Schroders

Margins at Risk

An examination of how environmental and social factors may affect profit margins within the textiles, apparel and luxury goods sector

Rick Stathers Head of Responsible Investment March 2013

Executive Summary Within this report we provide an overview of two parts of the textile supply chain: cotton production and industry labor standards. Cotton production is of significant value to the economies of some emerging markets, but it has also had a significant impact on water resources in some countries, both in terms of use (the Aral Sea has declined by 85% over the last 40 years partly as a result of cotton irrigation in Uzbekistan and Turkmenistan) and pollution due to poor agricultural practices. Indeed, the cotton industry accounts for 8–10% of global pesticide use, though this figure can be as high as 50% in some emerging economies. Water scarcity and increasing efforts to tackle environmental pollution are likely to add to the costs of cotton production, which will affect input costs for the sector. In addition, with the majority of cotton coming from small-scale farmers in emerging markets there are concerns about labor standards, creating reputational risks for companies. At the other end of the supply chain a great deal of work has been undertaken to address labor standards within Tier 1 suppliers. But as wage costs increase in emerging markets, due to economic growth in these regions, and as companies have increasingly adopted “just-in-time” business models, this has increased the pressure on the supply chain, which could undermine the work that has been done to improve labor standards. In addition the aquatic pollution resulting from manufacturing activities (e.g. dyeing) is a cost that has still to be internalized, but as emerging countries increasingly see the benefit of reduced environmental pollution, this will become a further cost for manufacturers in many emerging markets. There are clearly both tangible cost increases that will impact the sector and the ever present reputational risks to brands from being associated with poor labor standards. We analyzed the publicly available information of 20 companies with exposure to the textile industry, including manufacturers, supermarket chains and high street brand names. Seventy per cent of the companies list labor issues as potential risks to the business in their annual financial filings, whilst fifty per cent also cite environmental concerns and resource shortages. Eighty-five per cent of the companies had policies or codes of conduct addressing labor standards, whilst only thirty five per cent addressed environmental issues. The level of risk management varied enormously; from zero evidence, to extensive reports detailing individual suppliers, the results of supply chain audits and methods for integrating labor standards performance into purchasing decisions for example. There were a few examples where companies had implemented pilot projects enforcing living wages and high labor standards with one supplier, which tended to find that these better working conditions lead to improved productivity and a reduction in defects and so were effectively cost neutral. However, scaling these pilot projects up across the supply chain remained a challenge. Two companies have started to look at the long term challenges from climate change and resource scarcity to their supply chain and business models. Two companies have also begun trialing waterless production techniques. There were also two examples of the development of closed loop textile systems (i.e. recycling of second hand clothes). In terms of demonstrating the materiality of these issues within valuation models, this will have to be done on a case-by-case basis. This is due to a number of issues, sourcing practices (e.g. in-house versus out-sourced, Europe versus Asia), product profit margins (e.g. luxury goods versus mass-market goods), different revenue streams (e.g. single product revenues versus multi-line revenues). However the evidence of management of these issues should act as a proxy for the quality of management which could be used to make peer-comparative investment decisions. We would say that two indicators could be used as a good proxy for determining the quality of corporate supply chain management systems:

1. The publication of the percentage of suppliers audited and the results of these audits

2. Involvement in several industry level collaborative initiatives

Contents Page

Introduction ················································································································································ 1

Background to the cotton industry ············································································································ 2

Labour issues ····················································································································· 2

Water, habitat and pesticide impacts from cotton farming ··················································· 3

Pesticides ......................................................................................................................................... 3

Water ................................................................................................................................................ 4

Habitat loss ....................................................................................................................................... 4

From seed to fibre ····································································································································· 6

Environmental Issues ·········································································································· 6

Pollution ............................................................................................................................................ 6

Labour issues ····················································································································· 7

Business implications of environmental and social issues ····································································· 9

Translating environmental and social risks into brand’s P&L and strategy ··························· 9

Managing environmental and social supply chain risks ····················································· 12

Sector analysis of supply chain risk exposure and management ······································· 12

Conclusion ··············································································································································· 16

Appendix ·················································································································································· 17

Profit stream calculations for a factory’s P&L accounts ····················································· 17

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Margins at Risk Introduction

The ability of brands to access new labor markets and raw materials from a wider range of suppliers has grown massively over the last fifty years due to the advent of globalization. This, in turn, has lead to the price of clothing, in the developed world, steadily decreasing. However the ability to manufacture products at the lowest price is increasingly coming under threat due to a combination of environmental and social factors which are increasing the costs of production. Examples of this could be the impact of extreme weather events restricting the supply of raw materials causing prices to spike or the growing demands of workers in the developing world demanding better working conditions and pay, impacting manufacturers’ profit margins. Such factors will have varying degrees of impact and relevance throughout the lengthy, complicated and global textile value chain. Figure 1 (below) is a very simplified version of this value chain highlighting the different processes involved, the industries implementing these processes, and the potential environmental and social impacts as well as demonstrating the value added over these different stages.

Figure 1: Schematic of the textile value chain (source: Greenpeacei, WWFii, Schroders)

What figure 1 doesn’t provide is an idea of the numbers involved. For example Adidas, in its 2011 Sustainability Progress report, estimates that it has worked with around 1,232 independent factories in 2011, typically reflecting its Tier 1 suppliers which would be represented as clothing manufacturers in the above schematic. Clothing manufacturers are just the tip of a long supply chain, for example there are 25,000 cotton producers (“Farmers & growers” in figure 1) in the USA alone. Cotton is predominantly grown on small scale farms in the developing world, not larger industrial farms in the USA, so one can easily imagine how many individual suppliers there are right down at the base of this supply chain pyramid. This report takes a look at different stages of the supply chain, examining the environmental and social issues facing the cotton producers at the base of the supply chain before moving on to review the environmental and social issues at the manufacturing end of the supply chain. These topics are then framed in the context of their potential implications to business (e.g. costs of good sold, margins, reputational impacts) before providing a brief review of best practice supply chain management processes and an indication of the different levels of implementation within the sector.

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Background to the cotton industry Cotton is the predominant natural fiber used within the industry (we have chosen not to cover the environmental and social issues surrounding the production of manmade fibers in this report), it constitutes 85–90% of all the natural fibers used in the textile industry (other fibers include wool, silk and bamboo for example) and natural fiber is used in 45–50% of all clothes (with synthetics making up 50–55%)

ii,iii.

Around 25 million tons of cotton are produced each year

ii, with the vast majority of production being clustered

into a few countries (see Table 1, below). Production techniques vary from the huge industrial-agricultural systems of developed countries to the small scale, labor intensive systems in the developing world (90% of cotton farmers live on farms of less than 2 hectares)

ii. Yields vary depending on technology, industrialization,

climatic factors and soil quality but the average global yield of seed cotton is 1,670 kilogrammes per hectare (1,670kg of seed cotton will yield around 584 kg of raw cotton)

ii, though in Israel yields of 3,827kg/ha have

been recorded, demonstrating the influence of technology on production.

Table 1: National involvement in production and export of cotton

iv

China 32%

India 23%

USA 12%

Pakistan 9%

Brazil 6%

Uzbekistan 4%

Turkey 2%

Australia 2%

Source: UBS Investment Research 2010. Countries shown are for illustrative purposes only and should not be viewed as a recommendation to buy/sell.

The majority of this raw cotton is used in textile production in the developing world which accounts for around 75% of global textile production (Asia (ex-China) = 54%, China = 25%, South America = 14% and Africa = 6%)

iv. As a result, cotton, and its subsequent utilization, has a significant impact on some national economies

(in Pakistan it is estimated that cotton and textile products account for 70% of the nation’s export revenuesii,

whilst 80% of Bangladesh’s economy is dependent on the global fashion marketv).

As cotton production has become global, the costs of production have decreased forcing some countries to use subsidies to protect their domestic cotton industries by artificially reducing production costs, ensuring that national cotton producers can remain competitive on the world market. US cotton farmers receive around USD4bn/yr (the equivalent of USD10/ha). This subsidy has helped to bring US cotton production costs down from USD1.7/kg to around USD1.18/kg. Similar subsidies can also be found in other areas of the world; Greece and Spain, for example, account for about 2% of global production and receive around 16% of the total global subsidies, while China subsidizes farmers at a cost of around USD0.23/kg. These subsidies have artificially suppressed the cost of cotton, with the International Cotton Advisory Committee estimating that without the cotton subsidies prices would be about 26% higher

ii.

The predominance of small scale, developing world farmers within the cotton supply chain presents significant challenges to brands aiming to reduce the reputational risks of being associated with poor labor practices. The farmers themselves are a long way down the supply chain from the clothing manufacturers that brands have the greatest contact with. As we have pointed out in the introduction to this report, these Tier 1 suppliers in themselves can represent a vast number and, at present, attract the greatest attention in terms of brands’ supply chain management programs. Yet the risks of being associated with poor labor practices throughout the textile supply chain is very high as demonstrated by the 2006 World Wildlife Fund report, “Cleaner, greener

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cotton”, which highlights some of the labor issues that can arise from this small scale farming model. It cited a report by the Indian Committee of the Netherlands which claimed that nearly 450,000 children between the ages of 6–14 were employed in cotton fields in India during 2003–2004, of which 90% were girls and 90% were under debt bondage. Migrant children put in 11–13 hours per day whilst local children put in 9–10 hrs/day

ii.

The use of child labor within the cotton industry is highlighted by the on-going, high profile, international campaign focused on the Uzbekistan cotton industry. The Government of Uzbekistan is alleged to force pupils out of school (busing them to the cotton fields) and forcing them to harvest the cotton. The Government regularly makes announcements condemning this activity but has still to allow international observers into the country despite it signing up to the International Labor Organizations standards. As a result of the high profile campaign and media interest, 60 companies have signed up to the “Cotton Campaign” pledging not to knowingly source Uzbek cotton harvested with forced child labor. Whilst this sounds good in principle, in practice, the lengthy and convoluted textile supply chain means that it is very difficult for brands to be able to trace the origin of cotton unless they are willing to take on additional costs to implement a chain of custody requirement, as implemented for those sourcing organic cotton, which allows consumers to trace the origin of the final product back to the grower. Whilst there are serious concerns about the labor standards within the cotton supply chain, the fact that cotton is traded as a commodity and the lengthy supply chains in the textile sector mean that the potential brand ramifications are small and that a response to this issue is required at a sector and government level. Nevertheless the lack of engagement in this issue by a brand demonstrates a lack of awareness of the risk, or of a desire to manage it, which could impact consumer perception and hence revenues.

The cotton industry accounts for around 8–10% of global pesticide use (up to 50% of all pesticide use in some developing countries) and, as a result, pesticides can be a significant constituent within the overall production costs (around 10%)

ii, not to mention adding to the overall environmental impact of production. Pesticide use

is regulated, but it will not always be enforced and the negative impacts of poor pesticide use could lead to increasing environmental regulation especially as access to fresh water reserves in many cotton producing countries becomes less due to the combined impacts of pollution, over-consumption and climate change. In addition pesticide use can lead to resistance in target species which will require increased pesticide use (further increasing costs) as well as causing the elimination of natural pest control vectors whose economic value at controlling pests is provided for free. There are also concerns about the potential health impacts of pesticide use within childhood development. We are not intending to explore these issues within this paper, but merely referencing them as a means of demonstrating that as developing governments tackle health and environmental issues this may result in increased input costs for cotton farmers which could be passed on, affecting raw material costs for brands. Cotton farmers could reduce the exposure to pesticides use through the adoption of integrated pest management (IPM) techniques. In India these have been shown to decrease pesticide use by 60–80% whilst yields have increased at the same time. This has had economic benefits for the farmers in terms of reduced production costs and higher revenues totaling around USD250/ha. There have been similar findings in other regions where IPM techniques have been employed. The Pesticide Trust estimates that IPM can double yields from 780kg/ha to 1500kg/ha and reduce pesticide use by 68%. In the Punjab province of Pakistan, IPM techniques have led to birds returning to feed in fields resulting in a 50% decrease in pest attacks as the birds provide a natural pest control service

ii.

Another alternative for potentially reducing pesticide use is through the use of Genetically Modified (GM) cotton (which currently accounts for 30% of all cotton grown) and can also improve yields, though there are consumer concerns (in Europe) about GM products and GM will still require limited pesticide use which will still incur the risk of resistance developing within the targeted species and hence ultimately driving up the need to use pesticides. Studies have shown that GM cotton produces higher yields than organic cotton but the benefit of increased revenues from higher yields is offset by higher input costs (e.g. pesticide costs) and lower prices (e.g. organic cotton is priced at a premium to non-organic cotton).

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In 2009 Schroders published its report “Water: Cheap and abundant, but not for long” which highlighted the growing challenges in water supply and demand around the world. Within the report we wrote that agriculture accounts for 70% of global water use and is thus highly exposed to water stresses, and cotton production is no exception. Around half of the world’s 35 million hectares of cotton production are irrigated (accounting for three quarters of global cotton production). Water abstraction for cotton production has already had noticeable impacts on the river basins where cotton is produced, particularly in already water stressed regions:

– The water decline in the Indus (Pakistan) over the last 60 years has lead to a loss of habitat range for the Indus

River Dolphin

– The Aral Sea (in central Asia) has declined by 85% due to irrigated cotton cultivation in Uzbekistan and

Turkmenistan over the last 40 years

– In Gujarat (India), water could be tapped at a depth of 10 meters in the 1950s, in contrast boreholes now drilled

as deep as 400 meters may run dryii

It is estimated that to produce one kilogramme of cotton lint (about enough for a pair of jeans) requires about 8,500 liters of water (around 30 bathtubs) on average (4,710lt/kg in China and 20,217lt/kg in India). The impact of water scarcity on cotton yields was one of the factors which lead to the 2010 cotton price spike (see figure 2, overleaf). China’s domestic cotton yields were reduced by a drought during 2009/2010 which forced China to import more cotton. As a result India, in order to protect its domestic supply and prices was forced to restrict its cotton exports. At the same time, Pakistan (another major cotton producer) was hit by devastating floods which reduced its cotton harvest. This all came at a time when the world was beginning to emerge from recession and demand was increasing resulting in the spike in cotton prices as shown in Figure 2. On top of the potential impacts of this to retailers’ profit margins (Primark saw a 2% decline in profit margins from 2010 to 2011, a large part of which was due to cotton price increase) also came the announcement from China about raising the minimum wage, adding further pressure to profit margins (a topic which will be covered in greater depth later in this report).

Figure 2: China Cotton price (328 grade)

Source: Bloomberg 23 April 2012. 10 year average: 16561.72RMB

As cotton demand has increased, this has led (as is the case with other agricultural products) to the clearance of pristine habitat to make way for cotton production. The riparian Tugai forests of the Amu Darya river basin in Central Asia have been impacted by water withdrawals for agriculture and land clearance, and it is believed

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that around 80% of the original Tugai forests have now been lost as a result of cotton farming. In Central America only 2% of the original hardwood forests in cotton growing areas remain intact and it is likely that we will see similar impacts in Brazil where cotton production is increasing

ii. Whilst this loss of forest has resulted

in recognizable revenue streams from cotton production, there is a growing body of research pointing out that forest clearance has larger long term economic losses than the short term gains made (e.g. the loss of carbon storage, water regulation and biodiversity) and that greater focus should be placed on the long term economic value of these ecosystems versus the short term economic gain (see our 2010 research report “Ecosystem services: Where’s the discussion?”). One of the common themes through this section is that of water, and, as highlighted in our 2009 report, we believe that the impacts of water supply and demand are going to see an increase in costs for water abstraction and in charges for emissions to aquatic ecosystems. We also believe that there is increasing recognition of the economic value of ecosystem services to society and that the long term benefits of maintaining these will outweigh the short term benefit of not doing so. These two factors will increasingly internalize the external costs of poor environmental practices within the textile supply chain, not only through increasing costs but also through declines in supply.

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From seed to fiber Once the cotton is harvested, it then goes through various production processes in textile mills to turn it from cotton lint into a useful fiber that can be used to make a garment (see Figure 1). China is the undisputed powerhouse in the textile manufacturing world, with its estimated 50,000 textile mills not only making it the biggest textile manufacturer in the world but also contributing an estimated 7.6% of China’s trade volume, worth around USD227bn in 2010

i. However the economic benefits from this industry have been gained at the

expense of the environment and the people of China. The World Wildlife Fund estimates that the textile industry is one of the highest polluting industries (along with the chemical industry) in China. This section aims to highlight some of the environmental and social costs that arise during the process of converting cotton lint into a wearable product.

A 2012 article in The Guardianiii states that the textile industry is responsible for around 17–20% of industrial

pollution with much of this being due to the absence of environmental regulations or the poor enforcement of these environmental regulations, resulting in many of those companies in the textile dyeing and processing parts of the supply chain opting for the lowest cost of production (i.e. circumventing waste water treatment). A campaign by Greenpeace has highlighted that many of the chemicals used in the textile manufacturing supply chain have PBT

1 properties. Greenpeace’s analysis has discovered PBT’s in the Yangtze River which will

have arrived there as a result of various upstream industries, such as textiles, plastics, non-ferrous smelting and mining. However, Greenpeace was also able to identify chemicals that were specific to the manufacture of textiles, namely alkylphenols and Perfluorinated Compounds (PFCs). These chemicals are also able to persist within garments and Greenpeace discovered the presence of Nonylphenols and Nonylphenol ethoxylates

2 in 2/3rds of the garments they tested (bought from high street shops)

vi. This suggests that many

textile mills are likely to be sidestepping waste water treatment processes in order to reduce the operational costs, though this practice results in high environmental and health costs downstream of the textile mill. Many of the chemicals discussed in Greenpeace’s analysis are regulated or banned in the product destination countries under legislation such as the EU’s Registration, Evaluation, Authorization and restriction of Chemicals (REACH), Japan’s Chemical Substances Control Law and the USA’s Toxic Substances Control Act. Within China, there is growing concern over the environmental impacts of textile mills and an increasing recognition of the need for environmental protection. This has meant that it is difficult to get licenses to set up new textile mills or to obtain additional water discharge quotas for the expansion of existing facilities, which will consequently increase the price of production as mills are forced to internalize the cost of pollution through the installation of waste water treatment facilities. Brands with leading environmental practices are already positioning themselves to remove harmful chemicals from their supply chains, for example H&M announced in September 2012 that it was banning the use of PFCs, recognizing that PFCs were hazardous chemicals which have negative impacts on the environment, reproduction and aquatic organisms. H&M is part of AFIRM, an international working team of companies from within the textile and footwear industries, educating suppliers to achieve good chemical management. In addition to the water pollution issue is the issue of water use. The textile value chain uses large amounts of water in the dyeing and finishing process (as we have shown earlier with one estimate being that 30 bathtubs of water are needed to produce one t-shirt; we note Nike’s estimate of 700 gallons [c. 10 bathtubs] of water are needed simply to grow the cotton).

1 PBT stands for Persistent, bioaccumulation and toxic, with the toxicity definition covering carcinogens, mutagens,

reprotoxins and endocrine disruptors 2 NPEs are known as endocrine disruptors due to their ability to mimic oestrogen and in turn disrupt the balance of

hormones in affected organisms

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Nike and Adidas, in response to water shortage concerns, have both trialed waterless textile-dyeing processes which use almost no water and reduce energy and chemical use by 50%. Nike is one of the few companies that has publicly recognized water as a risk to its product range and set itself the target of improving water efficiency by 15% per unit in apparel materials dyeing and finishing and footwear manufacturing by 2015

vii.

One of the striking things about the textile supply chain is the range of countries from which they source products (see Figure 3), with developing countries dominating this area due to the low costs of labor and other low production costs (e.g. environmental impact costs) associated with these countries.

Figure 3: Clothing retailer sourcing by geographic area

Source: Who will wear clothing inflation? UBS, November 2010. Companies/regions shown are for illustrative purposes only and should not be viewed as a recommendation to buy/sell.

This exposure to the developing world and the poor governance standards in these countries means that the textile sector has a long history of dealing with labor issues within their supply chains. We don’t believe that this is likely to go away any time soon as evidenced by a 2010 survey carried out by the International Textile Garment and Leather Workers Federation, which surveyed 83 factories in 3 countries, which collectively employed 100,000 people (predominantly women aged under 35) and were producing garments for export to the US and Europe. It found strong evidence of employers across the three countries abusing labor rights, such as not paying sick leave or pay when annual leave was taken, refusing to provide written contracts, and abusing the use of contract workers by hiring and firing just before a worker’s length of service reaches the statutory minimum beyond which a worker would be afforded the rights of full employment status. Workers would then be re-hired on another short term contract

viii.

Labor standards within a brand’s supply chain have been a high profile issue for sometime, with concerns about the impact of reputational damage driving action by brands to address labor standards within their supply chain. Whilst there is a moral imperative for brands to take this course of action there is also a cost management argument as well. If we look at the issue of wages, one can see these gradually increasing with the economic development within a country as well as due to workers in the developing world increasingly asserting their demands and expectations for a fair, livable wage. With labor costs accounting for around 20% of garment production costs (see Table 2, page 10) an increase in the livable wage will have a material impact on the overall cost of production. For example, Chinese wages have risen by 13% between 2000 and 2009 and in April 2010 China raised the minimum wage (not necessarily a living wage) by 20%

ix. Textile workers have historically been paid a

premium to the local minimum wage, but as the minimum wage has increased and as more employment

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opportunities arise in migrant workers’ home regions, demand for textile work has dropped. For example, in the Guangdong province in China there has been a decrease in migrant workers, as they have returned home to work on economic stimulus projects in their home regions. This has led to a change in demand for textile manufacturing jobs in the Guangdong region, where, in 2009, there were four workers for every three jobs, there is now only one worker for every two jobs, implying that wages would need to be increased in order to attract workers back to the sector. Perhaps because of the increase in employment opportunities closer to a worker’s home, increased recognition of the right to better employment conditions and the nature of the work, worker turnover in textile manufacturing is around 15% per month (this can increase to up to 50% before and after Chinese New Year). This issue of high turnover impacts the productivity of a textile factory as it faces the challenge of recruiting and training new workers (which can take anywhere between two weeks and three months), which results in lost hours worked. This can turn into a vicious circle as lower productivity and higher defect rates (from less skilled workers) will mean it can take more hours to meet an order. As factories are put under pressure to meet orders they will be put under pressure to hire quickly, meaning more use of labor brokers, student labor and the use of unregistered sub-contractors which can result in a failure to meet legal labor requirements (such as working hours and minimum wages – please see Appendix 1, for a review of how labor standards can impact profitability at a manufacturer). INFACT Global Partners (a supplier responsibility consultant) has heard of significantly more increases in the use of child labor in China since wage rises have been implemented

x.

The cost of labor is now a material, lasting, concern for brands as demonstrated by Ralph Lauren’s statement in the risk section of its 2012 SEC10-K filing: “the cost of labor has been increasing significantly, and as the middle class in developing countries such as China continues to grow, it is unlikely that such cost pressures will abate”. A view that is reiterated by Coach Incorporated in its SEC 10-K filing “Increases in our costs, such as raw materials, labor or freight could negatively impact our overall profitability. Labor costs at many of our manufacturers have been increasing significantly and, as the middle class in developing countries continues to grow, it is unlikely that such cost pressure will abate…..we may not be able to address such increases in raw materials or labor or transportation costs through pricing measures or other means. These increasing costs could also adversely affect our ability to achieve the gross margin objectives we have established.” However it is not just the cost of labor that can affect the cost of goods sold. The working conditions (e.g. health and safety) and employment conditions (e.g. working hours, contracts, freedom of association, collective bargaining) can all impact on productivity of a factory and firms which have begun exploring the benefits of enforcing high labor standards within their Tier 1 suppliers have found that despite the increase in investment in the workforce this has been offset by a decrease in defects and an increase in productivity. In 2007 Nike recognized that factories that invest in their workers can reduce turnover and increase their ability to produce quality products and so it began the implementation of its lean manufacturing principles; which is essentially a management philosophy aimed at reducing different forms of waste (e.g. inventory, time, over-production, defects) and so improve quality and production times. Nike is also aligning this with human resource management practices which will include freedom of association and productivity-based wage improvements, as efficiency and quality improve so does productivity and profitability, and these gains are shared with workers who will now have higher skill sets and more value in the market. In Nike’s 2011 “Sustainable Business Performance Summary” it reports that the implementation of lean manufacturing (also adopted by Adidas amongst others) has found that

– Apparel factories have shown defect rates 50% lower than non-lean factories

– Many lean footwear factories have seen increases in productivity of 10 to 20%

– On average lead times have been reduced by 40%

– Many footwear factories have reduced the time it takes to introduce a new model by 30%

Other firms may not have made such a quantitative or detailed analysis of the benefits of improving labor standards within the textile supply chain, but there are many anecdotal comments that imply recognition that this investment in social capital will yield financial benefits. For example, Shenzou International (a major Chinese apparel manufacturer) recognizes that: “Labor costs can be reduced with a more stable workforce” within its annual report and accounts.

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Business implications of environmental and social issues As the previous sections have shown, there are numerous risks that can impact and disrupt a brand’s supply chain. Many of these risks have been heightened by the trend towards low-inventory levels and the use of “just-in-time models” which have increased the risk of supply chain disruptions. In November 2011 the Business Continuity Institute published the findings of its latest survey on supply chain disruption

xi.

It found that:

– 85 per cent of organizations (covering 62 countries) had recorded at least one supply chain disruption during

2011, with 40 per cent of these occurring below the immediate (Tier 1) supplier

– Adverse weather was cited by 51 per cent of respondents as being the main cause of disruption (maintaining its

prominence from the 2010 survey)

– Supply chain incidents led to a loss of productivity for almost half of the businesses surveyed along with increased

costs of working (38 per cent of businesses surveyed) and loss of revenue (32 per cent)

– Longer term consequences included shareholder concern, damage to reputation and expected increases in

regulatory scrutiny

The authors of this survey concluded that its findings demonstrated that there was a strong need for businesses to strike a sensible balance between the need to drive down costs and the need for these cost savings not to be wiped out through disruption or unacceptable risk exposure underlining the need for companies to develop resilient supply chains in order to effectively manage systemic vulnerabilities and unpredictable disruptive events. The adoption of “just-in-time” models not only increases a brand’s risk exposure to supply chain disruption but it can also be a factor in the creation of environmental and social risks within the supply chain. For example, the lead times which buyers give to their suppliers to produce product ranges has significantly reduced over the years shortening from between 90–120 days to between 30–45 days

v. This has increased pressure on

suppliers to meet production deadlines which will in turn increase environmental and social production pressures as factories work to meet the demands of brands. There is therefore a strong case to be made for companies to effectively demonstrate to their investors (and other stakeholders) the methodologies that are in place to identify risks within the supply chain (e.g. exposure to water scarcity or regions with poor labor laws), the tools the company is using to monitor and manage these risks (e.g. supply chain audits) and the outcomes of these audits through informative disclosure (i.e. companies need to back up assertions of supply chain management practices with facts and figures). The following section will demonstrate how these “non-financial” factors can impact financial value, before providing a brief review what a brand should be demonstrating to shareholders in terms of its risk management. As well as providing a high level review of the levels of risk management that a selected number of brands, in the sector, have implemented, based on publicly available sources and assessing this against their risk exposure.

As this report has demonstrated there are clear links between environmental and social supply chain risks and the financial performance of the brands at the top of the supply chain. The following example shows how these can potentially be translated into financial costs. Yarn can make up about 55% of fabric cost of sales, and fabric, in turn, can be around 50% of garment costs of sales (see Table 2 and 3 below). Therefore if cotton prices increase and are passed along the supply chain to the brands, a 50% increase in yarn cost would raise the fabric freight on board (FOB) price by 27.5% and garment FOB price by 13.8%ix. One can also use a similar calculation to link labor costs to increased FOB costs.

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Table 2: Apparel costs breakdown

50–60%* 15–20% 5% 5–10% 10%

Source: Who will wear clothing inflation? UBS, Nov-2010 *Of which indirect labor accounts for 40%

Table 3: Summary of raw material prices

60% 30% 5% 5%

Source: Who will wear clothing inflation? UBS, November 2010, Schroders

Whilst the price spike of 2010 certainly attracted attention, it is perhaps the long-term implications of Asian wage increase which will result in more sustained clothing price inflation. Such inflation could reverse the long term decline in clothing prices (see Figure 4 below). However this does not mean the 2010 spike should be ignored, indeed it should be treated as an indicator of potential risk multipliers that could arise due to resource shortages and climate change, in addition increasing competition for land could also lead to further price inflation (though cotton is able to be grown on marginal soils).

Figure 4: Long-term UK clothing price trend

Source: UBS “Who will wear clothing inflation?” November 2010

There are effectively three ways in which brands can respond to rising costs within their supply chain. They can implement practices to reduce the costs, they can absorb them into their margins, or they can pass through the costs to the consumer. The exact method (or combination of methods) will vary depending on the brand, its business model and consumer market. For example a high volume/low price business model will have greater exposure to input cost increases than high end brands as they will have outsourced production to developing countries in order to take advantage of the lower costs of production in these regions and hence decrease production costs, but they will also have lower profit margins in which to absorb cost increases. Whereas companies with low volume/high price models are more likely to be less exposed as they have tended to source production from highly skilled manufacturers in countries with strict labor laws which tend to be located closer to the product markets. This may mean a higher cost of production, but these costs can be absorbed into the high prices charged for the products.

-10%

-5%

0%

5%

10%

15%

20%

Q1

196

5

Q1

196

8

Q1

197

1

Q1

197

4

Q1

197

7

Q1

198

0

Q1

198

3

Q1

198

6

Q1

198

9

Q1

199

2

Q1

199

5

Q1

199

8

Q1

200

1

Q1

200

4

Q1

200

7

Q1

201

0

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Costs can be reduced through using some of the following strategies:

– ordering lower quality and more simple products

– encouraging/beginning supplier consolidation by brand

– changing the mix of natural fiber to man made fiber in their products

– changing the amount of material used

– or by sourcing from regions where labor costs are cheaper (e.g. labor costs are 20% lower in inland and northern

regions of China than they are in coastal areas). However simply shifting to regions of lower labor costs could

have other costs such as a less skilled workforce (leading to higher defect rates), the need to establish logistics

and the supporting manufacturing infrastructure

Alternatively, rather than simply looking to avoid costs, there is increasing evidence (as demonstrated through Nike’s lean manufacturing policy, amongst others) that cost pressures can be alleviated by developing management systems which help to address the cause of the input cost increases which will also have positive environmental and social outcomes. Absorbing cost increases within profit margins will be easier for higher margin brands but will also require management of shareholder expectations. Simply increasing prices is a possibility but it is a strategy fraught with potential negative outcomes. Research by Yougov suggests that clothing prices may be elastic and so any increase could see consumers trading down. However consumers would prefer a higher price over deterioration in the quality of the product, as long as consumers were confident the quality and durability of the product is warranted in the higher price. Table 4 (below) demonstrates the impact on EBIT margins based on three different scenario responses to rising costs.

Table 4: Scenario analysis on pricing increase

100 104 Price +4%,

Vol flat 100

Price +4%, Vol -4%

100 Price +10%,

Vol -10%

(40) (44) Costs +10%,

Vol flat (42.2)

Costs +10%, Vol -4%

(39.6) Costs +10%,

Vol -10%

60 60 0% 58 -4% 60 +1%

(45) (45) Flat (45.0) Flat (45.0) Flat

15 15 No change 12.8 -15% 15 +3%

Source: UBS Who will wear clothing inflation? November 2010. The opinions stated include some forecasted views. We believe that we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee that any forecasts or opinions will be realized.

The Yougov research indicates that the consumer response will vary depending on the level of price increase. 16% of consumers would switch if prices increased by 10%, whilst 50% of consumers would switch if prices increased by 20% per cent. Price elasticity appears to be higher for low-income households (i.e. changes in prices have a higher impact on the consumer purchasing habits in low-income households) and in the UK it is estimated that that the price elasticity is 0.9 (i.e. a 10% increase in pricing would deliver a 9% decrease in consumer spending)

iv. This research implies that it might be in the interests of brands to absorb costs in the

short term to avoid losing sales volumes, but in the long-term this may not be a sustainable strategy for low margin brands. Given that population growth and ecosystem decline are already creating competing demands for agricultural land (food, clothing, fuel) as well as increasing demand on the land and the ecosystem that land is situated in (exemplified by water stresses, soil quality decline and soil loss, ecosystem decline), and that there is the

12

climate change risk multiplier impact which will impact on all of the aforementioned factors. It would therefore be prudent for brands to start taking measures to address medium term input cost inflation sooner rather than later.

Finally there are the potential environmental and social risks associated with the continued economic development of the emerging markets, which will exacerbate environmental and social risks (if not effectively addressed now) either through increased economic development leading to higher input costs (e.g. higher labor standards and environmental regulations) or through the increased consumer demand which will no doubt represent an opportunity for the brands in this sector, but only if they address the growing environmental and social impacts within their current supply chains. Demonstrating concerns for just such issues is Marks and Spencer’s, which has undertaken a review of the impacts of climate change on its food and general merchandise supply chains over the period of 2020–2030. One of the findings of this project was changes to the geographical distribution of raw materials, including cotton.

This document has clearly set out the potential financial implications from environmental and social issues arising from within a brand’s supply chain, and that these risks can be material to the business, and therefore there is a need for brands to be able to demonstrate to shareholders that they are managing this risk to shareholder value. At present most of the brands that we looked at within this sector would recognize these issues as business risks as demonstrated by statements within their annual filings, but the level of response to managing these risks varies. In order to demonstrate management of these risks brands should develop and implement management systems for improving labor standards and decreasing environmental risks within the supply chain. At a minimum this would be evidenced through the adoption of a set of supplier guidelines or policies which would cover labor standards (e.g. working hours, compensation, child labor, freedom of association, non-discrimination and equal opportunities) in some leading examples these policy statements also address environmental factors (e.g. water use, hazardous substances). A policy is only as good as its enforcement mechanisms and brands should therefore ensure that a policy is effectively communicated, training is provided for suppliers and that an enforcement program is in place for non-compliance. In order to monitor the implementation of these policies brands should undertake supply chain audits (these can be announced or unannounced and use internal or third party auditors), based on a risk assessment of the supply chain. Brands should also ensure that training is provided for their buyers and sourcing teams, as this will ensure that environmental and social issues are embedded into the sourcing decisions from the start, as opposed to being an add-on process at the end. As Nike puts it “the aim is to audit then remediate then source, but we have tended to source then audit then remediate”. Transparency and disclosure will ensure that stakeholders have confidence that brands are actively implementing supply chain policy statements and that these policy statements are not just empty rhetoric. This transparency could include, but is not limited to, quantitative data on the audit process (e.g. number of suppliers, per cent audited), data about non-compliance and tools to rectify this. In addition to these steps there are numerous sector initiatives that brands can participate in which will help to improve their own capacity, develop industry best practice and improve the environmental and social standards within the supply chain. Investors can then use an analysis of a brand’s supply chain management program alongside an assessment of the risk exposure of a brand (e.g. percentage of revenues from textiles, product profit margins, sourcing locations) which can be used in the stock valuation and selection process.

Bearing the previous section in mind, we analyzed the publicly available information (annual reports and accounts, 10-k filings, corporate responsibility reports and web-site information) of companies with exposure to

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the sector; this included companies which had brands within their portfolio, but may not necessarily be included within the textile and apparel sector (e.g. Associated British Foods which owns Primark). Table 5 is a list of the companies that were assessed:

Table 5: Companies analyzed for this report

French Connection Britain Apparel Retailers ┼

Inditex Spain Apparel Retailers ┼

Next Britain Apparel Retailers ┼

Debenhams Britain Broadline Retailers ▲

Marks & Spencer Britain Broadline Retailers ▲

Myer Holdings Australia Broadline Retailers ▲

Wal-Mart Stores United States Broadline Retailers ▲

Burberry Group Britain Clothing and Accessories ●

Coach United States Clothing and Accessories ●

Prada Italy Clothing and Accessories ●

Ralph Lauren United States Clothing and Accessories ●

Shenzhou International Group China Clothing and Accessories ●

Ted Baker Britain Clothing and Accessories ●

Texwinca Hong Kong Clothing and Accessories ●

Associated British Foods Britain Food Products ■

Tesco Britain Food Retailers and Wholesalers ◊

Adidas Germany Footwear ▼

Asics Japan Footwear ▼

Nike United States Footwear ▼

Yue Yuen Hong Kong Footwear ▼

Source: Industry Classification Benchmark’s taken from taken from Bloomberg. Companies/Countries shown are for illustrative purposes only and should not be viewed as a recommendation to buy/sell.

Our analysis rated companies on the quality and extent of their risk management programs, and then made a qualitative assumption of a company’s exposure to risk. Whilst the first stage is relatively simple to undertake (e.g. is there a supply chain management policy? does the company disclose the results of its audits?) the assessment of risk exposure is much more challenging. One of the limitations of this study is that it focused, in the main, on two areas of risk within the textile supply chain, cotton production and labor standards. However exposure to these risks varies by company due to a number of reasons:

– Revenue exposure (e.g. the majority of revenues for Coach and Prada come from handbag sales not clothing or

the parent company has a wide range of different revenue sources as is the case with Associated British Foods)

– Business model (companies within the study have different pricing strategies, enabling some to absorb cost

increases more easily than others)

– Manufacturing model (it is difficult to get clear visibility on the revenues that are dependent on products

sourced in different regions. For example Prada has a large amount of in-house production based in Europe,

whilst Nike has a high exposure to developing countries meaning exposure to labor standards and costs is not

suitably comparable)

Because of this, the risk exposure analysis was a much more qualitative process based on a combined assessment of the business model, the revenue exposure to textiles and the country sourcing exposure. Figure 5 summarizes the results of this analysis.

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Figure 5: Differing risk profiles of companies with textile and apparel exposure

Source: Schroders. Chart is for illustrative purposes only. As can be seen from Figure 5, there are several broad findings from our analysis. Footwear brands have, in general, the most developed risk management systems within the sector, but they also have high levels of risk exposure as they tend not to have a diversified revenue line through low product differentiation, their sourcing is predominantly in emerging markets and they have a high brand value which would be at risk should the brand be associated with poor labor standards.

In general companies in this sub-industry tended to have fairly limited evidence of risk management processes. All had a policy statement regarding supply chains, but the evidence of the implementation of this policy statement was much less thorough than the evidence provided by footwear manufacturers for example. However the business models and revenue streams mitigated the materiality of these companies exposure, to a degree. Broadline Retail These companies limit the materiality of their exposure by having a wide range of revenue streams. There is a clear difference between the levels of work being undertaken to manage this risk across the group of companies, we note that one of these companies has only recently been listed and is in the early stages of developing its corporate responsibility systems. Manufacturers These companies are the Tier 1 suppliers for the brands studied here. They have direct exposure to the rising costs of labor, fluctuating costs of raw material and labor disruptions caused by disputes over working conditions (hence the grouping in the high risk exposure area in figure 5). In addition there are increasing demands from their customers to demonstrate that they are complying with the supplier codes of conducts that these brands are issuing. It was therefore surprising that the level of publicly available information on their risk management process was so poor. Overall this study found that there was a large range in sophistication of the risk management tools used by companies ranging from the publication of a brief code of conduct to in-depth lengthy reports of processes to manage risk within supply chains, though the degree of response was not necessarily commensurate with the materiality of exposure.

Manufacturers

Clothing andaccessories

Footwear

Risk Management

Good

Broadline Retailers

Poor

Hig

hL

ow

Risk Exposure

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Seventy per cent of companies recognized social issues (such as rising costs of labor and poor labor standards) as being a risk to their business within their annual reports and account (AR&A), or equivalent

3,

whilst around fifty per cent listed environmental concerns and resource shortages as potential risks to their business. Given the acknowledgment of these social risks within the AR&A it was therefore encouraging that 85% of the companies surveyed had codes of conducts addressing labor standards, however this number rapidly dropped off when looking at environmental issues (such as water scarcity and use of hazardous chemicals), with 35% of companies having policies or codes of conduct to address these issues within the supply chain. This is probably a reflection of the relative “newness” of considering environmental concerns within the supply chain versus the consideration of social issues. It is therefore encouraging that two of the companies (Marks & Spencer and Nike) are undertaking an analysis of the environmental risks (e.g. climate change and water) to their supply chain over the medium term, and clearly environmental risks are a growing concern with both Nike and Adidas now trialing water free printing processes. One of the other consistent findings throughout this project was that pilot projects undertaken by companies with their Tier 1 suppliers to enforce labor standards (e.g. enforcing minimum wages, working hours) delivered higher rates of productivity, less defects and were generally seen as a “win-win”. However it would appear that in order to make these projects scalable supporting infrastructure and capacity needs to be built up both within the company but also in the manufacturers’ country, with one of the mechanisms to do so being industry collaboration. The final challenge is determining how material these issues can be to a company. Within this report we have touched on two different types of risk, rising input costs (raw materials and labor) and reputational risks. The impacts of both of these will be dependent on the business model and so how to factor these into the valuation of a stock will be a challenge. Cost forecasts can be adjusted in a valuation model relatively easily; all that is needed is an assumption of the growth in these costs which can be factored in to the Cost of Goods Sold figures. However the response by companies is harder to model, which is where an analyst’s comprehensive knowledge of a company and its management will add value. How to factor in the reputational risk as something tangible would be a bigger challenge based on an assessment of the probability of an event occurring (within which a company’s risk management approach is a key factor) as well as a view on the consequences of such an event, which in theory could be reflected in revenue lines. These factors could also be used as a general sense test for the quality of a company’s management which can be reflected in growth assumptions for the stock, or assumptions about its risk premium to its peers.

3 This is based on an analysis of the 17 Annual report and Accounts (or equivalent) that we were able to access

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Conclusion In 2008, Schroders was part of a collaboration of investors engaging with companies that had exposure to the textiles and apparel sector. The focus of that project was on the management of labor standards within the supply chain, recognizing that there were potential reputational risks that could arise from association with poor labor standards which could impact on shareholder value. This project set out to review the current state of play on this topic but also to explore the increasing importance of other environmental and social factors (namely water scarcity, pollution and labor costs) within the supply chain. There is growing evidence that supply of raw materials for this industry will face mounting headwinds due to several factors. One is that the physical environment is changing; there is already evidence of the impacts of cotton production on water resources, and a growing body of research highlights that the issue of water scarcity is only going to increase which will impact on agricultural yields. However the issue of resource scarcity is touched on by few of the companies studied within this report; where it is raised it is as a potential material risk within their AR&A, and very few discuss it within their focus on supply chain management (SCM). SCM practices predominantly focus on labor standards within Tier 1 suppliers, though the level of activity within this area varies by company. The other potential headwind is that as the economies in emerging markets develop it will lead to increasing demands for more stringent environmental regulations to reduce pollution and its contemporaneous effects which will increase the operating costs along the textile supply chain. The level of activity in managing supply chain risks varies enormously throughout the range of companies studied, but those with big brand profiles and serving a broad market (as opposed to the luxury markets) have by far the strongest approach. What was also of interest was that many of the broad-line retailers tended to have better supply chain risk management policies than the clothing and apparel companies, though this may be due to their supply chain programs covering a broader range of suppliers and the specific focus on the textile suppliers may be limited, but it was not possible to get good visibility on this. There is a strong case to be made for rising input costs within the sector from both raw materials and increasing labor costs. In the short term these cost increases can be managed through adapting the sales strategy or the products themselves, however this is probably a short term strategy and, over the long term, business models will have to adapt to this systemic change (it is interesting to note that both H&M and M&S are operating clothing recycling schemes – with H&M estimating that 95% of clothes that end up in landfill can be re-worn, recycled or re-used). When it comes to the issue of labor standards within the supply chain, companies are currently focused on Tier 1 suppliers and further focus throughout the supply chain will only be achieved through collaboration at the industry level. There has been a significant amount of progress in brand engagement with their supply chains. Since 2008 the level of engagement and leadership by some firms in this study is incredibly impressive, though it was notable that this engagement tailed off with those firms serving the luxury consumer market. Having said this we also note that the diversity in business models (pricing, different product ranges, alternative revenue streams) means that the materiality of this issue to company value will vary from company to company. It was also encouraging to hear about pilot projects demonstrating that improved working conditions can also be commensurate with improved levels of productivity, though it was disappointing to note that scaling these projects is still a major challenge. Ultimately there is a great deal of work being undertaken in managing supply chain risks (though this needs to extend throughout the supply chain and to environmental as well as social topics), there is clear evidence that this can impact valuation but the materiality will vary from company to company. If we were to suggest two performance indicators that could be used as a proxy for the level of engagement in this area by a company then we would suggest the following:

1. Publication of the percentage of suppliers audited and the results of these audits

2. Involvement in several industry level collaborative initiatives

17

Appendix 1

Profit = Revenue (1) – Cost (2)

1. Revenue = Price X number of products manufactured

Number of products manufactured = number of workers per day X hours per day X number of

products/worker/hour

Number of products/worker/hour = expected products per day X % absentee hours X drag X rework

% absentee hours, drag and rework are all affected by worker inputs = % workers>60 hours/week; average days

off per week; mix of employee experience; attrition; % of employees trained.

2. Costs = COGS X direct labor

direct labor = hourly wage + regular hours + rework hours + injury hours

hourly wage = employee experience curve

A factory could aim to improve profits by reducing costs of labor, but this would impact on the experience of the workforce, which would have a commensurate impact on the number of products made, and hence on revenues. Additionally small orders will reduce the revenues of a factory meaning that in order to maintain profits it will have to reduce costs, which would typically come through reducing the labor costs.

18

i Greenpeace, Dirty Laundry: Unravelling the corporate connections to toxic water pollution in China, 2011 ii Cleaner, greener cotton: Impacts and better management practices. WWF, 2006

iii “How can we stop water from becoming a fashion victim? The Guardian, Sustainable Business Hub, March 2012

iv Who will wear clothing inflation? UBS investment Research, November 2010

v Rio 2012: What can the fashion industry do to become more sustainable? The Guardian 16 January 2012

vi Dirty Laundry 2: Hung out to dry. Unravelling the toxic trail from pipes to products, 2011

vii “Sustainable Business performance Summary” Nike Inc. FY10/11

viii An overview of working conditions in Sportswear factories in Indonesia, Sri Lanka and the Philippines. International

Textile Garment & Leather Workers’ federation, April 2011 ix China Textile Manufacturing: Pain Along the Supply Chain, Citigroup Global markets, February 2011

x Suppliers’ social performance: indicator of supply chain risk. Infact Social Performance Solutions

xi “Business Continuity Institute survey reveals the high levels and deep-rooted nature of supply chain failure”, Business

Continuity Institute Press release 2 November 2011. www.thebci.org

Important Information: The views and opinions contained herein are those of the Rick Stathers, Head of Responsible Investment, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.

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