The Leather Pipeline - 30.09.14
30/09/2014
The world of business is still totally in the grip of the tensions between Russia and the West and the conflict in the Middle East where the US and several other countries have decided on airstrikes to assist the battle against the ISIS troops. This means the world is at war again.
Although the effects on the economy are still played down one has to expect that for a while things will not remain as easy as they were. For the moment we have to think about the refugees and their misery and the casualties. For the ones living in safety and freedom, oil and energy prices have come down, which is to be welcomed at the beginning of the winter season and offers many the chance to stock up for the season at substantially lower levels than a year ago.
In response to the crisis, many commodity prices are falling. Gold, silver, copper, cotton and many others are losing value in what can only be explained as a retreat by financial investors. Many remain pretty confused, because normally prices go up in time of crisis.
The European economies continue to suffer and sanctions against Russia are not good news either. It might be only a small portion of exports for several countries, but when things are bad anyway everything matters.
The decision of the European Central Bank (ECB) to pump more and cheap money into the system has at least one of the desired effects. The euro is falling and ended last week at levels below $1.27. This is welcome in support of exports. The US economy grew in the second quarter by 4.6 % the highest rate since 2009, which make the markets believe that the US Federal Reserve will raise interest rates sooner rather than later. This is supporting the US dollar too. However, there are also warning voices that the cheap money is not helping the economy or industry because it doesn’t end up where it is needed. With the excess of liquidity, banks in some countries are still discussing punitive interest on customer deposits.
This may favour the ECB’s ideas: consumers and companies may spend all their excess liquidity and this would boost consumption and investments.
Market Intelligence
There is no question that the leather pipeline in a difficult situation. People came back from the summer holidays with quite a bit of optimism and the All China Leather Exhibition in Shanghai made a number of people optimistic about the leather business for the rest of the year.
However, as usual the situation is not as simple as it may look sometimes. We have already discussed what we find critical about the general situation: we think that the world has changed in 2014 and not totally to the benefit of the leather business. If one is just picking up the positive you might come to totally different conclusions, but not if you are looking at the whole picture.
Globalisation has limited flexibility in supply chains and the leather business is no exception. Everything has to be planned and budgeted far in advance and this means, in our case, the timeframe of six-to-nine months. For some products this might be an adequate period, for others possibly not. What applies to the automotive industry is possibly not a good idea for general consumer products with a much shorter lifecycle, a dependency on fashion and pricing sensitivity.
The general consensus of the vast majority of people related to the leather business was and possibly still is that the expending middle-classes around the globe are willing to consider products made from leather as something they need to have. This might be true for some products, but leather is not for mass consumption any more nor as essential as many people might hope. Today image, design and fashion are far more the driving forces of consumption than the material itself; it’s only above certain prices that the material comes more into play and influences the decision of consumers who are willing to spend more to buy exclusivity.
The average consumer today is no longer interested in durability because the industry supplying consumer products is so much driven by growth that fashion changes more quickly than ever to make sure the next season’s production can be sold. This is definitely limiting prices and we tend to believe that the growth in production and the push to sell is such a driver of business decisions today that the focus on material is definitely fading. The undisputed fantastic performance of leather products since the last crisis in 2008 has created an opinion that the supply of raw material is so limited that the expansion of consumption would almost allow an endless increase in raw material values and in the price of leather. Any kind of criticism or questioning of this opinion has been waved away, in particular by the beef industry for very obvious reasons.
Consequently, supply management has become the driving factor that made the manufacture of semi-finished products (wet blue and crust) more and more popular; they are a tool for managing supply and prices. But since spring this year this strategy had shown a few cracks, triggered by the shutdown of the industry in Hebei province in China.
High raw material prices meant production costs in China for standard and commodity leathers had already begun to rise sharply. Labour cost, wastewater controls and effluent treatment made China become a far more expensive place to produce and many tanneries were no longer operating profitably, having lost the chance (with the Hebei closures) to have the dirty work done at very low cost. At the same time, alternative materials became cheaper again. We may just draw the attention of our readers to the price of cotton, which has hit a six-year low in the past week, and also to the price of oil, which is still the basis for many manmade materials, is coming down, in spite of all the crises and the geopolitical risks. This has made a lot of consumer product manufacturers opt for alternative materials, especially in view of all their suppliers telling them that leather will continue to rise in price and possibly become limited in supply.
The general slowdown in the global economy, the crisis in the Ukraine and also in the Middle East, the changes in Chinese domestic policy, the weak performance of several emerging economies … all this has been neglected by the leather pipeline until now. Everybody has just talked about the fantastic performance of the automotive industry, the increase in penetration of the usage of leather in cars and the extraordinary success of global luxury brands. This had made people so optimistic in their forecasts that any concerns were simply ignored.
If you still believe that raw material market goes in cycles then it is appropriate to ask when the current cycle of ever-increasing prices might actually come to an end. This cycle of growing prices has run for too long and when that happens, it is frequently called a bubble. The bubble is generally created when the valuation of prices can only be explained by the series, and not so much by facts any more. A bubble is also generally created when you need to explain and justify prices by theories and long-term projections and not by fair valuation. Lastly, when you borrow from the future to justify the present and you get people convinced that nothing can break the existing trend, you also have a bubble. However, it is still timing that counts and this means a trend can run for much longer than the hard facts seem to justify.
If we look at the hard facts of autumn 2014 we continue to worry about the writing on the wall.
Bovine leather as a material in the commodity range has become more expensive than many other options. The prices can only be justified for luxury items and in automotive (which have been the only drivers in the market for the last season). The global economy (except the US) is facing high levels of uncertainty. Political unrest is never a positive factor for consumption (and sanctions do not help). Luxury markets are showing some fatigue and a number of high street names are reporting under-performing sales already. Are the wealthy possibly a bit tired of spending?
The political situation in China does no favours to luxury consumption. Profitability of the leather industry is down and cash-flows are deteriorating. Significant stocks of semi-finished material can be located all over. There is a general decline in commodity prices and direct substitutes for leather are becoming cheaper as a consequence, while the price of leather continues to go in the opposite direction.
So we face reduced consumption of leather in finished products for price reasons. There are also major shifts in the currency markets, which influence local values of material. Meanwhile, sheepskins are exceptionally cheap and will substitute bovine leathers wherever technically possible.
On the positive side one can just prolong what we have seen so far, with the big beef industry continuing to invest in the vertical value chain and managing available raw material supply for the leather industry. This can be played out for a long time, but totally ignores the demand side. On the demand side we have to watch the growth in automotive, which is not so price-sensitive and could possibly compensate for declines in other sectors.
No matter which position one takes, it will eventually all depend on global consumption of leather. Supply does not change by too much and what is missing in one origin can be compensated for in another. Tanning capacity is another factor. The rapid expansion of tanning capacity, production and trade at origin (mainly in the US) has created a shortage of raw material from the production point of view, but in our opinion not from the leather demand side. We had islands of outperforming demand, but not overall.
We do not see leather demand as being strong enough in the coming season to absorb all of the material in the pipeline and in stock in tanneries; it will be interesting to see how the pipeline deals with this.
The split market has obviously bottomed out and the massive correction has come to an end. It is certainly premature to speak about a rebound and this is also adding to our concerns. It will still take a few months to evaluate the situation and to see if splits are back in the material mix for finished product manufacturing. For the moment, there is lower supply due to lower tanning volumes and split productions. Prices are attractive (as skins prices are), but up to this stage this has not led to a strong rebound in demand yet. Collagen demand is now entering its high season and we will have to check if this will restore demand for splits in this section in the winter season.
The skins market is still divided into segments. On the one hand, double face and rugs (for decoration) are still doing quite well while the nappa business is absolutely dreadful. The shoe and handbag industries have not yet integrated the material into the their collections and only some medium-to-high-end products have made inroads into manufacturing. There is not enough technical development being made by skin tanners and chemical companies to take full advantage of the price spread between skins and hides. In the coming weeks the Muslim world will celebrate the festival of Eid al-Adha and this will boost supply of raw material again. This is good news for those buying skins and bad news for those in need to sell them.
We think that the month of October will be pretty decisive for the trends for the rest of the year, or possibly until the end of the season. Most leather orders and prices will be fixed for the coming seasons, budgets will be made for 2015 and consequently the fundamental business parameters are in hand already for the decisions to be taken. The kill in Europe will now increase and in other parts of the world possibly be just flat.
We understand that leather orders and colour instructions are below budgets and expectations after the summer, and even the premium auto brands are under-performing on the forecasts. The Christmas holiday season is already around the corner and this year it is fair to assume that it is going to be a long break and European productions will close early and, with the prices we have reached, everyone will try to keep inventories at the lowest levels possible.
We have learned that there are many other influences commanding the price trends these days and so predictions are difficult. However, we think it might be a good idea to advise very careful inventory management for the weeks to come.
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