Tariff Troubles Threaten to Impact The Gap's Sales, Supply Lines

The Gap's (GPS) abysmal first quarter earnings results could be impacted further by a trade war that has now become a two-front battle.

Shares of the The Gap were down about 12% in late morning trading. The San Francisco-based apparel maker was battered by a big miss on earnings and serious declines in same store sales across its key brands when it reported after Thursday's market close, which is a dynamic that could be complicated further as the trade war threatens to increase costs for consumers and temper growth in its third largest market, mainland China.

CEO Arthur Peck called the tariffs tantamount to "attacks on the American consumer" and lamented the impact that these external factors are having on the overall industry. The addition of restrictions on Mexico set to take effect on June 10th could further weaken American consumers.

"If the rising taxes on Mexican goods coming into the U.S. are implemented as the president threatens, consumers won't have much choice but to pay the rising costs on items like beer, tequila, food, appliances, automobiles and auto parts," Mark Hamrick, Senior Economic Analyst at Bankrate commented. "While federal income tax cut gave consumers and corporations additional ability to spend, billions of dollars in tariffs on Mexican imports does just the opposite and worse."

Of course, that rationale is important to note for apparel retailers as well, given that Mexico was the United States' second largest supplier of goods imports in 2018 and apparel imports from the nation have increased by double digit percentages in recent years, challenging India and Vietnam for a top five spot of sourcing nations.

Mitigation Moves

The options for a retailer with tariffs are threefold: pass on the costs to consumers and likely weaken demand, eat the costs and temper earnings and/or margins, or move global supply chains and sales agreements.

Luckily for The Gap, there are no Mexican suppliers listed among its top relationships. Instead, suppliers of apparel from India, Sri Lanka, Taiwan, South Korea, and China are listed as the top supplier relationships on FactSet.

Additionally, while the company does acknowledge it operates stores in the neighboring nation, it is not even listed in the top eight sales regions of the company. Of course, the supply chain agreements emanating from China are a sore spot.

Specifically for China, Peck noted that the company is working diligently to mitigate the potential problem for consumers by incrementally moving away from reliance on the region.

"As you're hearing on many of these calls, there is significant uncertainty around what goods the tariffs may apply to and at what level they may be applied," Peck noted. "But we've been migrating sourcing out of China for the last several years and will continue to do this responsibly going forward."

According to recent company filings, The Gap has reduced its manufacturing exposure to China from 25% to 21% over the past three years, indicating a pre-empted move out of the region even before the most recent issues.

"If you include only apparel, our penetration is approximately 16%, which is significantly lower than the relevant portions of the industry," Peck added. "We're actively monitoring the issue. We're actually actively engaged in the conversation, and we're managing our sourcing operations accordingly."

That level is indeed lower than peers like Abercrombie & Fitch (ANF) which reported that over one quarter of its goods are manufactured in China.

The Gap's exposure would put it more in line with VF Corp. (VFC) , the maker of Vans shoes, Dickies, and currently the owner of Wrangler and Lee Jeans prior to their spinoff into the awaited Kontoor Brands IPO. The apparel retailer has largely been viewed as a safe haven stock for the sector.

Additionally, with less than 5% of its sales coming from China, it would be at a far lessened risk compared to Adidas AG (ADDYY) , Tapestry (TPR) and Nike (NKE) , which have China sales charting in the teens as percentage of total sales, according to Wells Fargo.

So, while one fifth of the company's imports coming from China overall and a small, but not insignificant, degree of sales coming from the region is a cause for concern, The Gap won't be the most tariff impacted apparel maker.

The issue comes over whether it even matters where products are sold or made if they are simply doomed to sit on the shelf in stores irrespective of location.

Inventories in the first quarter were up over 10% as sales slowed and the potential for tariffs to temper consumer demand could worsen.

In short, The Gap has big issues to concern itself with, but tariffs could end up being the least of it. Unfortunately for dip buyers that's not necessarily a good thing.

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