The Effect of Rising Interest Rates on the Apparel Business

For nearly a decade, interest rates have remained near zero, meaning it was very inexpensive for businesses to borrow money. But those sunny days may be over. Twice this year, the Federal Reserve has raised the prime rate, and it is expected to do so again later this year.

While the interest-rate increases have been small, they are still a factor in every business’s bottom line. In June, the Federal Reserve raised the benchmark rate to between 1 percent and 1.25 percent. Businesses typically pay a little more than the benchmark rate.

With this added operating expense, we asked several finance experts and factors how apparel manufacturers are coping with this interest-rate change.

Mark Bienstock, Managing Director, Express Trade Capital

While the two increases in the prime rate have slightly increased apparel producers’ costs of funds, it is not the key driver that is negatively affecting their business. It is, however, compounding their profitability concerns.

The industry continues to be battered by the online shopping experience. Those manufacturers that had the foresight to create a platform to handle the fulfillment business are the winners and survivors of the paradigm shift in dealing with today’s consumers, either through the retailer or consumer directly.

This requires a significant capital investment that only a select group of manufacturers are capable of providing. We continue to witness a shakeout of those poorly capitalized entities that are unable to sustain the requirements of the new shopping experience.

Sydnee Breuer, Executive Vice President, Rosenthal & Rosenthal

Increasing interest rates will definitely affect not only apparel companies but any company that borrows money. However, apparel companies will be particularly challenged in coping with the increases due to the difficult retail environment.

The retailers will not want to accept an increase in pricing to cover the increased interest rates as they fear consumer resistance to price increases.

It will be yet another example of how apparel companies will need to be vigilant regarding their own costs, including being smarter about the money they borrow, tightly managing their overhead and controlling their inventory levels in order to continue to compete in this difficult retail environment.

Rob Greenspan, President and Chief Executive, Greenspan Consult

Interest expense is a component of the income statement. It records the amount of interest paid to banks, factors and other debt-bearing instruments.

In the case of an apparel manufacturer or importer, the interest expense to the bank or factor varies on the amount of leverage (borrowings) the company needs. The more leverage in the company, the higher the loan, which results in higher interest expense.

Bear in mind, while the Federal Reserve is now raising interest rates from historically low levels, the cost of money borrowed by banks to lend to their customers is still low.

But these increases will cause the prime rate and Libor rate to rise. Many companies pay their lender prime plus or Libor plus a negotiated rate. The Fed increase will cause a ripple effect on everyone who borrows.

As an example, if interest rates increased by 1 percent, that increase would cost a company $10,000 for each $1 million of its annual borrowings. If a company’s loan averages $5 million, its interest cost would be $50,000 higher if rates were to increase by 1 percent. While this is important, the interest cost should not be a reason for a company to overreact.

With rising interest rates, the company should look for ways to lower its borrowings to help control rising interest rates. Possible solutions for apparel manufacturers to have more liquidity in their business is to lower inventory levels, get shorter terms on accounts receivables, get longer dating on their accounts payable and, of course, retain more profits in the business. All of these things can reduce a company’s borrowings and help control rising interest costs.

Sunnie Kim, President and Chief Executive, Hana Financial

The consensus seems to be that interest rates will indeed rise again. Any increase in rates will have a negative impact on apparel manufacturers’ income as the current state of the retail market does not suggest there will be a significant turnaround in the near term.

Most retailers are reducing the number of their stores, creating fewer opportunities for manufacturers, which could exacerbate the issue even more.

Given the reduction in retail, manufacturers will be unable to pass these costs off to retailers as they may have in the past. Ostensibly these manufacturers will potentially find themselves in a tighter cash-flow position when combined with continual hikes in the minimum wage.

Therefore, companies may find themselves operating on a smaller scale to meet their higher operating expenses.

Robert Meyers, President, Republic Business Credit

Until this point, apparel manufacturers have largely been unaffected by rising interest rates. It is possible that highly leveraged apparel manufacturers have experienced a minimal impact on their profitability from increased borrowing costs, but one would speculate most have increased their operating income or decreased overheads during the same period.

The increasing Federal Reserve rate will impact short-term interest rates more than long-term interest rates, meaning consumers have probably seen their credit-card rates increase but not their banks’ 30-year conventional mortgages.

Going forward, an environment with increasing long-term interest rates could impact apparel manufacturers. These impacts are typically seen as increases in national savings and investments (debt) or through decreased spending ability as there becomes an actual cost-of-borrowing debt.

Until recently, most bank loans were structured at or below targeted inflation rates of 2 percent, meaning that the dollar you borrow today will actually be worth more next year than what you paid to borrow the dollar. This structure encourages spending, investment and economic recovery following recessionary periods.

The other potential impact leveraged apparel manufacturers may have noticed is in the mergers-and-acquisition world. Customarily, companies will see the value of their equity decrease as interest rates rise. This shift is largely due to valuation formulas that discount future cash flows by taking into account the cost of debt, among other factors.

Dave Reza, Senior Vice President, Western Region, Milberg Factors

Rising interest rates, even when anticipated, adversely impact many apparel manufacturers. Most, but not all, borrowers utilize revolving bank lines or factoring advances that are based on the prime rate.

Those who rely heavily on short-term funding to augment working capital will have to find ways to absorb the increased costs by modifying costing and customer pricing and improving balance-sheet management. Strategies include improving accounts-receivable turn, reducing inventory levels and/or seeking additional terms from vendors.

Companies that have term loans with floating interest rates tied to prime or even Libor will have to generate more cash to service debt. If the increased debt service is significant, they have trouble staying in compliance with covenants in their lending agreements.

Despite news of pending rate hikes, companies cannot always “pass along” rising costs to their customers, especially in an environment where vendors face tremendous customer price sensitivity.

All of these dynamics should incentivize apparel companies (along with any other borrowers) to find other costs savings in their expense structures, improve balance-sheet management (to lower average borrowing levels) and where possible adjust pricing to offset the higher costs of borrowing.

Louis Sulpizio, Managing Director, Originations, White Oak Commercial Finance

The raising of interest rates as late as June 2017 signifies a stronger economic outlook and is a mechanism for controlling inflation.

Many apparel companies are not focused on the implications of a rate hike, but they should be. Managing costs is vital to operating profitably at optimum levels. It is imperative for businesses to better manage cash flow and, more importantly, inventory control. Out-of-season goods need to be moved in a timely manner.

Companies need to constantly work their vendors for better pricing and better buying terms that help in maintaining gross margins and bottom-line profits. Additionally, distributions should be tightly managed to assist in capital preservation, limiting the amount required to be financed.

As we all know, the end game is the bottom line. Profits cure a lot of problems.

Kevin Sullivan, Executive Vice President, Wells Fargo Trade Capital

Our clients generally do a great job of analyzing interest-rate risk and preparing for eventual increases. Most understood that rates couldn’t remain as low as they’ve been for an indefinite period of time and have planned accordingly.

While it certainly has some impact on the bottom line, we also analyze this risk as it relates to the ability of our clients to manage potential increases and have generally found that it doesn’t represent a significant risk to most.

The bigger challenge relates to how well a company is managing the significant changes in distribution channels. If a company has begun to experience losses due to the loss of significant retail customers, interest-rate increases certainly represent a bigger issue than they would for a company that has built enough equity to navigate through today’s market challenges while diversifying their customer base.

Ken Wengrod, President, FTC Commercial Corp.

If apparel manufacturers have been negatively impacted by the current rise in interest rates, I can safely predict there were other negative aspects that contributed to the impact such as over leveraging with insufficient capital, maintaining excessive inventory levels and chasing sales to cover unnecessary overhead expenses.

Smart businesspeople stay focused on costs they can control, such as the costs of goods sold and their inventory levels.

It’s critical for manufacturers to stay focused on their true consumer—not the retailer. Those manufacturers who produce merchandise that consumers need to have in their wardrobe are those who maintain strong margins during swings in the economic markets.

Manufacturers should be monitoring all other expenses as well from concept to market. Over the years, I have found that manufacturers have a tendency to focus on the wrong costs. Instead of focusing on the rise and fall of interest rates, they should monitor their hidden expenses, such as actual costs of producing a garment, including working losses (waste), excess freight costs (in and out) and over sampling, to name a few.

Their lines should be narrow and deep with a full appreciation of economies of scale such as the ability to take advantage of outsourcing where it maximizes costs and efficiency.

A lot of manufacturers focus on costs that are obvious. Few scrutinize these hidden or soft costs. Studies show that 20 percent of the cost of a woman’s dress includes logistics (freight/warehouse) and idle time from the time the cotton is picked to when the garment is purchased by the consumer.

Today, it’s not about just labor costs. It’s about the advantages of cluster manufacturing and near shoring. Manufacturers need to maximize velocity and cut down their inventory levels, which were created to never miss a sale.

Those astute players understand this approach and stay competitive by looking inwardly and controlling what they can control.