Market Intelligence - 11.6.13
11/06/2013
In the US, the economy is beginning to recover – the labour market, housing market and private consumption have improved significantly – but the situation is still fragile. In Europe, the situation remains very vulnerable. The nations and prices in the south of the continent might have bottomed but there not really much of an improvement. They would need further cheap finance to safeguard their budgets and to handle the crisis. Unemployment is high and even in Germany the growth is now starting to slow and some are expecting the north of Europe to head into recession. Consequently, the European Central Bank is pretty reluctant to raise interest rates and to stop the purchasing of government bonds.
Stock markets, which were running from record to record, took a break because investors became more concerned about the easy money policy. The worst problem for stock markets is always higher financing cost. However, with the lack of alternatives for investment, money steps in and out of stocks and commodities and despite having become more sensible, a major pull-out hasn’t happened yet.
The growth in China has begun to slow and the government is targeting just 7% growth for the years to come. It seems that the main focus is on environmental issues as well as consumer safety.
The euro has in the meantime made a reasonable recovery and after having traded for a long time below 1.30 to the dollar it has now gone up to levels around 1.32. Most pundits are expecting the dollar finally to rise, but we have seen many times the opposite of what the so-called experts predict.
With the decline of the value of the US dollar, some of the commodities were able to regain strength although the balance of supply and demand, for example for oil, did not justify the recovery.
Market intelligence
For a while now we have seen the leather pipeline in a situation that could be described as “stuck” – missing the trigger needed to change the markets. One can almost physically feel the need for a change or a clarification to prepare for the second half of 2013.
No matter what happens, the pipeline has to deal with it. Fundamentally, it is fair to say that for the majority of the leathers produced, raw material prices have risen too fast and too far to make leather production profitable – not to mention the increased need for finance. This has been a problem for quite a long time and remains discussed, but unresolved.
The leather business has fewer and fewer players because many cannot afford to continue. Around the globe you hear about an increasing number of medium and small tanneries that have decided they are not going to continue in the second half of this year. Many of them are financially strong enough to pay their invoices, but they are fed up with making losses. They see raw material prices not adjusting and their customers not willing or being in the position to pay the necessary and equivalent prices for leather.
This in turn depletes expertise and kills a lot of the old-style and experienced operations which have been commanding and influencing the leather pipeline. These tanneries are usually either very traditional or delivering specialties to the few remaining smaller users and manufacturers of leather. They are flexible in their production, are in many cases willing and in a position to fulfil special requirements as far as products, volumes and delivery times are concerned. But many of them not only have margin problems but also feel also that they do not get the necessary support from chemical or machinery companies, not to speak of the problem of finding qualified labour to manage the business and the market requirements. The leather business will miss every one of them in the future.
The trend in the leather industry to become bigger and more industrialised is not new and the problem of lowering production costs per unit has pressed many of the producers towards bigger production. What may work for a few has become a heavy burden for many. Feeding production with raw material and financing the business was already problematic enough, but if you had the bad luck to deal with manufacturers that lost business and market share themselves you were badly hit.
In short, we are again in a period of inflated tanning capacity that is, as a consequence, inflating raw material prices and deflating finished leather prices. The simple reason why tanneries, in most cases, are not in the position to get the price they need and have to pay raw material prices that are so high is because sellers think they will find another buyer if one passes.
This situation is not new and is happening periodically. You can simply increase tanning capacity much quicker than raw material supply. Many have realised the situation and are working to find solutions. It is difficult because the drums have to roll, the production has to run, the customer has to be supplied, the turnover and the cash returns have to be generated in there is still always the hope that next month it’s going to be better. The problem this time is that we have had hardly any market correction for a long time and so the tanning industry is not in the position to buy raw materials cheaper and to find some kind of cost averaging.
Having said that, the situation might not apply to everyone: we still have the impression that a number of larger operators are on a different playing field. Between the big suppliers and the big industrial users of raw material, different kinds of contractual relations and price-finding systems are applied. Some of the big supply chains are operating on official report prices. Those which have such agreements are much better protected against raw material price rises and if it is well played the official benchmark price is not necessarily the one paid to the supplier. As a result, some of the bigger players are achieving better margins, lower cost of production and a much higher level of safety in their budgeting and projections.
They are still hit by fast and rising raw material prices, because the adjustments are never as much in time and the raw material has still to be bought and paid for far before the price adjustments are applied. However, the adjustments will come and the management can at least count on them. In the environment which we have seen over the past six to nine months, such agreements have been tremendously helpful and have supported the big industrial operations which are part of the manufacturing level between the beef industry and retail.
The other, “normal” players cannot count on such securities and have to manage the full risk. For many, the problems are no longer manageable. That’s why many are seriously starting to think about their future. Quite a few have lost confidence and this has made some decide to close their business in the near future. Those which still think they can reach the shore are facing the prospect of deciding how much money they can afford to lose to wait for better times. If it’s not their own money they are burning they will have to prepare good stories for their banks to receive the credit facilities they will need to continue.
A worry that affects all tanners, regardless of size, is that leather customers are getting more and more anxious about the price for their material which is connected to official reports. The next steps in the supply chain are affected and after a long time of high price levels, leather as a material becomes a headache - particularly because the beef industry has used the expression ‘supply shortage’ as the main argument to justify the continuing rise and sustained price levels we have seen. A lot has already been done to defend against this: less leather used in products, more concessions on quality, different articles - but it hasn’t helped. The cocktail of excessive production capacity, optimism about retail sales, low interest rates, the beef industry using their stock management and not the price to determine the available volume and speculation has kept prices rising. Even a small retreat, which we have seen recently, cannot be considered a correction the market requires.
Consequently, there are now quite a number of large retailers and producers setting up meetings internally and externally to understand what they have to expect from the next seasons and if there might be any kind of a tool to handle the situation better than just pay what is requested by the reports and indices.
The easiest solution would be to avoid leather as a material. However, in many cases this is not an option and so they are shifting either to cheaper origins, cheaper articles or just using less leather in their designs. This wouldn’t matter if the global demand for consumer products containing leather is going to rise to the same extent that leather is reduced or the leather substitutions would rise that much in price that the price for leather would be protected by the price for the alternatives. Both of the options do not seem likely.
Consumer sales might be stable and possibly even a bit better here or there, but a major boost can hardly be expected for the coming six to 12 months. We must also not forget that the shoe industry is manufacturing for the summer season of next year and this generally uses less leather than in winter. Upholstery leather demand will certainly get somewhat better after the summer holidays, but leather in the mass production for furniture has lost a bit of its shine. Automotive might be growing in total but it is not clear which market segment and by how much. However, the automotive industry will also remain extremely price conscious.
Let us summarise the facts we have now been dealing with for a long time:
• There has been steady growth and good demand for luxury products and luxury cars equipped with leather.
• There have been moderately lower kills in the origins of the premium quality hides.
• Bovine raw material supply is declining in the high quality sector and moderately rising in the lower prices origins.
• Europe is still stuck in the debt crisis. Unemployment remains high.
• China’s growth is slowing and there are indications that the Chinese shopper might take a little break.
• Low interest rates and the constant injection of money makes financing cheaper but borrowing not necessarily easier. Finance of many tanneries in China is secured by the ‘grey market’ which is not stable and secure. It has however supported private consumption and financing.
• Tanning is not profitable for most operators.
• The beef industry tried successfully to control the by-product market by managing supply to support and stabilise prices. The impression is that in some parts of the world this has slowly increased stocks. Official sales and shipping statistics do not confirm a constant and sufficient flow of by-products.
• Many companies have now begun to review their options on how to return to profitability without paying more for leather.
We think it is now important for everyone in the pipeline to define his position as well as the possibilities to deal with the situation. The essential step is definitely another rise in leather prices no matter what this means for the individual company and the demand. Independently of what is going to happen next, in the raw material market the limits for leather prices have to rise and leather producers have to get used to the fact that the price for leather can fluctuate in the wider range.
The calculation from leather to finished product or retail has to be reviewed to make sure there is enough room to handle the future. Either leather becomes a material which is again able to obtain price premiums in the retail market or the future will be difficult when the matter has to be sorted out the hard way.
The split market continues to be driven by the non-leather demand. This is still rising and more and more collagen productions are either opened or expended. The substitution of expensive grain leather by splits has also increased the demand from the tanning industry and so split prices are not only high, the product itself is becoming difficult to get.
With the non-leather products setting new price levels and achieving in some cases significantly higher added-value, is there is very little room for split prices to decline. However, some limits are set and we see some of the split substitutes presently falling in price and this might have a temporary influence on splits at a later stage this year.
The skin market is twofold. On one side the market for fine and dense wool remains pretty good and prices have recovered after the correction seen a few weeks ago. The open wool and nappa-type skins are still struggling. Business is not good and in particular in China people are talking about reasonably high stocks sitting around. With the summer arriving and temperatures rising it is not an inviting situation to sit on salted skins that have not found a buyer.
We have to admit we are surprised lamb and sheepskins are struggling so much because they should have taken more benefit from the record price levels of bovine material that we have seen in the second quarter of this year. We expected significantly more substitution in many areas by lamb leather, but so far producers cannot confirm any significant increase in demand from traditional consumers of bovine leather.
We cannot get away from the idea that the market requires a correction. However, as already said this requires not only somebody buying but also somebody willing to sell at lower prices and so far the suppliers are not willing to surrender in the sense that they expect the leather industry to require more raw material soon. This applies in particular to Asia where raw material procurement for the production cycle for the second half of the year starts about six to eight weeks before Europe. So, most of the suppliers believe the leather producers in Asia will have to step into the market pretty soon - within the next two to four weeks at the latest. Under normal circumstances this would be true, but it might be a bit more difficult this year. Even if the leather producers need to replenish we believe they are now considering very intensely how they are going to run their businesses for the rest of the year.
Suppliers will fight until the last drop of blood before they adjust raw material price levels. Nobody knows how long they will be patient, but at this stage it doesn’t really seem likely that tanneries are going to be buyers for bulk raw material quantities if prices remain the same or try to be pushed up. We maintain our opinion that a correction of another 5% to 10% would solve a lot of the underlying problems in the industry. There is no fundamental problem with leather demand yet, but with every week or month where profitability is not restored, production and consequently demand for raw material will decline. This might not only be by management decisions, but also possibly by companies closing down or falling idle.
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