MARKET INTELLIGENCE

Macroeconomics

Most of the interesting news of the last few weeks has been about the US economy as almost all of the statistical data seems to confirm that the US economy is slowing down.

Retail sales reported by important retailers such as Wal-Mart and Home Depot have fallen and the consumer price index fell by 0.2 %. While analysts had expected figures of around 83, the consumer confidence index produced by the University of Michigan actually dropped to 78 points.

Ford Motors announced that it will cut production by 11% in the third quarter and plans a 21% cut in the last quarter. General Motors was already facing significant problems and with the supply industry in the state that it is this was another strong blow to the Detroit car giant. Due to the huge importance of the auto industry in the USA, these problems will certainly also leave a footprint on the general economy.

The most problematical statistic, however, was the drop in existing home sales by 4.1% and the increase in unsold homes. If this is indicative of a drop in house prices, the USA consumer could be in for a pretty rough ride.

The $ and oil prices continued to move within their established ranges. While oil hasn’t hit the $80 mark yet neither has it fallen below $70. Meanwhile, the $ is still trading against the euro in the 1.26-1.29 range. With the hurricane season now approaching, speculators will once again use every storm as an excuse to push oil prices up again.

Europe’s largest economy, Germany, has confirmed concerns that any improvement in the economy might be short-lived with the ZEW Indicator of Economic Sentiment falling to unexpected record lows.

Market intelligence

The last two weeks have not been as quiet as we anticipated in our last issue. As far as raw materials were concerned, most players admit that there was a reasonable amount of interest from tanners around the globe. The activity was not spread equally, but everybody got a fair share of the business.

While American suppliers enjoyed decent interest from Asia, European players reported more interest from their domestic or regional client base. Consequently, it appears our concerns about the lack of activity prior to the fair in Shanghai were unjustified. The product flow in the pipeline remains steady and constant.

Demand for shoes and accessories stable

Although we still think it is a little premature, we need to have a look at the current status of the leather industry. There seems very little doubt that shoe manufacturers’ and their suppliers’ order books still remain well-filled and even the worries about a slowdown in the American economy have failed to cause concern about the global demand for leather shoes and accessories. The strong performance of the emerging markets is easily compensating for any kind of concerns one might have about the ‘old’ economies. So, there is still no reason to believe that we will face problems on the demand side in this sector of the market in the short-term.

Uncertainty in upholstery sector

In the upholstery segment, it is still too early to make any decisions and there are two reasons why the situation is not easy to judge:

a)     furniture still depends significantly more on the developed economies and demand variations in these markets influence the business much more;

b)     the leverage effect on finished product prices is at its highest due to the large consumption of leather and the proportion of the material price in the total finished product price.

One will have to wait and see what the main supply markets in Italy, China and South America report from their customers over the next eight to ten weeks, before we have a clearer picture.

For the USA, most forecasts are predicting a slowdown in the economy and the housing market—a significant factor in the consumption levels of furniture—and the real estate market is already showing signs of significant fatigue. In Europe statistics are reporting a moderate improvement in the consumer markets, but not one that could really be described as a strong performance yet. The large economies such as France, Germany and Italy may present better statistical performances, but private consumption is still quite weak and due to the problems in the labour markets and ongoing discussions about the social welfare systems there does not really seem to be a convincing argument for spending to grow substantially over the coming months. The demographic factor and the ‘singles society’ or one-parent families are not really paving the way for more sales either. Last but not least, leather is not currently ‘in focus’ in terms of interior design and remains dominated by either price or by a specific affinity for leather as a product. So, growth in the interior leather market must also come from the emerging markets and one doesn’t get the impression that we could see the same market performance here as we have for shoes and small leather goods.

Car upholstery is another big question mark. The global car market and production is stable, but we are seeing a major shift within brands and manufacturing locations. The large production cuts by the US manufacturers may have been compensated by success stories of Asian or a select few European brands, but we fail to see any sign of strong growth and certainly no potential for any price increases.

Meanwhile the garment market, in terms of quantity, is playing such a limited role in the consumption of bovine material that it can be ignored in this review.

Balancing the market

Although it is hard to calculate the exact production and consumption figures for the market in general and for individual markets, for the sake of this report, let’s assume that the strong performance in the side leather business is at least compensating for any variation in the upholstery sector. Even if this market is not even growing that much, it is rising faster than the effects of possible consolidations in the other markets. On the condition that we remain within the same frame of supply and demand that we have seen over the past two years we would have already run into problems.

The global production and demand for leather and leather products in the past few years could only be met by absorbing the available inventories along the pipeline. We don’t know if everybody will agree, but in the past the balance between physical demand for finished products and physical production of bovine material was not in balance. Therefore to defend against raw material price increases the only possible solution was that sellers/producers of raw material were basically ready to sacrifice their stocks to cover the gap as we are now starting with a significantly lower average inventory—unless the additional volume bought by Chinese tanners in 2006 is sitting in some hidden warehouses somewhere.

Most of the pundits these days claim that they do not see any chance for a change in the market and believe that everything will stay the same going into the 2006/2007 season. This opinion may be understandable and a ‘safe’ statement to make, but it cannot cover the realities of the market.

A continuation of this situation without any change will be restricted by the natural limitations of supply and we see the situation as one where ‘leather production has been outstripping raw material supply and requirements have only been met and the product flow achieved by reducing and absorbing existing inventories along the supply chain’.     

For each individual involved in the market, it is now time to decide if they believe that this statement is true or false.

If it is false then it is easy: there is no supply shortage to be expected and not only will there be sufficient access to raw material, but also no risk of further price rises… end of the story.

If the statement is fundamentally true it is much more difficult. Why? Well, because there is no single answer or possible solution to the problem.

We have no crystal ball, but what will actually happen is fairly well known. At the beginning of the season, however, it is always wise to have a clear picture about the outlook and market fundamentals. We are currently dealing with the bovine market alone.

Supply

The easiest situation would be that the supply of hides will increase quickly and compensate for the gap. Various analysts are assuming that with the rising wealth in the emerging markets the production of beef will also increase and solve this problem. We do not believe that the production of beef is as elastic as the variation in demand for leather. Although global beef consumption will rise and while countries such as China are rapidly growing their herds and mass producers in South America can also increase their kill quickly, the global demand for beef will, in our opinion, not increase by significant quantities in the near future. Cheaper proteins such as pork and poultry will benefit first, so the supply chain cannot bridge this possible gap.

Demand

If this is the case then the demand side will again have various options:

1. A general slowdown in the global economy and a slide in total demand
2. A reduction in demand due to regional economic problems (such as the Asian financial crisis of 1997, Russian crisis of 1998)
3. Better use of the existing resources (design, fashion, etc.)
4. Substitution of the product (leather) by other materials (price, fashion, etc.)

If none of the above happens, then it is obvious that demand will be decreased simply by the fact that there will not be enough material to fulfil market expectations and therefore:

1. Not all producers will have access to sufficient material to meet their requirements and/or cash and profitability problems will disqualify producers in the market place and leave existing orders in the pipeline uncovered
2. Rising prices will eventually slow down demand

The price factor normally takes a reasonable period of time to have an impact as this tends to hardly move in between the seasons as orders are placed and have to be delivered for a longer period of time—at least from reliable partners.

So, one has to look at the first option to discover what is likely to happen first.

Profitability problems

There are presently numerous complaints about profitability and, against the balance of supply and demand, some large buyers of leather and leather products are even demanding price reductions. This is a difficult task when production costs and raw materials are moving in the opposite direction. In addition to this there have been no reports  about voluntary shut downs along the supply chain. Quite the reverse is true and there are some quite ambitious plans to expand the leather industry in countries such as India, Pakistan, Russia and in Central and South America. With expanding production, limited resources and no short-term indications that leather demand is declining, we are in a classical ‘survival of the fittest’ situation.

This comes down to a question of economics based on the individual cost and price structure. With the segmented leather business and the completely different use of leather in shoes/accessories, upholstery (car, furniture) and others (garment, specials) it is first and foremost a competition between the segments, before it comes down to enterprises competing.

We feel that presently the shoe or better side leather industry is holding the best hand of cards just as some years ago car upholstery was the front runner. With less leverage involved, higher added value, and a larger participation in the growth of the emerging markets we feel that the side leather segment is in a better situation for the coming season.

A service such as Market Intelligence can and should not go any deeper into the analysis of details now and if some readers feel that more knowledge is essential to proceed, then it may be wise to carry out more detailed research and benchmarking in order to find out where you stand as an individual in terms of the possible competition for limited resources and the fundamental chances of succeeding in such a market.

Even if one doesn’t agree with the standpoints expressed here, if questions were raised and answers have been given, hopefully it is enough to trigger a certain amount of contemplation about the wider perspective and individual position.

In the weeks to come most players will be busy collecting information and impressions after the summer break and looking for the first indications for the winter semester. Many will meet in Asia over the next fortnight and many buyers of leather and leather products will be on the road as well as raw material suppliers. Various furniture fairs are on the calendar, shoe fairs and much earlier this year Lineapelle in Bologna will take place in mid-October. All this should be more than enough to collect good information and grasp the sentiment of the market situation for the next three to six months. We were a bit cautious in our last report and raised concerns that there was a possibility of less stress in the raw material supply. This rather contradicts the questions we have raised in this issue. As we have seen, a lot will depend on how the demand side develops in the short-term and how much cost, price and cash issues immediately influence corporate decisions. A lot of these questions will be answered in the weeks to come.

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