According to a Bloomberg survey of 14 analysts and traders, cotton prices are expected to fall 51% to $1 per pound by December 31, 2011. The price decreases will likely be driven by an increase in supply following greater output from new sources, as well as a recovery from the exogenous factors such as floodings in Australia and freezing weather in China . This led to a 6.3% year over year decline in the country's 2010 cotton output despite rising demand. Investors interested in benefiting from a decline in cotton prices should take a closer look at clothing retailers and mall REITs.
Between March 2010 and March 2011, cotton prices rose +161%. Clothing retailers have been directly hurt by the sharp rise in cotton prices. In a February 2011 conference call, Glen Murphy of Gap Stores (GPS) described the current situation by saying, "...for the first time, in a decade or more, we're seeing some inflation that is quite high..." Larger players like Wal-Mart (WMT), Gap Stores and Nike (NKE) have been able to, as Wal-Mart's William Simon said in a recent conference call, "work with suppliers to reduce inflationary costs when possible," but the prospect of continued margin pressure has depressed the valuations of the entire industry group.
Of course, retail stock valuations are not suffering solely because of rising input costs. These companies are also facing uncertainty over future consumer spending in the face of stagnant wages and rising energy costs.
But for a companies like Gap Stores, whose cost of goods sold as a percentage of sales has historically ranged from 59% to 64%, a reduction in cotton costs could yield both profit growth and industry wide multiple expansion. Such prospects could unleash pent up buyout forces that seem to have been put on hold following the political turmoil in the Middle East and the natural disasters in Asia and Austrailia. For more information about potential buyouts and other special situations, click here.
While retail stocks face legitimate headwinds, we remain constructive of many of the stocks based on low valuation multiples and interesting cost opimtization opportunities. For more information about these opportunities, read the following article.
MALL REAL ESTATE INVESTMENT TRUSTS
This is a less obvious beneficiary of falling cotton prices. Mall REITs like Simon Property Group (SPG) and General Growth Properties (GGP) are much less sensitive to short term prices in cotton, but there are longer term consequences. If cotton prices decline and allow consumers to spend more money-- in turn allowing retailers to make larger profits-- the REITs will ultimately benefit from both increased overage rental income and improved longer term pricing power.
While falling cotton prices should benefit mall REITs, investors should be aware that REITs are most sensitive to interest rates, and that several notable funds including Baupost Group and Glenview Capital have adopted a negative view of the industry because of valuation concerns and interest rate views.
Disclosure: I am long GGP.