These 3 Apparel & Footwear Brands Are Well-Prepared for Chinese Wage Inflation

Chinese labor cost inflation won’t hurt all apparel and footwear companies equally. Investors should place their bets on those who diversify their supply sources geographically, move upstream, and invest in technology.

Jan 9, 2014 at 2:01PM

It is an open secret that most of our branded shoes are manufactured in China because of lower labor costs. However, China's position as a global low-cost production hub could change in the future as the nation faces inflationary wage pressures. Footwear and apparel brands like Nike (NYSE:NKE), VF Corp (NYSE:VFC) and Under Armour (NYSE:UA) are seeking alternative ways of staying cost competitive in light of such trends.

Buy and build
Cost efficiency is not solely an issue of buy versus build--it is about maintaining sufficient flexibility to meet demand. VF Corp has set itself apart from its peers with its supply chain management practices. The company utilizes a unique combination of sourcing channels: in-house manufacturing, outsourcing, and a new hybrid called "The Third Way."

VF Corp derives a good balance between in-house manufacturing and third party manufacturing. As of June 2013, it produced about 145 million units internally, which accounted for 30% of its supply, and outsourced the rest. Besides allowing the company to make some of its products cheaper and faster, in-house manufacturing gives VF Corp a stronger bargaining position with its suppliers because the company has inside knowledge of labor and material cost trends.

On the other hand, The Third Way involves third party manufacturers building purpose-built factories for VF Corp, leveraging the company's manufacturing knowledge derived from a century's experience in making jeans and workwear. At its investor day in June 2013, VF Corp mentioned that a factory was currently being built in Bangladesh with assistance and input from its engineers, with a target production of up to 9.5 million units in a few years' time. The Third Way represents the best of both worlds for VF Corp, allowing it to combine its strengths in manufacturing with the flexibility of outsourcing. VF Corp's long term target is for The Third Way to account for two-fifths of its total supply, which should result in further cost savings.

Diversifying beyond China
While China still remains the world's largest supplier of footwear and apparel, not every company depends on the nation equally. Nike is relatively geographically diversified when it comes to sourcing for its products. Independent contract manufacturers from 28 countries across the world supply Nike with its branded apparel. Vietnam (instead of China) is the largest country of origin for Nike branded footwear, accounting for 42% of the product mix in fiscal 2013. In fact, China's share of the Nike branded footwear supply mix has fallen from 36% in fiscal 2008 to 30% in fiscal 2013.

VF Corp is also less reliant on China for its sourcing than its peers. According to its management, VF Corp produces about a fifth of its units in China, while the industry averages 40%. In addition, VF Corp derives 40% of its supply from the Americas, which enables it to save on shipping costs and increase its speed to market for certain products.

Investing in technology
Nike has tackled labor issues head-on with investments in new, less-labor intensive technology. For example, Nike uses automated stitching to reduce both labor and processing time. Only one person is needed to operate a single stitching machine to complete the entire upper portion of a Nike Air Force One shoe. Also, stitching Nike's iconic Swoosh pattern takes about one-third of the time it previously took with manual stitching.

If you thought that automated stitching was helpful, Under Armour went one better with its new SpeedForm shoes. These shoes boast of a seamless heel cup that did away with the need for any stitches. Furthermore, Under Armour's SpeedForm shoes were made at a Chinese bra manufacturer's factories. This could open up new possibilities of manufacturing both apparel and footwear in a single integrated facility, reducing issues with production overcapacity.

Final Foolish thoughts
Chinese labor cost inflation won't hurt all apparel and footwear companies to the same degree. Those who have diversified their supply sources in terms of geography and moved upstream to reduce their reliance on contractors will be less affected. Furthermore, companies like Nike and Under Armour could even gain an edge over their peers with respect to cost competitiveness as they reap the fruits of their technology investments.

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Mark Lin has no position in any stocks mentioned. The Motley Fool recommends Nike and Under Armour. The Motley Fool owns shares of Nike and Under Armour. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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