Dreadful first-quarter earnings results from retailers have been plentiful, but all have failed at mentioning the biggest threat to the sector moving forward.
Try two words: fast fashion.
For years, the likes of H&M, Forever 21 and Zara have ripped up the status quo in retailing. Out is the personal feel in buying merchandise from team members, in is mass production of things seen on the catwalk just weeks earlier. In are prices that are stupid cheap, made so by garments being sourced from Turkey, Malaysia and other walks of life that we will never visit. In the process, these fast-fashion retailers have basically destroyed the profit margins of specialty apparel players Abercrombie & Fitch (ANF) and Aeropostale (ARO). They have also weighed on the performance of Macy's (M) and J.C. Penney (JCP), but not to the extent of specialty apparel retailers that have a very centralized business model -- they don't sell Fossil (FOSL) watches or Coach (COH) handbags, for example.
But just as some in the old guard thought they had solved the fast-fashion dilemma by striking unique partnerships or lowering their own cost bases, they are about to be walloped again. I had the chance to tour H&M's largest store in New York City for TheStreet on Wednesday. There I was, an hour before opening, perusing four floors of cheap apparel, shoes and home goods. It seemed as if every article of clothing was sourced from a different low-wage country. Like everywhere I turned, something interesting caught my attention, such as a denim jacket with '80s-inspired rock music patches stitched on.
And then, out of the blue, I got it -- H&M has grander ambitions than simply hawking slim-fit clothes. The company wants to sell home goods that rival Target (TGT). More sneakers that compete with lower-quality, lower-priced Nike (NKE) kicks at Kohl's (KSS) and J.C. Penney. I think other sectors in retail, namely department stores and big-box retailers, are poised to have their margins rocked by fast-fashion players over the next five years. You won't see their impact appear in a single quarter, but gradually -- each quarter a couple of basis points on gross margin here, a couple on operating margins there.
More immediately, I think these three apparel-selling retailers are poised for difficult back-to-school seasons based on what I am seeing from fast fashion. The quality of their products has improved a touch, prices are being driven sneakily higher, and exec teams are lightning-quick in adopting new trends.
Guess (GES): Stock has fallen about 1% in the past month, underperforming the major indices. The company will be hurt on several fronts outside of the fast-fashion impact, including a slowdown in demand in emerging markets and lingering effects of the strong dollar. Fast-fashion stores resemble Guess stores except for one big difference -- their prices are 50% less. Huge problem for Guess, especially as its product quality is not too far removed from fast fashion (it will naturally say otherwise).
Abercrombie & Fitch: According to my research, the company is at significant risk of missing consensus earnings estimates on the first quarter. So many negatives here it's hard to count: (1) strong dollar; (2) poor fashion, only modest improvements under new execs; (3) slowing demand at key overseas tourist destinations (see Burberry's warning this week); and (4) certain lines in the fast-fashion retailers resemble the American prep that Abercrombie & Fitch made famous -- except at half the price in the case of hoodies, jackets and jeans.
Wal-Mart (WMT): Indeed, mighty Wal-Mart sells other things besides apparel. But a good portion of a Wal-Mart stores' sales floor is devoted to high-margin, fast-turning apparel. The company has had success in the last year in apparel, which has helped to offset costly investments in employees and sharper food prices. This dynamic may change over the next 12 months, exposing Wal-Mart's pressured margins even more. European-based fast-fashion retailer Primark will be entering the U.S. this fall, and along with H&M's expansion, could whack Wal-Mart's apparel business.