How Will 3-D Printing Affect the Apparel Industry?
It could eventually be a disruptive technology, but it has some barriers to clear first.
Although we believe that many apparel companies have developed competitive advantages enabling them to earn outsize returns, for the most part we see these competitive advantages as shorter term in nature, thus falling more toward the narrow-moat end of the scale. In fact, only two companies in our apparel coverage universe have a wide moat rating. As fashion trends change to reflect the values and cultural identity of the times, we think different competitive advantages are demanded and rewarded. In the 1990s, for example, consumers were willing to pay a premium for brands and wanted logo merchandise. After 2008, consumer preference shifted to value offerings. We think these constantly evolving preferences leave the industry very exposed to the threat of new entrants.
3-D printing is in its very early stages of market penetration, but it seems to possess many attributes that would allow it to be competitively advantageous in the current fashion environment. We note three trends that currently command price premiums: technical differentiation, improved fit, and customization. 3-D printing not only advances each of these three characteristics, but unites them and provides attractive cost advantages while doing so. However, we see quite a few barriers to overcome before 3-D printing is a significant threat to mass manufacturing. In the near term, we see 3-D printing most affecting jewelry and accessories manufacturers, increasing the presence of design-it-yourself kiosks in stores and used in one-off designs. In the very long term, if the technology can scale up, we expect companies with strong brands and technically differentiated products to be the winners, while those with supply chain cost advantages, value-oriented nonbranded products, and differentiated fit will be most exposed to the threat.
Apparel Industry Is Attractive to New Entrants
By its nature, apparel is a very dynamic industry with trends constantly evolving to reflect the values, individualism, and cultural identity of the times. As a result, we believe competitive advantages are shorter-lived in fashion retailers, leaving the industry highly exposed to the threat of new entrants.
Our belief that different competitive advantages are valued by consumers at different times is reflected in our economic moat ratings. Apparel manufacturers have a preponderance of no moat (no competitive advantage) or narrow moat (competitive advantages that we think are more likely than not to last at least 10 years) ratings versus wide moat ratings (competitive advantages that should last at least 20 years) when compared with other consumer industries.
A look back over the past three decades also supports the thesis that competitive advantages tend to be shorter-lived. In the 1990s, it was the brand intangible asset that wielded pricing power as consumers embraced logos and brands to identify with a particular group. This trend shifted in the 2000s as the economy took a turn for the worse. It became bad taste to flaunt wealth through brands, and consumers shifted to prefer value offerings. In this new world, the apparel companies that outperformed were those with cost advantages allowing them to provide a value offering while maintaining profitability. The 2010s have seen the beginning of yet another shift. Brand has re-emerged in importance, but not for the same reasons as in the 1990s. A brand can't simply be cool--now it needs to represent a better, technically differentiated product and resonate on a personal, not group, level.
As a result of the changing values, the companies that outperformed each decade changed. In the 1990s, outperformers included strong, well-defined brands like Gap (GPS) and Abercrombie & Fitch (ANF), with both stocks posting an average annual return on investment north of 35% during the decade. In the 2000s decade, these two companies reversed performance, and it was value offerings like Ross Stores (ROST) and H&M (HM B) that flew higher for investors. Although we are only about halfway through the current decade, we can see the emergence of new leaders, with Under Armour (UA) and Lululemon Athletica (LULU) up more than 25% in average annual return on stock investment for the first half of the decade. Shifting consumer demands have a significant impact on shareholder returns.
Current Trends Favor Technical Differentiation and Personalization
In the current fashion environment, we see brands with technically differentiated and superior products and brands that resonate with consumers on a personal level as those most competitively valued. Examples of technical differentiation include Luon fabric, which is Lululemon's signature soft four-way stretch fabric with sweat-wicking capabilities. North Face ThermoBall is a synthetic alternative to down that preserves all of down's warmth capabilities. Denim has also seen tremendous innovation in fabrication, with Levi's jeans now showing the same fit and stretch capabilities as leggings. In personalization, we have seen an increase in customization options, including at Timberland, where you can customize the color and finishes of your boot.
Companies that deliver technically differentiated or customizable products are outperforming competitors. We expect these companies, including Hanesbrands (HBI), L Brands (LB), Lululemon, and Nike (NKE), to deliver a higher return on invested capital than companies like Gap, Gildan (GIL), and Guess (GES).
3-D Printing Has Potential to Provide Significant Competitive Edge
3-D printing technology not only advances these competitively demanded capabilities but unites them. 3-D printing works by successively layering a material down under the control of a computer. First, the computer reads a model created through computer-aided design, from a 3-D scanner or by a camera with special software. Then, the software slices the object into very thin layers. Next, the printer deposits the material layer by layer. The type of material used in the printing has advanced from simple polymers to include many other materials such as chocolate, sugar, and metal as the processes for 3-D printing have expanded. Finally, the product may need finishing, depending on the product and type of material used.
This process yields many competitive advantages in the apparel industry. 3-D printed products can easily be customized and specific to a body. Tweaks to the CAD program are easy and quick to implement. Further, fabrics and materials can be mixed, as assembly no longer depends on the limitations of thread. New materials could theoretically be developed as manufacturers experiment with the technology.
As an added benefit, many of these advanced capabilities are delivered at a lower cost. Unlike manufacturing processes that involve human labor or machinery, CAD programming can deliver greater levels of complexity and customization with almost no added cost. Also, as the process involves no cutting and very little finishing, there is almost no fabric waste. With a process that involves very little manual labor, wage rates no longer play into the manufacturing decision, and products can now be produced in their final markets, which removes the time and cost of shipping. Finally, as each piece can be made as it is ordered, inventory can be perfectly matched to demand.
We view this last point as one of the most beneficial in the apparel industry and one of the largest potential upsides to margin. Fast-fashion retailers including H&M and Zara have some of the highest margins in apparel retail, despite operating more expensive supply chains. Because their supply chains are more responsive to consumer demand, they have less discounting than competitors. This leads to high-teens operating margins versus high-single-digit or low-double-digit margins at competitors. 3-D printing could allow companies to achieve an even higher level of responsiveness and at a lower cost than current fast-fashion practices. As a result, we think fast-fashion firms could lose their competitive advantage if 3-D printing became a widespread, scalable manufacturing solution, as the new technology would give all apparel companies the capability to be as highly responsive, or more so, as they are.
Apparel Designers Have Begun to Experiment With 3-D Printing
We think 3-D printing has entered the experimental stage with apparel fashion designers. Part of the Museum of Modern Art's collection allows visitors to design a Kinematics garment from a body scan, customize it, and then order the design from Nervous System, to be printed through outsourcing printer Shapeways. The garment is very differentiated from traditional apparel as it varies in rigidity, drape, porosity, and pattern all within the single textile.
Victoria's Secret, a major component of L Brands, has also experimented with the technology, featuring a 3-D printed garment in one of its fashion shows. A corset, wings, and hat were made from hundreds of nylon snowflakes and encrusted with Swarovski crystals. The snowflakes formed an interlocking pattern that could either move like fabric or stand rigid, again displaying the unique technical aspects of the fabrication process.
Other designer endeavors scale the expanse of the fashion design scale, ranging from Karl Lagerfeld at Chanel to Project Runway contestants. Karl Lagerfeld brought the Chanel jacket into the 21st century through molding the vest in one piece, creating a futuristic design with broad, square shoulders. Project Runway gave contestants access to a 3-D printing lab to use the bridges of New York City as their design inspiration in a group challenge.
Current Constraints Limit Threat to Mass Manufacturing
Despite the significant media attention garnered by these experimental efforts, we believe quite a few barriers need to be overcome before 3-D printing can become a significant threat to established apparel mass manufacturers.
The first obstacle is fabric capabilities. Early 3-D apparel designs mostly used nylon or other plastic-like polymers that could feel stiff and unnatural. This also tended to limit designs to very futuristic-looking pieces with intricate cut-out patterns. Electroloom has advanced this by allowing for use of a mix of polyester and cotton fibers. A silk and acrylic blend is currently in development. However, Electroloom's technology for using these materials is much more limited.
The first tank top printed on the Electroloom took 14 hours to assemble. The company is working to improve efficiency by adding a second pump, which has cut this time in half. The goal is to get the printing time down to 2 hours.
A second obstacle is the method of printing. Electroloom works by spraying fibers onto a form to obtain the correct shape. This means that mannequins of target sizes need to be used just as in traditional manufacturing. Perfect customization would require a body mold of each person to be made first and the garment second.
A third significant obstacle is durability. The printed apparel items have been very fragile; Electroloom noted that one tank top has survived repeated wearing, but if it were to catch on a doorknob that would be enough to destroy it.
Until these obstacles are addressed, we think it is unlikely that 3-D printing will be viewed as a viable alternative for full apparel manufacturing.
Early Competitive Impact Likely to Be Limited
We do think that 3-D printing will continue to make inroads into apparel design, just not as a full replacement manufacturing option.
First, we see it being more widely used in jewelry, accessory, and embellishment production. Products composed of metal or plastic can be printed much more seamlessly and affordably. These products can then be worn alone as jewelry, attached to other fabrics such as leather belts and handbags, or sewn onto existing apparel such as T-shirts as embellishments. This is the type of printing that was used on Project Runway. The Fabricate application can be used with the Cube 3-D printer. This creates various embellishments and glues them onto fabric; they can then be sewn onto traditionally manufactured apparel.
Second, we see continued use in one-off pieces or parts of collections. Because designs using current 3-D printing technology tend to look futuristic, we think designers may incorporate one or two items to create buzz, but not the whole collection, as wearability would be limited.
Third, we see a potential for design-it-yourself kiosks in apparel retail stores or online like that at MoMA. Design-it-yourself options have become very attractive to consumers seeking personalization options. Retailers that have incorporated this technology include Nike, whose NIKEiD allows customers to customize shoes, and Timberland, with a boot-customization option. Printing the piece could either be done internally or outsourced to a 3-D printing service and then shipped to the customer.
Fourth, we see this technology as potentially aiding and speeding the design process as designers can use 3-D printing to quickly develop prototypes right in the design studio for review and tweaking.
We expect very little impact on our coverage universe in the near term. We see strong brands with high-demand products like Nike and Timberland possibly seeing a slight benefit from customization capabilities, while we see jewelry, embellishment, and accessory manufacturers being slightly negatively affected; however, most of our coverage universe outsources accessories manufacturing and would thus not be affected. Therefore, given current technical limitations, we believe the overall impact on the top and bottom lines will be negligible for investors' purposes.
Long-Term Impact on Moats Could Be Substantial if Technology Improves
Long term, we think 3-D printing technology is poised to have a significant impact on the apparel industry, assuming the technology improves to address current limitations and scale.
Looking at the three key strengths of 3-D printing--cost advantages to perfectly matching supply and demand and elimination of shipping time and cost, customization capabilities, and ability to create products with various levels of complexity and batch size at roughly the same cost--we think it poses the largest threat to apparel manufacturers and retailers that owe their competitive advantage to cost. In our opinion, 3-D printing would allow apparel retailers of any size and geographic location to produce products at the same or lower cost than those that currently possess economies of scale or responsive supply chains.
Conversely, we think some apparel companies are in the position to use this technology to widen their economic moats. Particularly, we see apparel companies with strong brands or technically differentiated products improving their brand intangible asset as they use 3-D printing to create new innovative designs that are in line with their brand identity and further their differentiation from competitors. Although the entire manufacturing process may be upended with the technology--including the possibility that printers become so cheap that apparel can be printed at home--we think these companies will retain the value of their designs. As long as they are able to cut costs to match revenue generated by apparel design, the companies should maintain their economic moats.
We have conducted a competitive moat analysis of our retail coverage universe to assess exposure to the 3-D printing threat. We stress that we view 3-D printing only as a threat in the very long term and only if current technological limitations are able to be addressed. As such, we would not recommend this analysis playing into near-term (five years or less) investment decisions.
Not surprisingly, our two wide-moat companies-- VF (VFC) and L Brands--scored the highest, along with Inditex (ITX). Inditex is somewhat of a surprise, given that we have highlighted it currently as a company with a significant cost advantage. However, we think its Zara brand intangible asset is also very strong and the company will continue to do well in a 3-D printing environment because of this brand intangible asset. In fact, all three companies have very strong brand identities in high-fashion/high-performance categories. In our opinion, these designs and fabrics will continue to be valued even if 3-D printing resolves all of its current shortcomings.
On the other end of the scale, we have Kohl's (KSS), Macy's (M), and Gildan. Kohl's and Macy's both sell other branded designs. If people were ever able to gain the ability to buy designs online and then print the items at home or through an outsourced printing company, there would be no need for department stores selling other brands' apparel. Gildan would be highly exposed because the majority of its business is unbranded basics for printwear. This type of product would be very much threatened by increased competition, given that its cost advantages would no longer be relevant.
VF Should Perform Well in a 3-D Printing Environment
Taking into account current valuations, we would highlight VF as one of our best ideas in apparel retail. This stock also scored as the most defensible to the 3-D printing threat, thanks to its strong brand portfolio. We feel comfortable with its wide moat rating and its potential to generate returns higher than its cost of capital for at least 20 years. The stock is currently trading at about a 23% discount to our $82 fair value estimate.
We think VF is poised to take advantage of three market trends. First, we believe the outdoor and action sports market is a large and quickly growing opportunity, with activewear apparel now often worn in place of casual and weekend attire. Although we see this fashion trend changing to something new in the long run, we see it as a near-term additional growth driver. Based on NPD data, we think this enlarged athletic/casual category is a $46 billion opportunity with a focus on higher-margin performance and comfort products. VF's North Face is already a leader in the $25 billion global outdoor market and also provides high-performance sports apparel, an increasingly demanded category thanks to the fitness craze. We expect that this category to be a key growth driver for VF and further acquisitions will be made to increase exposure. We model it growing organically to over 65% of revenue from the current 59% penetration over five years. Second, we see VF leveraging its vast global supply chain to support additional international sales and think international markets can grow from 38% of revenue to just under 45% of sales in five years. Finally, we see direct-to-consumer sales growing to 30% of sales from the current 26%, with e-commerce being the fastest-growing, most profitable channel.
We see margin expansion providing another 2-3 points to constant currency earnings growth, on average annually, driven by mix shifts to outdoor and action sports revenue (gross margin is roughly 4 percentage points above total), international (gross margin is about 7 points above overall), and direct to consumer (gross margin is roughly 20 points above overall). Although the direct-to-consumer channel is likely to need increased selling, general, and administrative investment, we think the business will still result in overall higher operating margins.
We think acquisitions will be a significant additional value driver. We expect VF to focus merger and acquisition activity on the outdoor and action sports space. With a strong dollar, we think international acquisitions are particularly attractive. Given the firm's well-oiled integration machine, ability to drive cost synergies, and vetting process with an eye for strong brands with slightly broken operations, we think this is a value-enhancing strategy.
We expect 2015 revenue to grow 3% organically, fueled by 12% constant currency growth in the outdoor and action sports category, 5% constant currency jeanswear growth, 1% imagewear, and 2% sportswear constant currency growth, slightly offset by an 8% constant currency decline in contemporary brands. We expect foreign currency headwinds to remove 4.5 points of the 7.5% constant currency growth rate. We think international and direct to consumer will fuel constant currency growth in the double-digit range. We assume the operating margin will be flat at 14.9% because of the impact of foreign exchange in 2015.
Over the next five years, we think VF can increase revenue and operating income at compound annual growth rates of 9% and 11%, respectively. Our 2016 acquisition assumption adds $1.2 billion in revenue and $96 million in operating profit. We see growth in outdoor and action sports weighted heavily to the Asia Pacific region, which we see growing at a 24% compound annual rate, while we expect Europe, Middle East, and Africa and the Americas to grow in the low teens on average, yielding 11% total compound annual growth. We see the jeanswear coalition as more mature but still capable of delivering 4% compound annual growth as a result of innovation and international expansion. We think operating margins can expand from 14.9% (adjusted) in 2014 to 16.3% in 2019. Expansion should be driven by the aforementioned mix shifts as well as a recovery in outdoor and action sports as returns on Timberland are recognized, in jeanswear as innovations aid gross margin, and in sportswear as VF invests in a brand reboot.
Bridget Weishaar does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.