The Leather Pipeline - 03.11.15
03/11/2015
Depending on where you live and which media channel you use, the headlines in the past weeks have varied greatly. In Europe the news is dominated by the refugee problem, a humanitarian drama that has helped bring to light all the mistakes in the Middle East policy of the EU. Now the EU has to deal with the consequences.
The Middle East is a big problem and the confrontations in Syria, Afghanistan, Yemen and so on used to be just TV news for the Western public and not something that could influence their lives. Now everyone is beginning to realise that the consequences are far bigger in many respects. The conflicts of interest of the superpowers in the region need to be synchronised in a period when communication is already reasonably poor due to the conflict around the Ukraine and the imposed sanctions. Since the war cannot be ended without strong and agreed action (and this will already be difficult enough) the refugee problems for the EU will not ease. The US is already preparing ground troops and preparing the public, which is not an easy job after the adventures in Afghanistan and Iraq.
The Chinese economy is another matter of great interest. Everyone understands that the economy isn’t growing as it did in the past. Over-capacity, rising costs, production moving to other destinations due to the cost problem, the slump of the stock market in summer and problems in the property markets are named as some of the reasons. State companies, which are carrying big debt and are inefficient are a big problem too.
The government is trying to modify the economy and move to a more quality- and technology-oriented economy, focusing more on domestic demand and developing the service sector. However, the country still has to guarantee jobs and rising wealth for all to prevent social unrest. The government has tightened controls and reduced personal freedom in some areas. The deal is – and mostly accepted by the majority – rising standard of living for less liberty and more state control.
The financial markets seem to monitor only the decisions of the US Federal Reserve and the European Central Bank in regard to interest. Nothing moves oil prices, interest rates, currency exchanges. General data such as labour market statistics, purchasing manager indices, political decisions, and gross national products, which use to be watched carefully by the economists and investors, are presently having barely any effect on markets and prices. Everyone is just waiting to see when and where interest rates will change or more liquidity will be pumped into the markets. Here the main focus in on the ECB, which still seems to continue the policy of cheap money, and the FED, which in its most recent statements seems to be at least thinking about a rate hike, which everyone was expecting in October and now expects to come in December.
This has lifted the value of the dollar against the euro. The exchange rate rose by about 2% and traded at the end of the period around the $1.10 level. Oil prices are bouncing recently around the platform established in the summer with trade in the $40s for the barrel.
Market Intelligence
The situation along the leather pipeline is beginning to change a little but it must still be analysed with care and with a different focus on different segments. A general statement for the leather business and industry, as was made frequently in the past, is not adequate for this time.
For most of 2015 so far it’s been pretty easy to predict a decline in leather production and consumption and consequently a decline in raw material prices. We have now reached a point where the situation can be reviewed again and with more facts and possibly a more solid base of information for the future. It seems right to draw a bottom line and to have a look where we stand today.
The situation over the past six months in the various streams of the leather pipeline has been completely different and price declines are directly linked to the demand. This might also be a warning to those who had tried to link the price trend just to supply.
Despite the general economic problems in the world, automotive production and the demand for premium models has scarcely declined. Despite various problems in several parts of the world attractive, expensive cars still create enough customer attraction and manufacturers have been able to continue their high levels of production. The premium heavy hides predominantly used in this segment lost only a fraction of their record values and prices have declined by just about 10% since their peaks in the first quarter of the year.
The upholstery market faced a seasonal decline throughout the summer. Upholstery leather demand had been driven in past years by a strong property market, in particular in China. New homes had to be furnished no matter if they were used or not. To a certain extent this applies also to other regions of the world, including the US, and easily offset declines in western Europe. However, raw material prices and leather prices had been inflated by so much that the material had become too expensive in the volume sections of the market and season by season more leather was substituted by alternatives. In particular in western Europe, where only the top-quality range is made from leather, the consumer is no longer inclined to consider leather as a material to upgrade the appearance and image of their living rooms. Switching to fabrics and microfibre can be done without much risk to sales and price has become the dominating factor. The seasonal decline of sales and manufacturing kept demand under control over the summer. The general level of business declined the most in the lower-quality range while medium and higher qualities were less sensitive. Prices for upholstery-related hides have dropped by 25%-40 % in value.
The shoe segment is the one most hit. We don’t think that the number of shoes sold has dramatically fallen in the past year, but price is ‘the factor’ and so even more leather has been substituted in this segment and raw material prices here have fallen by between 40%-60 %.
The luxury segment is a bit of a special section. Normally one would have expected the same scenario as for premium cars. Despite the anti-corruption policies in China and the sanctions in Russia one would have expected the luxury segment to keep its leather demand steady. In particular considering that luxury companies are reporting mixed results at worst and are far away from any major slump or downturn in sales. Several are even still growing and the leathergoods section is considered to be still one of the best divisions. It’s something of a mystery then that top quality calfskins and kipskins have faced fierce headwinds with declining demand and prices dropping by 30%-40 % from their peaks.
Maybe another lesson suppliers have had to learn is that expensive is not necessarily luxury. Luxury is quite stable because the wealthy do not change their spending attitudes very much. However, only a few brands are really luxury and accepted by the rich. Others seem to believe they fall into the same category, but they thrive on general cycles of fashion and demand. Only a small part of all luxury business is really related to high-quality materials and consumes far less volume than many people think. Manufacturing capacity and sales are not very elastic. The major change in this section has been the investment by some of the major Italian and French brands in their own tanneries at a time when all labels and brands had serious plans of expansion and many wanted to enter the premier league in terms of image and prestige, which led to an inflation of short-term demand, with most focusing on the same leather types. This policy has been far less successful than many hoped.
Another major mistake was the assumption that high retail prices justify high raw material prices. The idea of many suppliers and packers is that their revenue is directly correlated with the finished leather product price and if the price goes up their share should be significantly higher. What worked at the beginning didn’t continue to work because the big and successful high fashion brands are far away from being welfare organisations. When they realised the intentions of their suppliers and saw that raw material and leather prices were beginning to hurt their margins they began to take action. Only the very top end is tightly connected to the material, but this volume is not enough to justify and sustain the record levels we had reached. Consequently, even these limited and prestigious raw materials found a lot of resistance and had to adjust their prices as well.
With a significant price reduction for these high-quality and specialty raw materials a number of Chinese tanners and shoe manufacturers were attracted to enter this market segment; they were looking for productions and articles with higher added value anyway. A lot of raw material was redirected to China for the production of high-quality women’s shoes for the domestic market and in part for export to the US.
It is also worth having a look at what has actually happened in terms of demand. It might be easiest to use an image to explain what has actually developed and has led us to the situation which we are facing right now.
Traditionally the leather pipeline is organised in different circles expanding from a very strong and almost totally inelastic inner circle. This inner circle is represented by a very small production volume for specialty products only. This includes artisan production, craftsmanship and specialities of any kind. Demand in this sector always exceeds manufacturing capacity. In the next circle we find leather producers and manufacturers with very strong business that depend on leather. The volume of this business is higher and includes high-street fashion, quality products that carry a very strong leather DNA and finished products that depend on leather as a material. Also in this section demand and changes in production volumes can be considered as minimal.
The next circle contains the biggest percentage of demand and production. Here we find all the mass manufacturers from automotive to shoe and upholstery. They are the big tankers that need quite some time to change direction, which means this generally only happens from season to season. It takes time for design, product development, marketing and sales to agree on material changes, but when they do reach agreement, this is where we see the biggest influence on the supply chain.
The outermost circle includes manufacturers that cover extra and excessive demand, which is extremely short term but can have a serious influence on pricing. This demand shows up very quickly and just as quickly disappears. Manufacturing in this sector is mainly driven by capacities that are idle in normal times. Although this might only be 10% of the total (nobody can really seriously quantify the number) it is exactly this excessive demand that is pushing the raw material market over the levels that actually can be economically justified.
This image may help explain what has happened in the past year. Prices overshot. Suppliers were delighted, because this was exactly what they were looking for. Tanners and leather manufacturers were happily using extra capacity and building overcapacity without really seriously estimating and analysing the real physical demand for their products. Both sides were basing their business strategies on rising demand but were actually guiding each other into the dead end we have experienced in the last six months.
Inventory along the supply chain increased, margins eroded or even turned negative and optimism about improvement faded and finally disappeared. The market correction went on, overcapacities were closed, demand diminished and everything looked totally negative for at least the very outer circle and in part also for the next one in.
It is definitely time to have a look again to see if we are beginning to return to a situation that is more balanced now. Several players are already saying the trouble is over and in particular beef producers and sellers are trying almost everything from week to week to create stability and to create a market picture that would justify a turnaround in prices. From our point of view it is still far too early for this, although the situation is certainly no longer as bad as at the end of the first quarter of 2015. At that time almost 100% of finished products in the leather pipeline were too expensive, mainly because of raw material prices and rising production costs in China. With the price corrections of today we can see changes in some sections of the market.
Business is never at a standstill and in particular the leather business in the past six month has not been bad in all segments. Many sellers, impressed by the market conditions, have been willing to adjust their prices to sell their material. Buyers in the two innermost circles saw margins returning, which always increases confidence. Buyers in circle three reduced their inventory position as much as they could when prices were too high and are now returning inventory levels to normal. This does not apply to all market segments in the quality range and is only happening in the medium and high-end sectors.
As cheap as the low end might have gone, alternative materials have become so popular and successful it will not be easy to revitalise the demand for leather in this part of the business. It is pretty obvious that many suppliers and producers are trying their utmost and they are also trying to use the generally fading pressure on prices to stabilise revenues in their segments. There are enough rumours stating that some of the biggest players have decided to withdraw offerings to threaten customers to get them to buy and pay more, which is a dangerous game. If potential buyers see this policy for what it is, they will feel even more inclined to leave leather alone as a material.
As a bottom line, we believe that the balance between supply and demand has become more stable in the medium and higher-end market. The interpretation that this is already the beginning of a new and firmer trend is, in our opinion, far too early. Tanners have replenished their stocks, the holidays are ahead of us and the season is running, but additional leather orders can at this stage not be expected. The sheep and lamb nappa market might be a warning for those who think the same, simple cycles of the past will continue.
The split market remains in the doldrums as before. There are hardly any buyers for standard splits. In particular in China so many shoe factories and PU-split tanners have closed and this has not yet compensated for by new customers, articles and productions. Reports from the skin market are also frightening. Only the top end for lightweight double-face and top-quality nappa continue to sell well. The rest is in real trouble. Low-quality skins are almost impossible to sell and the extra volumes from the Eid al-Adha slaughter in Muslim countries cannot be digested by the market. Many sellers have to sell – if they can – at prices that are not even covering processing costs. Prices in the range of $1-$2 per skin are pretty common. The leather fair in Istanbul in this first week in November might offer us new directions and hope for an improvement, at least in the Turkish market. The Turkish tanners themselves are not very optimistic.
For the coming two weeks we expect intense attempts to stabilise prices and to stop the decline in the bovine sector. Better sales in the US and Europe in the past week have at least increased confidence. For the most attractive (cheapest) articles we think that the chances are quite good. However, when one looks at the price grid of origins many still look overvalued. The stabilisation of one type will possibly not mean a better situation for another, or better said we would describe the raw material market at present in settlement-and-adjustment mode.
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