While cotton prices are below the 140-year peak of $2.20 a pound reached on March 7, they remain more than double last year’s prices taking a toll on the profit margins from retailers like Aeropostale (NYSE:ARO), which reported that rising commodity costs contributed to its 10% drop in first quarter operating margins. GAP (NYSE:GPS), American Eagle Outfitters (NYSE:AEO) and J. Crew have also been impacted as well as most others in the industry. Below we take a quick look at what trends are driving this surge in cotton prices and the impact on the ARO.
We have a price estimate of $36, which is premised on the expectation that profit margins will be around 14%-15% through our forecast period.
Following are the major causes of the cotton price rise: ((When Will Cotton Finally Settle Down?)) 
1) Drought in China a major cause of concern:
China is the largest producer of cotton in the world. At the end of last year, China witnessed its worst winter drought ever delaying the plantation of new cotton crop in the Hubei province of China. China’s inability to meet its domestic consumption has forced it to ramp up cotton imports to make up for the shortfall.
2) Unseasonal Rains in India and Floods in Pakistan
India, the second largest cotton producer in the world witnessed unseasonal rains. This led the government to restrict the cotton exports, in order to safeguard the domestic supplies of cotton. The global shortage of cotton led to a speculation that cotton prices would rise further resulting in hoarding by traders creating an artificial short-supply and driving the prices up in the futures market. During the same time, Pakistan, also a major producer of cotton, was hit by devastating floods, further aggravating the issue.
Before the recession, cotton prices were steadily moving up at a much slower rate than recently. This trend stopped as consumers reduced their clothing purchases. However, with the demand for clothing picking up alongside the shortage of cotton, the cost of the raw material has soared.
Where is the cotton price headed? (Morgan Stanley Cuts Cotton Price Forecast 15% on Bigger Acreage)
We believe that the cotton prices may not hold up to these levels in 2011, as the production numbers in Asian countries stabilize during the year. Prices have fallen from the March 7 peak of $2.20 a pound to around $1.30 recently. Chinese farmers are now looking forward to increasing the cotton production after the price surge, and the market is expecting better yields from China and Pakistan along with a 7% increase in the global acreage in 2011.
Moreover, the Indian government is looking forward to lifting the cotton export cap to clear up the unsold cotton inventory and make way for the new crop. This will certainly help increase the global stock-to-use ratio from the current 17 year low level.
If this improves profit margins in the near-term, the shares should see a nice recovery.
Disclosure: No positions