While prices are below the 140-year peak of $2.20 a pound
reached on March 7th, they remain more than double last year's
prices taking its toll on the profit margins from retailers like
Aeropostale (
ARO
), which reported that rising commodity costs contributed to its
10% drop
in first quarter operating margins.
GAP
(NYSE:GPS),
American Eagle Outfitters
(
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 to 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 meets 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 the
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 the 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 the is cotton price headed?
((ref:1)) ((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 the 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 so as 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.
See our full analysis for ARO