teardowns in tech…

Teardowns have become a staple of IT investing.  Every time a new consumer device appears, tech websites get hold of one and rip it apart. They then publish lists of the components the device contains, along with cost estimates and a guess at assembly time and expense.

It’s all very interesting information.  Sometimes it can be the key factor in deciding whether to buy or sell the stock of a component manufacturer or designer.  Who wouldn’t like to have his chips in the iPhone4S, for example?  Or, suppose your company had a key chip in an older model but has been bumped out by a rival in the latest one?

…and for garments

The Wall Street Journal had an article last week where it did the same thing for a polo shirt.  Not exactly high tech, but I think it’s still interesting  in showing industry structure and where the money is.

KP MacLane

The article is about KP MacLane polo shirts, created by Katherine and Jared MacLane, two former Hermès sales managers who decided to become fashion entrepreneurs.  They sell their shirts online, at http://www.kpmaclane.com, for $155 a pop.

There certainly is a market for expensive polo shirts.  A Hermès polo, for example, retails for almost 3x as much, at $455.  Unlike KP MacLane’s, the Hermès offering does have a pocket.

selling points

According to the company website, the key selling points for the KP MacLane product appear to be:

–environmentally friendly;

–made in the US;

–upscale, niche;

–fusion of European tradition with American “craftmanship,” “ingenuity” and “pride.”

unit costs

The merits of this polo shirt aside, unit costs are as follows:

materials               $10.35

manufacturing     $11.05

shipping               $8.17, including $3 for an embroidered bag the shirt comes in

total                     $29.57 .

pricing

The MacLanes have set the wholesale price for their shirts at $65, a markup of something over 100%.  The wholesale to retail markup is about another 150%.

why is this interesting?

What do I find interesting about this business?

The MacLanes are a startup, so their unit costs are very high.  If they become a success, they’ll be ordering fabric in much larger lots.  This will mean they get a better price.  The same with the cloth-cutting and sewing.  My guess is that they’ll easily shave $2 each off their materials and manufacturing costs, even if they make no sourcing changes.  That would push their per unit outlays down below $25.

That would only be for starters.  But the MacLanes would certainly never lower their prices.   Any cost declines would only become extra margin for them.

On the other hand–and this is what’s really important–if the MacLanes can achieve a $155 price point, their cost of goods is almost irrelevant.

They currently mark up by $125 over the cost of each shirt.  With the economies of scale in sourcing that I’ve assumed, they would increase the markup to $130.  That’s only 4%.  If the MacLanes had a different objective and decided to source both materials and assembly from China, they could probably get their unit costs to $10 or less.  They’d lose their Made in the USA selling point, of course, which might be fatal; their quality control problems would increase exponentially; and they’d only raise their markup by $15.

In addition, it would also defeat the whole purpose of their business, which is to use marketing to create a non-commodity product, that is, one whose selling price is not based on the cost of production.

In other words,…

…the real money in the garment business is not in the manufacturing.  It’s in the brand creation.  The Hermès polo shirt I mentioned above probably doesn’t have production costs higher than the MacLanes’.  But Hermès has spent years of time, effort and spending on creating a brand image that wealthy people want to embody and are willing to spend extraordinary amounts of money to exemplify.

Notice also that the retail markup is hugely greater than the wholesale markup.  Yes, there’s a greater risk in owning retail outlets and in-store merchandise.  But the control of the brand message and of overall inventory is far superior to what a wholesaler is able to do.

the Internet

The internet is still in relative infancy, so I don’t think all its implications for retail are yet apparent.  Some already are, however:

–The role of physical distribution networks as gatekeepers for new products is diminished.  Entrepreneurs like the MacLanes can reach directly to the consumer through the internet, to create pull-thorough demand for their products at low cost.

–Weak brands, like those of many department stores, will face increasing difficulty, as will the brands they carry that use them as their principal means of distribution.  I think this means strong brands will be forced to establish their own retail outlets.  Weaker brands will fall by the wayside.

–For startups, a sophisticated web presence that clearly defines and exemplifies the brand attributes will be essential.

current investment implications

The number-one lesson is to avoid garment manufacturing in favor of branded retailing.

There’s a secular case in favor of luxury retailing, especially for firms that control the majority of their retail distribution.  The same line of thought argues against generic physical distribution, especially physical distribution of the type department stores have.

On the other hand, the broadening of economic recovery in the US is creating a cyclical investment argument in the opposite direction.

What to do?  Several possibilities:

–let relative valuation decide whether you want to make the secular bet or the cyclical one (personally, although I love luxury retail stocks, I’d prefer he cyclical),

–don’t bet.  Avoid the area entirely if you’re an individual investor; look like the index if you’re a professional,

–look for non-garment retailing, like sporting goods,

–find an indirect way to play the recovery of the average consumer.  This is my choice.  I’m betting on hotels.  I’ve owned IHG for a while and I’ve recently bought MAR.