Inditex ITX:SM S
October 08, 2014 - 8:30pm EST by
WeighingMachine
2014 2015
Price: 21.00 EPS $0.00 $0.00
Shares Out. (in M): 3,120 P/E 0.0x 26.0x
Market Cap (in $M): 65,520 P/FCF 0.0x 30.0x
Net Debt (in $M): -3,112 EBIT 0 3,286
TEV ($): 62,408 TEV/EBIT 0.0x 19.0x
Borrow Cost: NA

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  • Fashion
  • Apparel
  • Retail
  • Spain
  • Sector Short
  • Deteriorating Fundamentals
  • Europe
  • Slowing growth
  • Family Controlled

Description

I believe Spanish retailer Inditex (ITX:ES) shares represent a compelling short with the potential for 30-50% downside from today’s price.  While Inditex has been a fantastic growth stock thus far, I believe shares will decline for the following reasons:

1)       Unit growth has slowed and will continue to slow going forward.  Until recently, Inditex was growing square meterage by ~10% annually.  This year, space will grow 6-7% (though capital expenditures are at an all-time high –see below).  With over 2,000 Zara stores worldwide, Inditex’s core concept seems to be nearing full penetration in most markets.  While this is 40 % below lower-end competitor H&M, given Zara’s higher price points and positioning (high fashion), I think the total market potential is lower.  Store/space growth is increasingly dependent on Zara’s smaller concepts – Pull & Bear, Massimo Dutti, Bershka, and Stradivarius being the largest (have 700-1,000 stores each).  While these concepts have proven to be successful – all are profitable and growing, on average these stores produce sales/store of E1.4 million (with Massimo Dutti being the highest at E1.9 mn per store) vs. average sales per store for Zara of E5.5 mn.  As such, further penetration of these concepts is not going to be enough to move the space growth needle.  Further as the company strives to maintain growth, I expect new store productivity to decline as Inditex is forced to select suboptimal locations.  Lastly, given the law of large numbers, it is becoming increasingly difficult to move the needle with a new concept. 

2)      Increasing competition – like H&M, Inditex is facing increased competition from Primark, Top Shop, Uniqlo, etc. 

3)      Gross margins are going the wrong way.  Gross margins have declined since 2012.  Given an increasingly competitive environment, I expect further gross margin deterioration. 

4)      Significant exposure to Europe - 66% of revenue came from Europe in 2013 (20% Spain, 46% Europe-ex Spain).  Perhaps everything in Europe isn’t really fixed and consumers will tighten purse strings. 

5)      Free cash flow has deteriorated as capital expenditures have soared.  Capex is at an all time high on an absolute basis and capex per net square meter added for the last three years is 40% higher than the previous three years (2014 will be higher still). While the number of net store openings has been flattish over the past couple of years, capital expenditures are at all time highs.  The company has not answered this question to my satisfaction though it is in the midst of refurbishing some of its older stores, is required to build out logistical infrastructure as it continues to expand geographically.  Additionally, the costs of launching its online offering (both developing the websites across countries) and creating logistics to support this channel are likely an additional burden. 

6)      Operating Margins have declined since 2012 and are likely to continue to decline – it seems that nearly everything is going against the company – increased competition is likely to pressure pricing and gross margins (and possibly same-store sales), increased competition is driving up the cost of real estate, higher capital expenditures will continue to drive up depreciation expense. Customers now expect the option of purchasing online increased costs of online presence (free shipping in many markets and free returns in all markets).  The liklihood of returns would seem to be high for an online fashion and the cost of handling returns is expensive.  Trying to force growth is likely to reduce the productivity of newer stores (and potentially cannibalize existing stores). 

7)      Valuation – None of this appears priced into the stock.  Inditex trades at 3.3x 2015 estimated revenue, nearly 15x my 2015 EBITDA estimate, 26x earnings, and over 30x free cash flow.  For a business that I estimate will grow free cash flow-sub 5%, this seems very high.  Valuing the company at 16x NOPAT shows 33% downside. 

It has been my experience that when things go wrong in retail, they can go really wrong (to a greater extent than is typically seen when things really go wrong).  When LfLs cut negative, operating margins can fall significantly as retail has a high level of fixed costs which can cut hard if sales start to go the wrong way. Strategic choices become more difficult to make and the chances of management making a critical error increase (plowing more money into leases for a new concept, changing fashion in a more dramatic way at a core concept, etc). Though I don’t think Zara is anywhere near irrelevance, I think the future is likely to be much more difficult than the past though this is not at all reflected in the share price. 

Background

Inditex is one of the largest fashion retailers in the world with 6,500 stores and is on track to do nearly E18 billion in retail sales (62% of which are through its core Zara brand).  2/3 of its revenue comes from Europe with the remainder divided between the Americas and Asia.  The company has positioned itself as affordable high quality fashion.  Inditex is nearly 60% owned by the Ortega family. 

Historicals

Inditex (EUR mn)

                     
 

2007

2008

2009

2010

2011

2012

2013

1H13

1H14

2014

2015

2016

Revenue

9435

10407

11084

12527

13793

15946

16724

7655

8085

17881

18854

19663

  Total Growth

 

10.3%

6.5%

13.0%

10.1%

15.6%

4.9%

 

5.6%

6.9%

5.4%

4.3%

   LfL growth

 

0.3%

0.0%

3.0%

4.0%

6.0%

3.0%

 

4.5%

     

   Space growth

 

14.0%

8.0%

10.0%

10.0%

11.4%

9.0%

 

6.5%

     

   FX

   

-2.5%

3.0%

-1.0%

2.0%

-3.0%

 

-4.0%

     
               

 

 

     

Gross Profit

5349

5914

6328

7422

8180

9529

9923

     4,486

      4,658

     
 

56.7%

56.8%

57.1%

59.2%

59.3%

59.8%

59.3%

58.6%

57.6%

     
               

 

 

     

EBITDA

2149

2206

2374

2966

3258

3918

3926

     1,624

      1,617

     

EBITDA Margin

22.8%

21.2%

21.4%

23.7%

23.6%

24.6%

23.5%

21.2%

20.0%

     
               

 

 

     

EBIT

1652

1609

1728

2290

2522

3117

3071

     1,219

      1,194

3145

3286

3396

OPM

17.5%

15.5%

15.6%

18.3%

18.3%

19.5%

18.4%

15.9%

14.8%

17.6%

17.4%

17.3%

  OP growth

                 

2.4%

4.5%

3.3%

                         

Zara Revenue

     6,264

     6,824

     7,077

     8,088

     8,938

   10,541

   10,804

     5,004

      5,206

 11,367

  11,985

   12,506

  Growth

 

8.9%

3.7%

14.3%

10.5%

17.9%

2.5%

   

5.2%

5.4%

4.3%

   % of total

66%

66%

64%

65%

65%

66%

65%

65%

64%

64%

64%

64%

 

Valuation

Zara Valuation - Base Case

 
   

Share price

21

Shares outstanding

          3,120

   

Market Capitalization

       65,520

Less: Net Cash

          3,112

EV

       62,408

   
   

2015 EBIT

          3,286

Less: taxes

           (756)

NOPAT

          2,531

Mult

16

   
   

Business value

       40,488

Plus: Cash

          3,112

Total

       43,600

   

Shares o/s

          3,120

Value per share

13.97

   

Downside

-33.5%

 

I actually think I’ve been fairly generous in my assumptions.  The 17.4% operating margin which drives the 2015 EBIT number is toward the high end of what I’ve seen achieved by fashion retailers who sell their own product.  A 16x NOPAT multiple is essentially a market multiple – while Inditex generates attractive returns on equity (and capital which excludes leases), I believe that going forward its growth will be very similar to the overall market.  There is a more draconian set of assumptions which involve declining LfLs and a further decline in margins (and a 14x multiple) which would get to a 50% decline. 

Where could I be wrong?

1)      Zara is a relatively unique concept and will not be as impacted by competition as more commoditized players like H&M.  To some extent this is true though I don’t view the environment as static.  As H&M suffers negative comps, I expect that the company to allocate an increasing % of its space to more fashionable attire (closer to Zara).  Walking through an H&M, there appears to be more overlap in the offering with Zara (H&M has expanded beyond basics) which I think will pressure prices and LfLs. 

2)      Weakening Euro means FX impact will now be positive.

3)      Given high exposure to Europe and a significant fixed cost base, a pickup in the European economy could provide a significant boost to profits and margins. 

4)      Perhaps the company is able to somehow launch another very successful concept.

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

-Slowing growth
-Continued decline in margins
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