Levi's Won't Be Unraveled by Cotton Price Surge

Expensive cotton is in vogue again and apparel company investors aren’t too happy about it.

Cotton prices have surged 18% over the past month, and 42.5% year to date, to levels last seen roughly a decade ago. That has sent shares of apparel companies—including denim-maker Levi Strauss LEVI -5.13% —tumbling. On Wednesday alone, Levi’s shares were down 5.1% while the S&P 500 index was up 0.4%. Fast-fashion retailers H&M and Inditex were down 4.9% and 4.6%, respectively, while Gap shares fell 2.2%.

The share price declines make sense given how frayed apparel company investors’ nerves are. Clothing sellers have already been facing container shortages, factory shutdowns in Vietnam and increasing labor and transportation costs.

Levi’s commentary on the cotton-pricing issue should soften some of those fears—at least in the near term. On its earnings call Wednesday evening, the apparel company said that much of its own cotton prices have already been negotiated for the first half of 2022 and that it expects its cost of goods sold to increase 1% in the first half of 2022 compared with 2021 levels. For the second half of 2022, the company said it might be able to negotiate prices that will lead to a mid-single-digit percentage increase in costs compared with 2021 levels. Cotton accounts for about a fifth of the cost of producing Levi’s jeans.

High cotton prices are certainly worth monitoring, especially if today’s prices stay elevated and impact negotiations for deliveries further out in the future. The commodity’s historic surge in 2011, for example, ate into gross margins and profitability for some apparel companies that year and the year after. Levi’s gross margins declined by 2.2 percentage points in 2011, while Gap’s fell by 3.8 percentage points.

Those declines, however, also came during a period that Simeon Siegel, analyst at BMO Capital Markets, calls “promotional warfare.” That may have made it more difficult for apparel sellers at the time—especially those selling cheaper products—to pass on those costs to consumers. Today, many apparel brands—including Levi’s—have regained pricing power, partly because retailers are unable to overstock inventory and because last year’s stimulus has left many shoppers’ wallets fatter. Some brands also just have more cachet today, as Levi’s believes it does. Its average selling prices are up by more than 10% compared with 2019 and its gross margins are roughly 10 percentage points higher than they were a decade ago, during the last cotton price surge.

Levi’s comments seem to have assuaged investors’ fears, with its shares regaining some ground in after-hours trading. It isn’t an all-clear signal, of course. Apparel companies selling cheaper clothes, or those losing favor with customers, might not be as fortunate. Hanesbrands, which sells basics such as T-shirts and underwear, saw gross margins expand by just 0.6 percentage points in its last quarter compared with the pre-pandemic quarter, while Zara owner Inditex’s margins increased by just 1.5 percentage points. Levi’s saw its gross margin grow by almost 5 percentage points last quarter compared with pre-pandemic levels.

Today’s soaring cotton prices might not be as challenging as they were a decade ago, but not all apparel companies will have the soft landing that Levi’s seems to have secured for itself.

Write to Jinjoo Lee at [email protected]

This post first appeared on wsj.com