(Reuters) - Soaring cotton prices and higher wage deals in producer countries will challenge the ability of European retailers to push through costs to cash-strapped consumers in their home markets, potentially hurting margins.
Cotton is at a record high and workers in countries such as Bangladesh and China, major suppliers to the West, won bumper wage increases after strikes and political pressure -- a double hit for retailers reliant on price-conscious European shoppers.
Those input costs will affect firms across the region, from giants such as Inditex (ITX.MC) and Hennes & Mauritz (HMb.ST) to smaller firms such as Primark, although the manner in which they are pushed through -- or not -- will vary, said analysts.
"Pressure is coming from raw materials and labour costs, particularly those in emerging markets," Matthias Born, an RCM fund manager at Allianz Global Investors, said.
Those sectors unable to tap into emerging markets growth end up losers because they "ultimately have margin squeeze," said Mislav Matejka, equity strategist at JP Morgan, citing firms where "a significant proportion of the cost of goods sold is exposed to cotton or other commodity prices."
LABOUR PAINS
"For 20 years, clothes prices have come down and the volume was there. Now, with a relatively weak consumer environment and difficult labour market, they may need to reduce margins to protect market share," he added.
That wage pressure was seen in low-single-digit rises in state-owned Chinese firms, 5-10 percent in some German-owned firms and double-digit rises at outsourcing sites that produce IT or apparel for western firms, Born said.
Wage awards differ from factory to factory, but rises of 9 percent to 10 percent a year are expected over the next two years, a garment factory manager in Guangdong, China, told Reuters on condition of anonymity.
While Chinese workers have been particularly active in pushing for higher minimum wages in 2010, with support from Beijing, the pressure has spilt into other clothes-producing centres such as Bangladesh and Cambodia.
Workers in Cambodia walked out in September over their demands for a 50 percent rise in basic pay, while Dhaka nearly doubled the Bangladesh minimum wage, although from a much lower base than for workers in China.
That wage pressure comes on top of a surging cotton price which has risen 70 percent this year and recently hit a record high on trade and fund buying, with further pressure from Chinese demand seen next year.
NO MARGIN FOR ERROR
Adding to retailer woes is the subdued economic outlook in Europe. Recent euro zone data showed economic growth of 0.4 percent in the third quarter, against 0.8 percent in Britain and 9.6 percent in China.
Higher input costs do not equate to margin squeeze, if they are passed on. But with consumers more price conscious -- UK CPI rose to 3.5 percent in October -- firms may decide to take a margin hit to preserve market share.
Primark owner Associated British Foods (ABF.L) recently said the sharp rise in cotton prices would likely hit margins at its discount fashion chain in the short term.
Next (NXT.L) said retail prices would rise 5 percent to 8 percent in the first quarter of next year and that consumers faced double-digit increases in the year as a whole, while Inditex executives have said prices will be stable in 2011.
The extent to which firms pass on costs, risking a loss of market share, or suck them up, with the potential for margin squeeze, will become more apparent as the year goes on, a London-based analyst said.
Gross margins for Inditex and H&M stand at 58.9 percent and 66.5 percent, respectively, Thomson Reuters Starmine data shows, just above their five-year averages.
MATERIAL CHANGE
H&M spokeswoman Charlotta Nemlin acknowledged the increases in cotton and wage costs -- especially as it sources two-thirds of its production from Asia -- and, while refusing to comment on pricing strategy, said gross margin was "not a goal in itself."
Tactics open to retailers, other than price rises, include changing pack sizes -- four pairs of knickers for five pounds, instead of four, for example -- or increasing the amount of cheaper, man-made fibres in the products.
The extent to which European firms are reliant on an Asian manufacturing base also differs and for those like Inditex, that produce a lot of garments in Europe, the impact is reduced.
Barcap analysts Karen Howland and Chris Chaviaras expect Inditex to positively surprise in its third-quarter results, boosted by a relative lack of exposure to Asia.
An Inditex spokesman said the firm sources more than 50 percent of its materials from Spain, Portugal and Morocco, with a further 14 percent from elsewhere in Europe.
It tends to be the exception, however, especially at the cheaper end of the spectrum. French supermarket chain Carrefour (CARR.PA) said 86 percent of its 300 clothing suppliers are based in Asia, mostly China.
Other big users of cotton, such as Kingfisher (KGF.L), Europe's No. 1 home improvements retailer, have looked to protect margins by pooling buying power from their different businesses and buying in even bigger bulk from suppliers.
While wages and cotton prices prove a drag it is not all doom and gloom, with respite seen recently in the form of global freight rates and the U.S. dollar, in which cotton is priced.
An oversupply of container shipping and a weaker dollar, on the back of the latest tranche of U.S. quantitative easing, have helped relieve some of the wage and commodity price pressure facing retailers, with both seen weaker into 2011.
