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 www.textilwirtschaft.de).

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

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