The Ethical Questions of Uzbekistan's Cotton Industry

Leo is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Update: Per Aeropostale's PR, they have agreed to sign the "We The Cotton Campaign" that states a firm opposition to the use of forced labor in Uzbekistan.

Investing ethically has always been a dilemma for many people. Yet strong top and bottom-line growth has often been fueled by the globalization and domination of countries with cheaper labor. However, there is a difference between fair trade that utilizes opportunistic outsourcing and blatant human rights abuses. One hotbed of controversy is Uzbekistan, the former Soviet state that has been harshly criticized for its cotton industry.

Cotton at a human cost

Every fall, over one million citizens, including children as young as nine and workers from the private sector, are required to work up to 12 hours daily in the country’s cotton fields, according to Human Rights Watch, a non-governmental organization. The workers are expected to work for free or very little pay, facing high fines and possible arrest if they refuse to comply. Opponents claim that this state-sponsored, communist cotton industry is a form of modern slavery. Proponents believe that Uzbekistan, a double-landlocked nation, needs this strong support of its cotton export industry to survive. Uzbekistan is currently the world's fifth largest exporter of cotton, trailing only the United States, India, Australia and Brazil.

As a result, the use of Uzbek cotton by major Western apparel retailers, such as Aeropostale (NYSE: ARO) and Urban Outfitters (NASDAQ: URBN), has been harshly criticized by supporters of ethical sourcing and fair trade. However, retailers who have been accused of using Uzbek cotton claim that Uzbek cotton is hard to identify and separate from the supply chain, since it is often traded through other markets, such as China and Bangladesh. In addition, many companies’ bottom lines would crumble if they realigned their entire supply chain with more acceptable and expensive sources of cotton.

Therefore, should companies comply with the demands to boycott Uzbek cotton, or should their shareholders simply accept this partnership as an inevitable phase of globalism?

The teens and the hipsters

For investors following Aeropostale, the company’s insistence on using lower-cost cotton shouldn’t be surprising. The struggling teen apparel retailer reported a 14% decline in same-store sales last quarter. This contributed to a steep 9% year-on-year decline in revenue. It also reported a net loss of $0.16 per share, down from a profit of $0.13 per share in the prior year quarter. It reported a meager profit margin of 0.52%, which means that any further expenses could simply sink the company. In addition, the company has gotten into a habit of using margin crushing markdowns to generate sales volume, which it also lacks. Therefore, the company has skirted around the issue of Uzbek cotton since it simply doesn’t have the wiggle room to relocate its supply chain.

Urban Outfitters, on the other hand, has been doing much better than Aeropostale financially. Even though same-store sales came in flat last quarter, the company’s earnings rose 38.6% while its revenue grew 13.9%. It also enjoys a much higher profit margin of 8.7%. The company caters to a younger, hipper crowd with its namesake brand, which produces apparel branded with humorous, ironic and retro graphics. Meanwhile, its fastest growing brand, Free People, is focused on a younger female demographic.

Therein lies the hidden threat to Urban Outfitters, which has seen its shares rise more than 50% over the past twelve months - its core audience.

The lessons of the past

Urban Outfitters notably caters to a young, wired and very socially connected demographic, a strength the company played on with the development of its new smartphone app, which features enhanced social sharing capabilities.

Therefore, Urban Outfitters would be wise to remember the trials and tribulations of Gap Inc., which was severely tarnished by child labor allegations over much of the prior decade. Gap suffered a PR nightmare when human rights groups plastered college campuses with posters of its weary overseas factory workers clad in its retail garments.

Perhaps fearing such a potential backlash, Urban Outfitters has recently shown signs of improvement. In its company policy, Urban Outfitters now claims that it “does not knowingly carry products” or “source any private label or own-brand products” from Uzbekistan. However, Urban Outfitters has not signed a widespread pledge to stop child and forced adult labor in the country, which has already been signed by 131 other companies, including Adidas, American Eagle Outfitters, H&M and Zara.

Is ethical sourcing a luxury of rich companies?

Considering that cotton costs have risen nearly 50% over the past decade, I believe that choosing more ethical sources of cotton is a choice that only richer companies with stronger bottom lines are able to make.

The Walt Disney Company (NYSE: DIS) not only signed the aforementioned pledge, but directly addressed the “ongoing problem in the harvesting of Uzbek cotton” by asking its vendors to “restrict the use of cotton in Disney-branded products until this matter is resolved.” Although that seems like a bold statement from the House of Mouse, investors should remember that cotton products do not comprise a significant portion of the company’s top line.

Nearly half of Disney’s revenue is generated by its media networks, and a third comes from its theme parks and resorts. Disney’s Consumer Products segment, which contains the most textile-based products, only accounted for 8% of its top line in 2012. Therefore, Disney has very little revenue to lose and a lot of positive PR to gain from its restrictions on cotton.

Is this just the way the world works?

In our globalized capitalist society, where publicly traded apparel retailers fight tooth and nail to preserve their margins while offering competitive fashions and prices, demanding retailers to change their supply chain overnight is impossible. Although bad PR is likely to result in some industry-wide pledges, the Uzbek cotton industry won’t go away soon.

The European Union has taken some actions, such as the refusal to extend a bilateral trade agreement with Uzbekistan, but the U.S. has actually increased bilateral ties with Uzbekistan over the past two years. These increased ties were part of an effort to expand the U.S. military land network into Uzbekistan's neighbor, Afghanistan.

The Foolish bottom line

I expect the use of Uzbek cotton to be a divisive issue for many years to come, even as larger retailers pledge to “not knowingly” use cotton sourced from the region. This brings us full circle back to my opening statement - that ethical investing presents a dilemma for many people.

Should we chide Aeropostale for purchasing the cheapest products possible when both its top and bottom lines are crumbling? Should we applaud Disney because it made a bold statement that is fairly inconsequential to its top line growth? Lastly, is there really any way to escape this conflict of numbers and ethics in the world of investing?

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Leo Sun owns shares of Walt Disney. The Motley Fool recommends Walt Disney. The Motley Fool owns shares of Walt Disney. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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