June 28, 2022

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The Fashion Spirit

Fashion’s ‘Reverse Inflation’ Has Costs Hikes Following Pricing Gains

6 min read

Fashion is backing its way into the new world order.

Inflation usually starts with rising costs on raw materials and other essentials that eventually force companies to bring higher prices to consumers.

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But this time through, the process has been operating out of sync. Many brands, particularly on the higher end of the spectrum, were able to hike their prices last year, supported by a strong consumer and a scarcity of merchandise given the COVID-19-induced supply chain backups.

That made for an industry filled with hot companies with better margins and led to more interest in the consumer sector (as evidenced by the string of fashion IPOs).

Now costs are going up in earnest with inflation at a 40-year high, with prices on all goods and services in the U.S. rising 8.5 percent over the past year, bringing the sector back down to earth.

BMO analyst Simeon Siegel calls the progression “reverse inflation.”

It’s not just a novel situation, but a disorienting one for investors who fell in love with the peppier look retail had last year with sweeter margins and strong growth prospects.

“When costs go up, retailers and brands and investors are trained to believe there’s room to raise price,” Siegel said. “The problem is, everyone [already] did.”

Over the long run, he described it as “net neutral” for retailers, but acknowledged “it feels negative now.”

That is particularly true at Gap Inc., which last week cut its sales outlook and shook up leadership at the struggling Old Navy. The retailer said it has “taken a more aggressive approach to assortment balancing resulting in increased promotional levels primarily at Old Navy.”

That sounds a lot more like the familiar retail narrative defined by price promotions than the power-margin story the industry was settling into last year.

“People are asking, ‘Is Old Navy the beginning of the end?’” Siegel said.

That might depend on how other chief executive officers across the industry react to the growing pressures — on cotton costs, on freight, on labor and more.

Many, including John Idol, CEO at Capri Holdings, and Chip Bergh, CEO of Levi Strauss & Co., have been vocal about being willing to run more profitable, healthier businesses even if that means giving up some size or accepting slower sales growth.

But how many will be able to hold the line as pressures increase and Wall Street continues to seek growth?

“The question right now is, Who owns their destiny?” Siegel said. “CEOs are generally not hardwired to shrink. They’re hardwired to grow. The nature of that seat is to desire to do something special. Retail has been programmed toward growth, which is what got us in the [promotional] problem. It is a very hard thing for a human to internalize that less can be more.”

Already the last couple of years have been a study in corporate change, with companies racing first to survive the early lockdowns, pivoting on the fly toward the web and then enjoying a big boost as consumers reemerged.

Now leaders have to reposition again. And the CEOs having to deal with inflation also are ones who perhaps in their careers have never actually had to face the issue, at least in fashion. There was a time in the 2000s when the fear actually was the opposite — apparel prices were so stagnant and, in some cases declining, that the fear was the industry would enter deflation and would never be able to escape it. They’re learning on the fly not just how to set prices next season, but a year or even two ahead — all while costs throughout the supply chain spiral upward.

Elaine Hughes, CEO of executive search firm E.A. Hughes, a division of Solomon Page, said: “What CEOs can control is the way they run their company, how many people they have, how it is structured to make sure people have multiple skill sets so instead of being siloed doing one specific job, they can do multiple jobs, preferably within a department.”

But setting up the business to operate in inflationary times is just part of the ever-expanding job description for CEOs.

“It’s a very lonely job,” Hughes said. “Who do you talk to? Who do you trust? It’s very difficult. But what has compounded the CEO role today is that there are a million things going on. With the Black Lives Matter movement there has been a stronger emphasis on teams devoted to diversity and inclusion for the entire company population. Employees are becoming disgruntled, where they want to become unionized. There are women’s issues within these companies.

“There are too many of the social and political implications that have fallen on the shoulders of a CEO,” said Hughes.

Now, she said, rising costs are being piled on to the top of their list of responsibilities, forcing corporate chiefs to ask: “How is inflation going to run its course and how do we, as a company, address it without alienating our customers?”

These are questions that seem likely to become even more pressing as fashion starts to openly contend with the new dynamic.

Greg Portell, lead partner in Kearney’s global consumer practice, said the cost increases retailers have had to pay haven’t flown through to company’s profit statements yet.

But they’re coming.

“We’re expecting a very challenging second and third quarter as the cost increases start to hit the cost of goods and the revenue line gets harder to move,” Portell said.

After a period when companies were fighting scarcity given the supply chain troubles and paying up to get goods to the sales floor or the customer, that could be a major adjustment.

“We project it will take about 18 months for companies to really get their cost management strength back,” Portell said.

The market seems to be one that will, again, separate the inherently strong operators from the players still finding their footing.

“You’re going to start to see some of the sunshine darlings, the flowers that came out after the storm, start to wither” if they don’t have the supply chain management chops, he said.

The next turn of the wheel might also highlight just which companies evolved enough through the pandemic and which ones stopped too early.

“If you look back over the past six months, mostly the companies dropped [excess funds] to the bottom line or bought back shares, they didn’t put the money into innovation,” Portell said.

Ezra Greenberg, a partner at McKinsey & Co., said companies have “real work to do.”

“The only way to solve something like this is to have all hands on deck,” Greenberg said. “It has to be a rethink of the way in which we run the business and what we do on the supply chains and what we do on procurement so you’re not working at cross purposes.”

That means how people work is going to change, again, whether through new corporate structures or supported by automation or something else.

“There is one empirical fact that is true in the United States — it’s that nominal wages, regular dollar wages never fall, they just don’t,” Greenberg said. “If you went from $10 to $17 an hour or $25, you’re never getting that back. So what do you do? It’s definitely OK to pay people higher wages, if their value added per person is going up. This is about, ‘How do I raise productivity by increasing the top line versus cost cutting?’”

One way or another, retailers are going to have to learn to cope with cost increases.

But first, that realization might have to set in.

“Companies have taken price and markdowns are basically zero, they don’t exist, especially within apparel and softlines — historically a very competitive space,” said Ike Boruchow, an analyst at Wells Fargo. “Not just investors, but companies have forgotten that.

“The five-year period leading into COVID[-19], gross margins trended flat to down every year, very consistently,” Boruchow said. “All of a sudden, you looked at the group and we’re 300 to 400 basis points above COVID[-19] levels on gross margin.

“You’re starting to see little cracks,” he said, pointing to the Gap warning. “You can’t keep pricing stuff up. The consumer is still in a good spot, even the low-end consumer is still in a good spot. But you can’t just raise prices to the moon in a category that has historically been fairly deflationary. I’m pretty concerned.”

Boruchow is not alone.

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