Beat China On Cost

The idea is out there: the entrance of China into the global trading community has become threat No. 1 for many western manufacturers. Since China joined the World Trade Organization, in 2001, it has been accepted wisdom that low-priced Chinese labour will undercut western manufacturers, driving them toward extinction. The rule is, you cannot beat the China Price. And that's held as especially inarguable if you have the bad luck of making something labour-intensive. Trying to compete against Chinese companies that can harness the vast flow of migrants moving from the countryside into the cities–well, that's like trying to sell air conditioners in Inuvik.

Or so they say. But then again, every era has had its economic bogeyman. In the '80s, it was Japan; in the '70s, OPEC. And before that it was the Communist bloc and all those millions of obedient, ideologically motivated workers, poised to undermine western civilization. But it hasn't quite worked out that way, has it? Not in a single one of those cases. Could it be that the China threat has been similarly overhyped?

Consider the case of Gildan Activewear Inc., a Montreal-based company competing in an industry that many assumed would be dominated by Chinese manufacturers. Gildan makes T-shirts–lots of them. This year alone, it has already manufactured almost 400 million of the things. Now, textiles, as everybody knows, is an industry ripe for a thrashing from the Chinese. First of all, it's labour-intensive: companies in the sector have to hire row upon row of sewers to stitch together each garment. Not only that, but under the WTO's Agreement on Textiles and Clothing of 1995, quotas that had been maintained by western countries on imports of textiles and clothing had to come off by the beginning of 2005. That move cleared the way for Chinese companies to gain more direct access to western markets. How could a company headquartered in Montreal, with no operations in China, ever survive?

Predictions of Gildan's extinction, however, have proven to be more than a little premature. In fact, they've been wildly off base. The company is doing quite well in the face of the China threat. Part of the reason is happenstance: Gildan's original market is in so-called imprintables–T-shirts sold to screen printers who drop a logo on the front for concerts and other promotions–and Chinese manufacturers have not heavily targeted the sector. But now, Gildan is expanding into the retail market, where it will compete head-to-head with Chinese firms. The move comes at a time when quotas have been off for only a year, and in a sector that China has been expected to dominate.

This raises a question: Is Gildan crazy?

The textile-and-clothing sector is a big part of the global flow of goods, accounting for some 7% of the total value of goods traded around the world. In many developing countries, clothing is the No. 1 export and the largest source of formal jobs in the economy. For that reason, the sector has always been a touchy area in global trade negotiations–until recently, it was the only major manufacturing sector that didn't come under the rules of the General Agreement on Tariffs and Trade, or GATT. Instead, the political regime for controlling trade in the industry has been a quota system on imports, maintained by such western countries as Canada, the United States and European Union members. Long a source of irritation for developing nations, especially China, which was the one country most affected by it, the quota regime for the most part came to an end on Jan. 1, and will be fully dismantled by 2008.

With the bulk of quotas ending this year, industry watchers expected western countries to be flooded with foreign imports in 2005. And that has largely been the case. Imports of Chinese-manufactured clothing to the EU are up 90%; imports to the United States are up 200%. Many assumed that Gildan would be a casualty in this new world of textile trade.

In 2004, in anticipation of the quotas being lifted, Gildan's stock (TSX: GIL) began selling off, declining from a high of more than $22 in March to a low of $17 in September. But it hasn't stayed there. In fact, the stock has recovered nicely. “In late 2004, going into 2005, the stock really took a beating,” notes David Pupo, an analyst with Orion Securities. “A lot of people didn't understand the story.”

What smart investors figured out was that Gildan had begun mapping out a defence to the end of quotas nearly six years ago. That was when the company first sent a team of employees around the world to study the global price of clothing. The economic emissaries returned with a wealth of data that executives used to determine the benchmark prices Gildan would have to achieve to stay in business as a global producer. In other words, they figured out what was going to be the new price of a cotton T-shirt, and then they developed a corporate strategy based on that price. “The first thing we did from Day 1 was to make sure that we benchmarked ourselves against the global market,” says Glenn Chamandy, the CEO of Gildan. “We said, 'This is where we need to set our selling price,' and every year from then on we started declining our selling prices in anticipation of getting ready for more of a global market. Which was the key. A lot of our typical North American competitors were dissatisfied with us, but we weren't viewing them as price setters anymore. We were looking at the foreign competitors.”

One of the biggest North American names in the sector, Fruit of the Loom Inc., filed for bankruptcy protection in the U.S. in late '90s, partly as a result of the thousands of expensive sewers the company employed in the United States, especially the historical (and heavily protected) textile-producing areas of the American Deep South. The message of Fruit of the Loom's crisis was clear: North Americans don't want to pay a premium for T-shirts made by North Americans. At the time, most of Gildan's production was in Canada, but executives realized that if the company was going to be successful, it was going to have to reduce costs–by going offshore.

It did that in 1998 by relocating some of its sewing facilities to Honduras, followed by more centres in Mexico, Haiti and Nicaragua. Gildan also built massive state-of-the-art textile processing facilities in Honduras and the Dominican Republic starting in 2001. The company employs some 10,000 workers, most of them sewers, but also local managers who oversee the operation of each hub, which produces some 375 million garments a year. (The company's Rio Nance facility in Honduras is the largest such operation in the world.) Wages in Gildan's factories are still higher than those paid in Chinese factories: the average wage of a garment worker in Honduras is about $100 a week–four times what a Chinese worker makes. But the combination of still relatively low wages and advanced technology–which has taken much of the labour out of textile processing–has allowed Gildan to lower its price per shirt to below that of Chinese manufacturers. “Today, if you look at our basic wholesale product–a white 100% cotton heavyweight T-shirt–we're selling it for just over a dollar,” says Chamandy. “The costs for a similar landed product from China today would be 10% to 15% higher.”

But it's not just inexpensive labour and advanced technology that have allowed Gildan to beat the Chinese on cost. Also important for the company has been a close reading of the mass of bilateral and regional trade agreements that exist the world over. Duties on imports and exports of cotton T-shirts still exist between many countries, and by strategically locating its production facilities in certain jurisdictions, Gildan has been able to ensure that it can ship duty-free anywhere into North America, the EU countries and Australia. When it comes to the United States, existing trade legislation with Central America allows free trade there, while the recently signed CAFTA agreement has lowered barriers between North America, the Caribbean and South America. Meanwhile, a Canadian agreement in place with Haiti allows Gildan to ship its product home more cheaply than other producers can. “We've set our manufacturing up for every one of our markets, so that we can ship without quota and duty,” says Chamandy. “That's important.”

But the big challenge for Gildan is still to come. In 2006, the company is going to start selling socks, sweatshirts, packages of T-shirts and golf shirts directly to retailers like Wal-Mart and Target–a market where Chinese manufacturers are already in place. The company is building a clone of the Rio Nance facility in the Dominican Republic (where, at about $60 a week, wages are even lower than in Honduras) that will dramatically increase its production capacity in anticipation of the move into retail. The strategy will see the company competing head-to-head with a larger number of Chinese manufacturers, as well North American sock manufacturers. Will they be able to stay off the ropes? Pupo, the Orion analyst, thinks so. He says the often-deciding factor in the retail market isn't cost of labour or global duty regimes, but rather the “response time” offered by the supplier. Or, as they say in the industry, it's all about helping the retailer achieve good GROI–gross margin return on inventory.

It's a commandment today that retailers don't like to hold stock. Inventory is expensive, and it takes up time and labour. As a result, retailers have pushed that responsibility onto suppliers. “Once upon a time, if you were a retailer and you told a manufacturer you needed a product for Jan. 1, you would have a lead time on that product of months, and the retailer would hold onto it for a long period of time in inventory,” says Pupo. “It's not like that anymore. Retailers are holding less and less inventory, so they're pushing back on manufacturers to become better at what they do.” So if a retailer wants, say, a small, red, boys' T-shirt for Jan. 1, the retailer who can deliver it closest to that date and at the right price is the one who gets the contract. Viren Joshi, a corporate risk manager with Export Development Canada, says the proximity to the U.S. market is an important advantage for Gildan. “Being located in the same hemisphere as your biggest customer is a good thing,” he adds.

In fact, shipping from China adds about 75¢ to every dozen shirts. But perhaps more important than cost is the service element inherent in the layout of the company's production and delivery infrastructure. To fulfill the requirement for fast response, Gildan has built a network of distribution centres in each of its markets, allowing it to quickly fill client orders. “One of the biggest opportunities is our service and fast response, which is critical in our industry,” says Chamandy. “We have vendor management inventory systems that can ship to our customers in 24 hours from the time they place their order.” Even if the warehouse is out of product, the fact that Gildan's sewing centres are in the same region as its clients means the company can quickly refill the warehouse. “Our cycle time from offshore is three weeks; from China it's three months in a container,” notes Chamandy. That fast response time is the company's secret weapon, says Pupo: “Low labour costs are no longer sufficient to ensure competitiveness in a quota-free market. You have to be close to your end user, and you have to have a good logistics pipeline. Labour is a very small piece of this now. Lead time is more important than labour cost.”

A recent report from the Geneva-based International Labour Organization that looked at the clothing and textile industry confirms as much. “Before 2005, the sourcing of clothing was largely influenced by quotas,” it found. But “vertical integrated production of textiles and clothing will provide an important comparative advantage to clothing exporting companies and countries….It is only through real or virtual integration that companies and countries will be able to compete in the rapidly expanding 'full package' market.”

The term “full package” refers to the idea that suppliers today have to do everything from original design to delivery of finished products, and that's exactly the kind of business Gildan has built. The approach has allowed the company's share price to recover from its pre-quota-removal plunge. “They're the world's lowest-cost, highest-quality producer,” says Cynthia Rose-Martel, an analyst with Jennings Capital in Toronto. “They've done well against everybody, not just China.”

In the past, the company has attracted attention from labour rights and other non-governmental organizations who were critical of the way it ran its offshore sewing facilities. Many customers, especially universities (which order a lot of sweatshirts for silkscreening), are part of a “clean clothes” campaign: they order only from companies that are perceived to run safe and fair offshore facilities. As a result, organizations like the Toronto-based Maquila Solidarity Network closely follow Gildan's actions, as part of a mandate to improve working conditions in Third World countries. And that raises the spectre of reputational risk to the company's business.

The issue came to a head in 2003 when a big Quebec pension fund announced it was going to sell its investment in the company. The fund was concerned about a CBC documentary report in which workers relayed a long list of grievances over working conditions. The company denied the accusations at the time, and over the past year Laurence Sellyn, Gildan's chief financial officer, has made concerted efforts to get on the right side of the debate. “Up to a year ago, we had difficult relations with activists,” he says. “But over time we have turned that around, and we've built up a constructive relationship with groups like the Maquila Solidarity Network.” In fact, he recently attended a forum in Quebec along with the head of the MSN, Lynda Yanz, at which they talked about the positives that flow from a non-adversarial relationship between NGOs and industry. In one recent case, NGOs worked with the company to reintegrate workers in Honduras into a new Gildan operation after they were laid off at another factory. In another case, the company worked with NGOs in Nicaragua to clear up an instance in which an outside contractor was accused of anti-union activities at a Gildan-contracted facility. Either one of those incidents could, in another time, have blown up into a media circus and damaged the firm's standing among clients. No wonder Sellyn has worked hard on that file. “We turned that relationship around–collaborating instead of taking an adversarial stance can do so much more,” says Sellyn. “We've achieved a lot through constructive dialogue. It's become a positive.”

Put the positives together, then, and it's little wonder that Gildan's stock has rebounded from its lows of 2004. Rose-Martel put out a report in January predicting Gildan would do well in the new era of tougher Chinese competition, and she made some money for the clients who followed her advice. She has a target of $46.50 on the stock, which is currently trading around $43. She expects earnings per share of $3.52 in 2006, the year in which its retail strategy will be unveiled, and a majority of analysts have a Buy on the company–which is something you might not expect, considering the accepted wisdom about the China Threat.

But the significant test will be whether Gildan's retail strategy is going to work. In 2004, the company held a 30% market share in wholesale, up from just 9.8% in 1998. In fact, Gildan's success in the wholesale market has been widely cited as the reason competitors like Tultex, Pluma and Oneita Industries have either gone bankrupt or exited the segment. But new sewing facilities expected to come online in 2006 will push Gildan's production capacity to more than 600 million pieces. That means there will be a lot of new shirts to sell. To move that product, the company has put in place a sales force, which has already been supplying some garments to the retail sector in Australia (where they ship to Kmart) and a small sporting goods chain in the United States.

The volume this year is small–only about 750,000 Gildan shirts will go through the retail channel. But watch out in the years ahead, says Rose-Martel. She speculates that Gildan has already been approached by the sector's heavyweight, Wal-Mart, which is reportedly impressed with Gildan's quality and just-in-time supply network. “The potential is massive,” says Rose-Martel, who expects Gildan's earning to grow by 20% a year over the next three years. “This is an enormous market and offers huge upside if they are as successful here as they were in the wholesale market.” Orion's Pupo, for his part, is slightly more cautious. “We prefer to have no returns from strategies in our numbers,” he says, “until the company tells us it's underway and they start to show us.” Nevertheless, Pupo acknowledges that he thinks a success in retail is in the wings. “We're confident they can pull it off,” he adds.

A western manufacturer beating the Chinese competition, in one of the most labour-intensive industries on earth, at a time when regulatory barriers have just been pulled down? It can't be done–except, of course, when it is. In fact, by selling to Australia, where Gildan's market share has been ramping up, the company is now competing in China's own backyard. That's a pretty fair reversal of accepted wisdom about the rise of the Middle Kingdom. Actually, it's a complete reversal. And according to Rose-Martel, Gildan–in “something of a show of bravado”–has actually contemplated exporting to China.

Yep, they must be crazy.