All posts by Chris

ZALANDO + ASOS = Love For Ever?

As I was landing in Athens yesterday evening (March 14) and going over my regular Close Of Business (COB) share price checking, I couldn’t help but notice a material and sudden 3% jump of ASOS shares at 3:57pm GMT, 33mins before COB. Wow what hapened there? The move can be explained by a 3:57pm announcement that Mr Anders Holch Povlsen bought 1m shares (c1.2% of the entire company) through his investment vehicle Aktieselskabet, with Tybourne Capital being the seller. The largest shareholder of ASOS increased his stake even more to above 29%, just shy of 30% at which level he would be obliged to do a tender offer for ASOS. 

This is big news and there are a few scenarios why Mr Povlsen increased his already big stake at ASOS. I doubt he wants to do a tender offer and I doubt he just thinks ASOS is undervalued and he can sneak in an extra 1% of the company at a good price as if that would make any difference to him. I also doubt that he was sitting at a pile of cash he had nothing to do with (although he is indeed a wealthy man) and thought “hah let’s buy more ASOS”. I believe he is thinking a lot more strategically. After all he is the owner of well known brands like Jack & Jones and Vera Moda with thousands of stores around the world and he needs to partner with big online platforms. Should investors start entertaining the scenario of ASOS and Zalando merging together!?

It actually makes sense for both Mr Povlsen and the rest of the shareholders at both companies if you think about it. I can think of 8 very good reasons why:

  1. The bargaining power with third party brands would increase…materially. The merged entity would be the undisputed global leader in online fashion and THE priority platform for third party brands. With more than 30 million active customers globally, active specifically on Fashion, any fashion brand would be crazy not to have the merged entity as the no1 parner of choice. Even investors’ concerns about the impact of Amazon Fashion on both ASOS and Zalando would diminish as Amazon would find it very difficult to compete with such a proposition.
  2. ASOS and Zalando operate in complementary geographies. Zalando is very strong in Continental Europe, ASOS is extremely strong in the UK and Australia and strong in the US, Russia and some markets Zalando would need time and money to invest with unguaranteed results.
  3. ASOS is strong in fashion and curation, Zalando is strong in technology. The combination can be explosive!
  4. Infrastructure efficiencies. Infrustructure, which is a bottleneck for both companies, is also complementary and material economies of scale can be achieved. Zalando has extended and automated warehousing in Germany where ASOS is now trying to build up (ASOS would no longer need to go through warehouse maturity and potential sales disruption). ASOS is building up the US (Zalando is not present there) and has a mechanised warehouse in the UK where Zalndo cannot break through despite years of investment.
  5. Operational leverage. The merged company could leverage costs better (marketing, personell etc) and achieve a combined higher EBIT margin than the sum of the parts currently.
  6. Talent acquisition and career development, a major factor for growth companies, would become easier. Who wouldn’t want to work for such a company? It would be the Google of fashion.
  7. The two companies have an overlapping shareholder basis which could make a merger technically feasible. Anders Holch Povlsen owns 29% of ASOS and 10% of Zalando. Baillie Gifford owns 9% of ASOS and 7% of Zalando. Capital Group owns 10% of ASOS and some part of Zalando (although it is not a top7 shareholder there).
  8. It increases stock liquidity  (particularly important for Zalando who has some Private Equities as shareholders) and makes it easier for some shareholders to divest their shareholding (of a larger Group) and many large cap long onlys to come in. Let alone the new company would be a large cap name, elegible as an investment with more funds (a dual listing in FTSE100 and Xetra DAX would be possible). The merged company would enter a more mature phase with its ownership structure and likely more stable one, which would make it a more appealing investment. 

How could the shareholder structure shape up?

If a meger was to happen I would bet money that Mr Povlsen wouldn’t sell a single share owning c18% of the merged company. I remember him telling me a few years ago “Chris I am not an investor. Investors buy and sell. I only buy”. I would dare to say that he would have a leeway to even own 11% more. Baillie Gifford would still own c7% of the merged conpany. Capital as a major ASOS shareholder would also be happy with a merger and could even increase its stake from a c5% initial stake. Maybe Kinnevik, a couple of hedge funds and the founders on either side of the trade (if they want to be less involved) could sell with their stake being picked up by Mr Povlsen and other long onlys (in the short term of course plenty of hedge funds would get involved). Given the shareholder structure I would expect an “all share merger” with a c38%/62% ratio based on current market caps ASOS/Zalando if such an event was to happen. 

What could the Board of Directors look like?

Admittedly there are a few cultural differences in the business philosophy of the two companies. ASOS focuses on customer engagement more with Zalando being the tech freaks. ASOS has a British BoD and Zalando a German one. Different mentalities yes but I don’t think that the gap cannot be bridged if the owners want it and when the potential success can be so mutually beneficial.

Let me speculate on who could manage the merged entity in an assumed merger. In a scenario where there are two CEOs then I can see Nick Beighton and Rubin Ritter filling up the two positions. Rubin can act as a COO as well given his experience. Helen Ashton would stay as the CFO given she is very thorough, numbers focused and well liked by investors. In another scenario though where the merged company goes for single handed roles then Nick Beighton could be the CEO given his extensive (successful) experience at ASOS, longer than anyone else from both ASOS’s and Zalando’s Management Boards. (A technical complication could be that usually with mergers the larger company places the CEO, i.e. Zalando in this case). Rubin Ritter would then be the CFO as he is the one dealing well with the company’s financials from Zalando’s trio and is Zalando’s main face with investors. David Schneider who deals “with fashion” at Zalando would likely find that this is the bread and butter within ASOS while Robert Gentz could be redeployed but cannot claim either the CEO or the CFO role in my view.

The merged company would then need a Strategy team (ASOS doesn’t have one at the moment), which Birgit Haderer (Opp) at Zalando could fulfill (she has been a Goldman Sachs banker in the past). The Head of IR role would stay with Greg Feehely at ASOS who has won plenty of “Best IR” awards during his career at ASOS and has ample of experience dealing with investors and analysts. 

It makes sense right?

The merged company (ZALASOS!?!?) 🙂 would have sales of more than 5bn, EBIT of 300m, growth of c25% with plenty of efficiencies to be extracted and material growth and margin opportunities. It would make sense right?

Author: Chris Chaviaras

Disclaimer: This is not an advice to buy or sell shares at either ASOS or Zalando. Do your own research before you reach any conclusions. I don’t currently own any shares of the two companies and I don’t plan to do so for at least the next 72 hours.

H&M: It doesn’t pay to be long…yet

Since last October the clearly articulated view of this blog has been that most UK consumer discretionary stocks, ex the online names, will touch post Brexit lows, a view I don’t intend to change ahead of the trigger of Article 50 next month. Proving my point Next and Dunelm have already crossed their post Brexit lows while Dixons Carphone, Debenhams and even Kingfisher (despite the helpful strong EUR vs sterling) are hovering very close to these lows. At the same time ASOS and Boohoo continue their upwards trend. Given no change to my view on the UK names I turn the focus on H&M today.

While I would have loved to approach this company from the positive side given it is already not a well-liked stock, I cannot see why buyers should accept a price above 200-210kr, i.e. 12-17% lower than current levels.

On January 31st the company reported FY results with Q4 beating estimates while the rephrased sales growth guidance hinted towards better LFL sales in the future that the market cheered on the day. I wouldn’t yet get excited for a few reasons:

LFL sales unlikely to grow by 2-7% p.a. as hinted by the new growth guidance

H&M changed its growth guidance from 10-15% annual store growth to +10-15% annual sales growth in constant currency while at the same time gave FY17 store growth guidance at +10%, the lowest in 15 years. If we are to assume that 10% store growth p.a. will continue midterm, although I think it is likely this will further reduce, then LFL sales need to grow by at least 2% for H&M to hit the low-end of its new sales growth range target. It has happened only twice in the past 9 years so the track record is not with the buyers’ side. To top up negative indications so far Q1 is shaped to start below the low-end of the targeted annual growth range.

Concerning sales trends in the US, China and the UK, H&M’s major growth markets

I got concerned when H&M’s management highlighted Scandinavia as a market that did reasonably well despite its maturity. I cannot remember the last time Scandinavia featured in H&M’s highlights. Unfortunately for H&M major growth markets like the US, China or the UK struggled materially while Germany, H&M’s biggest market also went backwards on a LFL basis. So where is growth going to come from?! I was even more concerned when I heard H&M blaming macro trends for poor performance. They have quoted several times in the past few years that macro trends should be irrelevant for a growth company, a quote I have always agreed with. In China New Look has 107 stores and manages very positive LFLs. Why H&M with 447 stores is well into double digit negative LFLs there? I think operationally H&M should have been a lot faster expanding into China but they weren’t. In the US with the economy expanding strongly and Trump promising great growth it is worrying H&M failed to outperform on a market it traditionally does very well.

Gross margin continues on a negative trend

H&M now offers a gross margin level (55.2%) almost 10pps below its peak and at a similar level to that of 2002, i.e. 15 years ago! With inventories up 26% in constant currency y/y I would bet markdowns will be again a problem in 2017 unless Spring/Summer sales surprise us positively (who knows?!). With the EUR continuing to fall vs the USD I cannot see much relief on the FX pressure either.

Cash depletes fast. Is the dividend at risk?

There is still leeway to maintain the current dividend level of 9.75kr for at least another 3 years assuming similar performance to 2016 (which is a pretty pessimistic assumption) but I would rule out any increases in the dividend even if performance improves. H&M’s net cash position has almost halved vs 5 years ago while capex continues to grow at high single digits. Now that’s important because H&M is a yield stock and if yields go up (follow Fed’s commentary) and the dividend doesn’t increase then the PE multiple can contract.

Are there any signs of improvement?

H&M’s track record is tragic in the past 5 years. EBIT margin is down 530bps, ROCE is down more than 10%, cash has almost halved but more importantly it is still difficult to call the bottom.

On the positives H&M seems to be finally making the right infrastructure investments as capex can be reallocated from lower new store growth into areas like click & collect, “scan to buy” and next day delivery. But there it is still early days on investments that should have been prioritized a long time ago. Results on the form of better sales will unlikely be visible before 2018. The lower store growth means that LFL sales could pick up as the mix of more mature stores increases but growing into Tier 3 and Tier 4 cities could mean that lower new store productivity may offset these potential LFL increases. Finally tight cost control seems to continue and easy comps from March onwards may offer some sales growth upside, while consensus is already mostly negative. But that’s not enough at this point in my view.

Conclusion: Do NOT buy YET

Now what kind of view is this? Is H&M a sell then? Well if you force me then Yes it is at the moment with another 10-15% downside as I believe that more cautious commentary by management at Q1 results is likely and although the stock is not very expensive on 19.5x PE, it doesn’t prove to be a growth stock either to justify a higher multiple. A declining ROCE and rising yields in the US could still call for some further multiple contraction especially if sales disappoint again, which is not very unlikely given the declining German sales in recent months including February (as per

BUT personally I don’t like the risk reward of a short and I will be looking at a level close to 200kr to open a long position (I can’t help it to be contrarian at the right level). Historically a c4.5% dividend yield has proved to be a good floor for H&M and to achieve this level H&M shares need to be below 215kr, i.e. 10% below the current level. Add some extra safety margin (at low probability) in case H&M needs to cut its dividend and I believe that 200kr can be a good support level hoping for a better fashion outcome in H2 admitting that fashion is a bit of a hit and miss with H&M.

So really if I had THAT crystal ball I would want to be short now and go long when the stock gets to around 200kr. Unfortunately I don’t have this crystal ball so I will do nothing now and closely monitor to see whether the level of maximum pain can be reached in the near term taking advantage of a good entry point. At the end of the day H&M is not a bad brand. If only it was on ASOS’s platform! I will support this view in a follow up post in the near future.

Author: Chris Chaviaras

4 reasons Steve Rowe’s strategy on M&S finally makes real sense

In full disclosure, in my time as an analyst I was never a buyer of M&S shares because amongst others I thought that the clothing business was in structural decline, M&S had an extremely poor track record in generating acceptable returns on incremental capital employed compared to its peers and its top management many times had ambitions beyond the company’s reach. So I have seen two CEOs come and go but never bought their ambitious plans. I must also say out of all the years I was a seller of M&S, I was wrong to be one during the time ex CEO Marc Bolland managed to finally get rid of the middlemen increasing direct sourcing and subsequently the buy in margin at M&S’s clothing business by a whopping 475bps!! That was over an 18 month period, but even then, even if I was wrong for that time I always thought that this mega gross margin increase, which by the way just got M&S closer to the levels of other more efficient businesses, was a one off and did little to address the structural challenges facing M&S. The stock had climbed up to 600p then but here we are again a year and a half later with the shares almost halving again.

With this intro in mind, I can’t believe I say that but now that the dust has settled I must admit I found Mr Steve Rowe’s strategy on M&S very sensible earlier this month. I think Steve Rowe has the most chances of success with his plan out of all the strategies and plans delivered in the past decade for M&S. He fits M&S just fine. He is a British CEO leading a very British brand and although I think he overdid it in his first strategy day last May disappointing investors by talking about Mrs. M&S in such a “wishy washy” way he recovered completely this month talking a lot of sense. Most and foremost he recognized M&S’s mistakes and weaknesses and instead of trying to argue for them he took action to mitigate them. This is noble and…value enhancing. 4 quantifiable (!) reasons I liked his strategy:

  1. He stopped the bleed internationally.

M&S is very British. Embrace it and move on. As an analyst I had done a study in the past showing that out of all of M&S’s ventures internationally in the past 20 years there was not once where M&S didn’t end up losing money. Brooks Brothers’ purchase, King Supermarkets’ purchase, its Canadian operations, its European operations you name it. Finally Steve Rowe is the CEO that closed the materially loss making International business recognizing it will never work and saving the company £45m of annual losses. Of course no CEO wants to say that he has no international aspirations but at least he chose to focus on the less risky franchise business. I personally still think investors should not factor in any major success internationally but shareholders can now safely assume M&S is £45m more profitable going forward.

  1. Delivered a plan to reduce General Merchandise stores

The clothing business is structurally challenged. Instead of arguing against it he recognized the negative base needs to reduce. There are two good things that could potentially happen here. 1. M&S will reduce space by 10% over the next five years. If the sales do transfer online (which is a good possibility) then it means that M&S will manage to save the costs of running that extra 10% space without losing sales. The cost savings could be substantial. M&S spends £823m annually in rent and property related costs so without even calculating any savings for staff expenses the savings could be c£82m p.a. by year 5. 2. If, as management claims, sales mix of Food:GM is 50:50 from 66:33 by year 5 then overall LFLs can also improve. GM LFLs have been negative year in-year out for as long as I can remember with the last two years delivering c-3% LFL p.a. If the negative mix reduces by 17% that means UK LFLs could improve by c50bps for M&S. This translates to c£20m of incremental profitability (£9,470m*41%*0.5%) (UK sales*41% UK gross margin*50bps LFL improvement)

  1. Spending responsibly

I need to give credit to Helen Weir here, CFO, whom I had first met at her capacity as CFO at John Lewis. She is disciplined and sharp. But I must also say that in terms of CFOs the last decade M&S is used to do well. I also liked Alan Stewart’s discipline and the projects he had undertaken had created value. Anyway the £400m of annual capex Helen Weir announced is the lowest in almost a decade while it is the first time I heard M&S really reviewing its approach to Capital Investment targeting shorter leases, evaluating underperforming projects and recognizing past mistakes. Now other than the potential to improve ROI there is another mathematical benefit to profitability from lower capex. This is lower Depreciation & Amortisation. Long term capex was reduced by c£150m which means that eventually D&A will reduce by as much but it will take time as D&A will be still impacted by an earlier spending spree over the last few years. If we assume an average depreciable life of c10y then D&A could be reducing by c£15m a year which means by the time the space will have reduced by 10% (in 5 years) D&A could be lower by c£75m.

  1. Reduced HQ costs

Steve Rowe went as far as to potentially displease some in the Head Office but his cost saving exercise will deliver another £30m a year.

It all adds up to big numbers within management’s control

If we add all of the above up then we are talking about £252m improved profitability by year 5, i.e. end of calendar year 2021. Sell side consensus PBT for March ’17 is £598m and hovers around such levels for 3years! So no growth for 3 whole years and then by March 2022 consensus PBT is looking for c£700m of PBT. According to the analysis above the PBT could be more like £850 in FY22, i.e. 20% higher.

What could screw it up?

What else? Clothing performance. But to erode £150m of incremental profitability (to bring us back to £700m of PBT in FY22) GM sales need to reduce by c7% on a LFL basis in the next 5 years. Now that’s not unheard of but with Mr Row reducing prices by 17% on average in 1700 lines and by reducing the space mix towards Food he has taken two important actions to try and fight negative LFLs.

The near term looks good…

I still abide by my cautious view about UK retailers in a post Brexit era but in other matters the weather is pretty cold and helpful for apparel retailers. Imagine M&S post a positive LFL clothing performance in 3Q in January, the stock will soar because people will start believing more and more into this turnaround plan. Additionally if Mr. Hammond delivers a pro growth budget with fiscal easing and delivers tax and VAT cuts then M&S shares can also benefit.

The risk reward is skewed to the upside for M&S’s shares

I like that Steve Rowe didn’t deliver a strategy assuming clothing sales will improve or that M&S can thrive internationally but instead delivered a strategy where the outcome is big but within his control. The £252m we calculated above is a 40% leeway in March ’17 profitability. At the same time M&S shares trade shy of 12x (and with Brexit I argue that’s as high as any UK general retail stock can go) but with a credible strategy the multiple can expand as people place more faith. This trigger can be 3Q LFLs. We know October was good. We just need a reasonable November and December which we may have as weather helps. Successful or perceived successful turnarounds can attract multiples north of 15x PE. That’s another 25% leeway from where we are today. Add the two together we are talking for more than 60% share price upside maybe and a good part of it within the next one or two years! I don’t even believe I claim that but it is not illogical.

Brexit will be tough but then people will turn to self help stories…I own M&S and I will be reavaluating my position above 400p or if everything suddenly falls to pieces of course. But don’t forget that around these share price levels all these rumors about some Private Equity buying M&S may start kicking back in. It may be farfetched and I certainly don’t really believe it but interest rates are still very low and hence the same logic for the rumors can apply.

Author: Chris Chaviaras

Disclaimer: The author owns shares at M&S