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Think For Yourself And Don't Believe Everything You Hear About The Effects Of A 10% Tariff Hike.

Summary

Smart investing requires you to do your own critical thinking about news affecting your positions. You can't always rely on business news outlets to actually think about what they report.

I believe the public at large and the investing public is being misinformed about the effect at retail of the increased tariffs on Chinese-made consumer products.

U.S. retailers and their vendors are likely to raise prices far more than the  tariffs alone justify.

I analyze one trade groups "analysis".

We investors should never forget to think critically about issues facing the companies we invest in. If we act without thinking through the issues we may blindly follow the herd in the wrong direction.

The activity in retail stocks following President Trump’s announcement of a new 10% tariff on many consumer goods reflects a lack of understanding of retailing. Maybe instead of stock prices of companies affected by the tariff falling, they should be rising. The announcement of the new tariff was a signal to the retail industry that the President had just handed them cover to raise prices in amounts far greater than the 10% new tariff alone justifies.  Now,  China's weakening of its currency, news of which is breaking out, is unlikely to get the attention of most American consumers and may enhance gross profit numbers even more

While presented as a complaint about the new tariff, one industry trade group, the Footwear Distributors and Retailers Association (FDRA) revealed, perhaps unwittingly, their members’ plans to pass the tariff cost to the consumer and on top of that cost add their normal markups. 

But, that’s not what the FDRA actually said in so many words. Feigning a concern for the impact of the tariff on consumers, the FDRA published a fake “analysis”of its impact. Part of the message showed how the price of three products could rise because of the higher tariff. The following is copied from the FDRA website:

Consumer Impact Analysis of Additional 10% Duties on Shoes From China:

  • A popular type of canvas “skate” sneaker currently retailing for $49.99 could increase to $58.69.
  • The price of a typical hunting boot could increase from $190 to $222.27.
  • And a popular performance running shoe could jump from $150 to $187.50.

(This is the same “analysis” that was presented as “news” on CNBC last Friday, without any journalistic challenge at all.)

You can’t reconcile retail price increases of 17% (sneakers), 19% (boots) or 25% (running shoes) to the effect of a 10% tariff on a pair of shoes at the port of entry into the U.S. without an explanation. You can’t even reconcile a 10% increase in retail prices to the new 10% tariff without an explanation.

Of course, the FDRA is not likely to want to volunteer an explanation because that would reveal its deception. (There is nothing political to be gained by the FDRA by telling the truth.)

The real impact of the new tariff is going to be on the bottom line of the retailers and their import suppliers. And, if anything, it is likely to be a positive one. Here’s how it will work, using the FDRA's  $150.00 running shoe example:

1. The U.S. importer (let’s pretend it’s a running shoe with a swoosh) will buy the shoes from the Chinese factory.

2. U.S. Customs will apply an additional tariff on the pre-duty landed cost of the imported product, i.e. on the Chinese factory’s selling price plus the cost of transportation paid to get it to the U.S. port. For this example, let’s say that cost is $35.00. According to the FDRA, the average existing tariff on shoes from China is 11%, or $3.85, and the new tariff is 10%, or $3.50, bringing the total cost to Nike up from $38.85 to $42.35, and increase of $3.50.  

3. Nike (NKE) is a premium brand and commands a ~100% markup on its products' “first cost” when it sells then to its retail store customers. Let’s pretend in this example that the customer is Foot Locker (FL). In this case, Nike’s markup, before the new tariff, produces a selling price to Foot Locker of ~$77.70 ((35+3.85) x 2) and a gross profit of ~$38.85. After the new tariff is implemented, Nike’s markup produces a selling price to Foot Locker of ~$84.70 ((35+3.85+3.50) x 2) and produces a gross profit of ~$42.35. That represents a gross profit increase of $3.50, or 9% more gross profit than before implementation of the tariff.  

4. Foot Locker also commands markup of ~100% on top brands like Nike, and marks up the shoes it purchased from Nike, before the tariff increase, to ~$155.40, giving it a gross profit of $77.70. After the new tariff takes effect, Foot Locker’s cost will be ~$84.70, which it will mark up to ~$169.40, giving it a gross profit of $84.70, which is $7.00 (9%) greater than its gross profit on the same shoes before implementation of the new tariff.

Here’s the truth: By itself, a $3.50 tariff passed on to the retail consumer can increase the retail price by only $3.50. That would cause the pair of running shoes with a swoosh going from $150 to $153.50. But, in our example, the act of increasing the tariff (not the tariff) provided an excuse for the retail price to increase by $19.40, which is 5.5 times what a direct pass-through would have accomplished. Where does the extra $15.90 go? Answer: it goes to the companies in the distribution channel from the port to the consumer’s front door.  Does it all end up on the bottom line of the P&L?  I don't know.  Probably not.  Retailers may see a fall off in demand and react by discounting part of the new suggested retail price back to near the "old" price.  Will some of it stick?  Probably.  Will the prices come down when the new tariff is removed? Almost certainly not.

This exercise reveals how the kind of price increases in FDRA’s press statements “could” happen. “Could” is the word used by FDRA in its deceptive “analysis”. That doesn’t mean every importer and every retailer will benefit to the extent the FDRA’s “analysis” reveals it “could”. Still, there is a great focus by investors on gross margin (gross profit/net sales). If importers and retailers simply passed on dollar-for-dollar the new tariff, their gross margin would be negatively impacted and that might also prove a drag on share prices. I expect that these companies will mark up the higher tariff amount but perhaps not by their standard ratio. In any event, it is hard for me to see that my retailers will suffer from the tariffs themselves.  I think most will gain.

CAVEAT: I don’t know what either Nike or Foot Locker pays for a pair of running shoes that carry a retail price of $150. Both are big, complex companies doing business in the U.S. and numerous other companies. I don’t have access to their internal cost sheets. All I have to go on are their published financial statements that don’t go all that much further into detail than some color on their general ledger accounts. I assumed a 100% merchandise markup (50% gross margin) assumption in this article. Nike’s overall gross margin for fiscal 2019 was 44.77%, but in addition to being after merchandise costs that number is after warehousing costs, third-party royalties, design costs, gains and losses on currency hedges and shipping and handling costs. Further, Nike sells more than just footwear.  Foot Locker’s gross margin for its fiscal year 2018 was 31.8%, but that number is after not only merchandise cost, but also rent, buyers’ compensation and shipping and handling costs. I don’t’ believe my rule-of-thumb number is that far off. My point: my analysis is imprecise. But, at least I have been transparent and have shown how I got there.  It would have been helpful if FDRA had been.

Anyone with greater knowledge or a different point of view about the effect of the increased tariffs on specific stocks should use the comments section to enlighten us all.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in nke over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.