohl's (NYSE:KSS) and big-box formats like Wal-Mart (NYSE:WMT) and Target (NYSE:TGT). Specialty retailers also began gaining share. In our opinion, department stores were doing themselves no favors with a store fleet that was desperately in need of updating, waning customer service, poor merchandise presentation, and an overall lack of a compelling consumer proposition. We estimate that department stores' retail market share fell from 7% in 2003 to 4% in 2013.
The department stores weren't the only ones to suffer. Brands carried by some stores began to lose strength as messy shelving, uninspired merchandising, and poor labeling came to be associated with them. However, retailers are no longer better positioned than brands to be closest to the customer. With the widespread and growing adoption of e-commerce, apparel manufacturers can now reach their customers directly. Research by PwC shows that more than a third of consumers globally have already bought products directly from brands or manufacturers. According to PwC's survey, more than half of online shoppers in China and the United States say they are going direct to brand sites. With the ability to provide a full range of choices on a single site, and to do so at a lower cost while still making a larger margin than retailers, manufacturers are actually better positioned than retailers to benefit from e-commerce. However, success is firmly dependent on brand cultivation, as brand loyalty is what drives the consumer to the manufacturer's e-commerce site and provides the opportunity to charge a premium.
The Internet is not the only other channel being pursued by apparel brands; more and more brands are opening their own retail outlets. Although they add a layer of complexity with a larger number of stock-keeping units, end customers, timing, logistics, and delivery, retail stores offer a unique opportunity to interact personally with customers, create a shopping experience representative of the brand, and collect valuable data on consumers and their response to products and marketing. In our opinion, a well-rounded multichannel strategy seems to yield the best competitive advantage, balancing fast, lower-risk, large-scale reach with control over brand identity and direct consumer relationships. PwC research shows that when consumers use multiple channels, the majority spend more at their favorite retailers; nearly 1 in 5 say they are spending at least 25% more.
In our coverage universe, Guess, PVH, and VF are best in class at having achieved a well-rounded multichannel strategy. All three companies have a diverse mix of wholesale, retail, and e-commerce operations.
For a Lifestyle Brand, the World Is Its Oyster
A strong brand intangible asset transcends a single product, fad, style, or category. Instead, it elicits a particular lifestyle, offering apparel and accessories for every eventuality. While the styles and specific products may change, the overall look, feel, and target market never will. In our opinion, this is the essence of a strong brand intangible asset; it provides companies the opportunity to charge a pricing premium as its doors allow consumers a one-stop shop for all categories in all decades and across all occasions. Because of this ability to be defined on a universal level but be flexible on a product level, strong brands can cross geographic boundaries and find success in an array of markets. This global attractiveness supports a brand's economic moat, giving it a distinct competitive advantage in penetrating new markets.
We estimate that the U.S. retail market alone is a $4.5 trillion industry, with clothing and accessory stores accounting for almost $250 billion of sales. Although large, the market is very mature. We estimate that growth in the clothing and accessory category will only average about 3%, implying that much of any company's gains must come through market share versus market growth. Globally, however, retail market upside remains rich. We estimate that nongrocery retail sales total approximately $6.8 trillion worldwide, with clothing and footwear specialist retailers accounting for just under $1 trillion.
Not surprisingly, emerging-market growth is still outpacing that of developed countries. We believe this trend has been even more accentuated in recent years by general economic weakness. Growth in China is slowing as the country moves toward middle-income levels and concerns are increasing as credit growth is rapid and through a shadow banking system. Europe is slowly climbing out of a long recession, but according to Deloitte, much of the growth is coming from an expansion of exports rather than stronger consumer spending, and access to credit remains difficult. We note particular ongoing weakness in Southern Europe. As a result of these factors, in addition to the threat that European new store growth is reaching maturity after numerous years of investment by U.S. brands, we think emerging markets will become key to apparel manufacturers' sales growth strategy.
Many of the apparel manufacturers we cover are approaching market saturation in the U.S. and Europe. We think those with brands strong enough and universal enough to be attractive to emerging markets and those with the relationships and structure required to expand into new geographies will have an opportunity to gain market share. Gildan and Hanesbrands are early in their international expansion phases, with approximately 10% of revenue generated internationally. Guess, PVH, and VF lead in global scale. Guess derives roughly 35% of its revenue from Europe and 11% from Asia. PVH generates about 46% of revenue from outside North America. Its Calvin Klein brand collects 20% of its revenue from Europe and 30% from Asia and Latin America, while its Tommy Hilfiger brand gets 47% of its revenue from Europe and less than 10% from Asia and Latin America. We expect Tommy Hilfiger to target growth in the Asia and Latin America markets and to benefit from Calvin Klein's established presence there. VF currently gets about 37% of its revenue internationally; we see this increasing to just under 45% in five years. Ultimately, we see international expansion being one of the most important factors to growth other than direct-to-consumer sales.
Efficient Manufacturing System Is Not Just About Cost
Fast fashion reshaped the way designers and producers thought about the apparel manufacturing process. Once basing the process solely on a cost-reduction model, apparel manufacturers now need to consider speed to market, ability to leave capacity open to late orders, and efficacy in reaching a global fleet of retailers, all while still paying attention to cost. Often, margin maximization is achieved not through the lowest labor cost, but by pursuing multiple strategies for different product lines and balancing speed and pricing power with production cost. BCG estimates that there are seven factors that play into strategic line planning optimization: de-averaging design, development, and the supply chain; reducing time to market; reducing end-to-end cost of goods sold; improving end-to-end product visibility; integrating online and retail channels; balancing local, regional, and global responsibilities; and aligning plans with trends in consumer purchasing and competitive offerings. We think these guidelines are an excellent example of how segmentation, strategic goals, and divergent methodologies play into modern manufacturing decision making.
We think scale is a significant aid to the flexibility that characterizes a winning manufacturing strategy, and we highlight Gildan, Hanesbrands, and VF as best in class in this category. All of the apparel manufacturers we cover have segmented product lines on characteristics other than brand, including geography, distribution channel, and/or product type, but a couple lead in other categories, as evidenced by premium margins.
Gildan has the most expansive owned vertically integrated manufacturing organization in our coverage. As a result of its control of the process from end to end, Gildan's operating margin of approximately 16% is one of the highest in our apparel manufacturing coverage and made even more impressive by the fact that its product line is mostly basic apparel with lower pricing power than other lifestyle brands. With about $12 billion in revenue, Gildan produces a much higher volume of product and can therefore benefit from additional economies of scale. VF produces 30% of products at owned facilities, while 70% is sourced. Its operating margin is almost 15%. A significant component of Hanesbrands' Innovate to Elevate strategy is the incorporation of manufacturing considerations into product design, which has led to higher margins and price premiums. Approximately 75% of merchandise is produced in the company's 41 manufacturing facilities or through third-party contractors. The adjusted operating margin is roughly 13%.
Pricing Power Allows Brands to Defend Against Rising Costs
Overall, we think costs are going to rise in 2014, so a company's ability to offset at least some of this increase in price yields a significant margin advantage. Of particular importance in the apparel industry is the cost of labor and cotton.
BCG estimates that labor accounts for 50%-60% of the cost structure in the shoe and apparel industry. This means that the industry as a whole is highly exposed to wage inflation. Enormous changes are occurring in the wage differential of traditional manufacturing hubs. According to Deloitte, China is the world's largest manufacturing nation, benefiting from a labor and materials cost advantage, strong government investing in manufacturing, and an established supplier network. However, labor costs have been on the rise with the emergence of a strong middle class, and the country is losing some ground to nearby lower-cost countries like Vietnam, Indonesia, and India. Deloitte notes that factory wages in China increased 20% in 2010 and the central government is encouraging the increase of minimum wages as a matter of policy by about 13% annually through 2015.
Apparel companies also have a heavy exposure to cotton prices. For example, Gildan, whose products are primarily cotton based, estimates that a change of $0.01 per pound in cotton prices would affect its annual raw material costs by about $4 million (approximately 0.3% of 2013 cost of goods sold). As this expense fluctuates, we think companies with a strong brand and high degree of product differentiation will be better able to offset higher costs with pricing increases, although it would be very difficult to fully offset a significant spike as was seen in 2011.
Based on these factors, we think Hanesbrands, PVH, and VF are best positioned to defend against rising labor, energy, and material costs. All three possess strong brands that command a pricing premium, which is the basis for their narrow moat ratings. Scale and a diverse manufacturing infrastructure allow them more of an opportunity to maximize cost efficiencies.
Our Top Picks
We highlight 3-star, narrow-moat PVH as our top pick in apparel manufacturing. The stock is currently trading 15% below our fair value estimate of $145. PVH was one of the highest-ranked stocks across all categories covered in our apparel manufacturing analysis.
We believe PVH has a significant revenue and margin expansion trajectory on the strength of its Tommy Hilfiger and Calvin Klein brands, which account for about 85% of operating profit. Following the Warnaco acquisition, we think the company should achieve about $100 million in cost synergies over the next four years. After structural issues with the acquisition normalize, we think the Tommy Hilfiger and Calvin Klein brands should be able to achieve mid-single-digit annual revenue growth on average over the next five years and about 260 basis points of operating margin expansion to 14.4% through high-margin international market penetration, upmarket distribution channel shifts, and supply chain upgrades. We see PVH as firmly committed to investing in brand strength, and we think this will yield ongoing pricing power, the basis for our narrow moat rating. We estimate PVH can achieve an average annual return on invested capital of 13%.
Although we believe the stock is currently fairly priced, we also highlight narrow-moat VF as one to watch. VF is the only company that achieved the highest rating across all categories in our study.
We think the company is poised to take advantage of three market trends. First, we believe the outdoor and action sports market is a large and quickly growing opportunity, with activewear apparel now often worn in place of casual and weekend attire. Based on NPD data, we think this enlarged athletic/casual category is a $46 billion opportunity with a focus on higher-margin performance and comfort products. VF's North Face is already a leader in the $25 billion global outdoor market and also provides high-performance sports apparel, an increasingly demanded category thanks to the fitness craze. We expect that this category will be a key growth driver for VF and that the company will make further acquisitions to increase exposure. We model it growing organically to 61% of revenue from the current 54% penetration over five years. Second, we see VF leveraging its vast global supply chain to support additional international sales and think international markets can grow from 37% of revenue to just under 45% in five years. Finally, we see direct-to-consumer sales growing to 25% of sales from the current 21% penetration, with e-commerce being the fastest-growing, most profitable channel.
Bridget Weishaar is a stock analyst for Morningstar.