Investment Thesis

The retail fashion landscape has always been one of intense competition but the last few months have proved a moment of reckoning for many household names. The main question is which retailers can survive but, furthermore, are there any that can thrive in this time and come out the other side in a, potentially, stronger market position. I would like to show the balance sheet strength of Inditex (INDXY), the advantages of its store names and its investment in online and how those factors may give it the needed edge over its rivals.

Company

Inditex is one of the world’s largest fashion retailers, with eight brands, selling in 202 markets through its online platform or its over 7,000 stores in 96 markets. Inditex, mainly represented by Zara, has found itself at the top of companies that dominate the world’s fashion industry. The eight brands under the Inditex umbrella are Zara, Pull&Bear, Massimo Dutti, Bershka, Stradivarius, Oysho, Zara Home and Uterqüe. These brands serve different consumer groups and contribute in varying amounts to the group. Source: June 2020 Investor Relation Presentation

Below is a brief overview detailing the target age group of the varying brands plus their 2019 sales and PBT figures:

Brand

Sales

Profit Before Tax (€bn)

Zara + Zara Home

€19.6 bn

€3.4 bn

Massimo Dutti

€1.9 bn

€282 m

Pull&Bear

€2 bn

€301 m

Bershka

€2.4 bn

€349 m

Stradivarius

€1.75 bn

€300 m

Oysho

€604 m

€70 m

Uterqüe

€115 m

€9 m

Visually displayed, the pie looks like this:

Source: June 2020 Investor Relation Presentation

The varying brands tend not to overlap in fashion styles meaning the group, as a whole, has the variety of trends covered. However, as you can see, the majority of the income comes from Zara (+ Zara Home). The Zara brand is the most broad, covering the latest fashion for men, women & children of all age groups.

If we examine how these sales are distributed across the globe then we see the following:

Source: Annual Report 2019

As we can see, the sales are heavily concentrated in Europe (62%) but therein lies both a strength and weakness. Negatively seen this means that currently the future success of Inditex is strongly linked to the economic health of Europe, but on the other hand, this displays that there is still room for growth in other markets.

The recent past

Inditex has seen consistent sales growth over the years:

Source: June 2020 Investor Relation Presentation

This has been reflected in the stable EPS growth over the years:

Source: Morningstar

What is also of importance given the current environment is how Inditex has been investing for the future:

Source: Annual Report 2019

There are 3 items I would like to highlight; first is the increasing dividend payout, then there is the cash retained for future growth and finally the payments made for investments in new productive assets. As we can see the dividend and the retained cash have grown over the years, and there has been a consistent investment in new productive assets which is always welcomed by shareholders as these should, hopefully, generate future profit growth.

If we compare share price growth over the last 5 years versus select competitors, namely H&M (OTCPK:HNNMY), The Gap (NYSE:GPS) and Fast Retailing Company (OTCPK:FRCOY) we don’t see a particularly exciting development:

Source: TradingView

Of course, the coronavirus events of the last months would depress the most recent moves but even before that it was not on an upward trajectory. Indeed, the Fast Retailing Company shows impressive growth during this time and a strong rebound since the March lows.

If we shrink the observation time to the start of 2019 then we see that, just before the corona virus struck, the share price had been on a bit of a charge, rising 30% over the prior calendar year:

Source: TradingView

But what was it about 2019 that was so positive for the group and what, if anything, can we take away from that, which may be useful when looking at today’s environment?

Today

The foundation that had been laid in the previous years was the large investment into technology. The fact is that the fast fashion high street in Europe is one where some heavyweights battle against each other (namely H&M and Associated British Foods PLC (OTCPK:ASBFY) owned Primark) but increasingly they are facing competition from online-only stores that can be found popping up on social media sites. Additionally there is the behemoth that is Amazon (NASDAQ:AMZN) which has been upping up its own fashion propositions and, typical to this online giant, putting pressure on the profit margins.

It is in this area of digitalization that Inditex has increasingly over the years been investing with greater focus.

At the end of 2018 Inditex launched online sales in a further 106 countries (bringing the total at that point to 202) with the ambition to have all of its brands available online worldwide by 2020.

Furthermore, June 2018 saw the appointment of Pilar López Álvarez, president of Microsoft Spain, to the board and the following year the board welcomed Anne Lange to the team. At that point she held more than 25 years of experience in technological innovation.

The innovations that Inditex is driving is both on the supply side and customer experience side.

To ensure that our competitive advantages are sustainable in the long term, in Inditex innovation is founded on two cornerstones:

– The development of our circular economy model with specific initiatives and projects in each phase of the value chain.

– The application of technology as a transformational cornerstone: Technology which, due to the complexity of the environment in which Inditex operates, requires multidisciplinary competences in a wide range of scientific disciplines, classified according to the UNESCO International Nomenclature for the fields of Science and Technology and, among which, the 16 categories listed on the right stand out.

Inditex is pushing a number of technological innovations in order to stay ahead of the curve. The company places the innovations under 3 main headers: Integration, Availability and Simplicity. Briefly described, they encompass the following goals:

Integration:

The attempt to integrate the online and physical store shopping experience to allow the company to deliver products more conveniently regardless of where items are or the physical location of the stock is at the time of sale.

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Availability:

The use of analytical tools to estimate the demand for products, using knowledge about changes in trends, the influence of external events and consumption habits. This should ultimately avoid excess production.

Simplicity:

The aim is to improve the purchasing process. For example, the use of analytics on item searches allowing product creation based on customer needs. Furthermore, improving the search for the item, the time needed for garment fitting and offering both self-checkouts and mobile checkouts are all actions with the intent of improving the shopping experience.

Outlook

The technological push, outlined previously, has been given a greater emphasis in recent months. In June this year the firm revealed plans to spend €2.7 billion over the next three years to accelerate its development plans. Of this amount, approximately €1 billion is earmarked for digital investments. Inditex expects that by 2020 over 25% of its sales will be from online purchases. Furthermore, more than 1,000 stores will be shuttered and a greater focus set on larger, digitally-integrated stores.

Such outlays are not such a great financial burden given the strong balance sheet position of the firm. The net cash position of Inditex at Q2 2020 was €6.5 billion.

However, what is unclear is how consumer habits may change due to the effects of the pandemic.

It has already been seen that the pandemic has changed fashion and shopping with decreasing sales of workwear and increased sales of casual wear and athletic wear. These effects are easy to understand but the real question is how the new normal will be and the resulting longer term fashion trends. Understanding and reacting to these trends will be vital, which is where the investment in technological innovations (the integration of store and online inventories to hopefully avoid excess products in inventory) should give Inditex an advantage.

Dividend

Below is a table showing the dividend payout over the most recent years:

The dividend yield in 2019 at time of payout was approaching 3%. This year, because of the uncertainty caused by the virus outbreak, the decision over a 2019 dividend was delayed before finally deciding on a payout in the second half of 2020. This explains the major decline in payout when comparing 2018 vs. 2019.

The yield looks like the following:

Source: TradingView

It is not the most enticing payout but, as seen, there has been a consistent increase over the years and the strong cash balance of the company should mean that there lies no immediate danger to the payout. However, as was seen earlier this year, the company is not afraid to put the dividend on ice if it sees that in its greater interest.

Valuation and Conclusion

An investment in Inditex would be predicated on an evaluation of the future success of this company in the face of the current and future headwinds. As mentioned, we see strong competition from other fast fashion retail names, a continuing move to online shopping and shifting fashion trends accelerated by the pandemic.

As presented, Inditex has set itself up to try and meet these challenges with big investments into technological innovations that should help it get ahead of the game. Its flagship brand ‘Zara’ is a trusted name by shoppers and, according to Forbes, the 41st most valuable brand in the world in 2020.

Looking at the historical P/E valuation, we see the following:

As you can see, depressed income this year because of enforced store closures led to an inflated P/E ratio as the share price did not proportionately fall as far. This means using this valuation at the moment would not be a useful metric.

The majority of the income for the company is currently coming from Europe, but the company seems intent on driving expansion in new territories, sometimes in an online first strategy. This ability to change and innovate, to follow where the consumer is going is a valuable aspect of this firm. This, coupled with its innovations that should provide shopping flexibility, fulfilment from physical or online stores, the use of RFID to track all items and present availability real-time to customers and to monitor consumer demand in order to swiftly react to new trends, means that we should not see this name follow the same downward path that, sadly, some household names have in the last few months.

For those looking to invest in fashion and retail names, among fast fashion, Inditex is a solid choice going forward. However, given the slim margins and the increasing pressures on the margins led by other online retailers, including Amazon, it will be an ongoing challenge to continue to drive profitability upwards. Although Zara is a global name, it does not command the same desirability that luxury brands can, which, furthermore, can also command bigger profit margins and are insulated from online upstarts. For those looking to enter the fashion space, the moat provided by a luxury brand may be a better place to start your search since currently, as good as it is, the evidence would not be compelling enough for me to make a stake in this company.

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Disclosure: I am/we are long AMZN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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