Description

Short ZGN:

As a de-SPAC trading above $10, Ermenegildo Zegna (NYSE: ZGN) is one of the most compelling consumer shorts in the NTM. The market is capitalizing a one-time hype super cycle as a secular growth story. We believe this trend is playing out its lifecycle like any fashion boom/bust and is finally peaking in popularity. As global luxury markets begin to cool, ZGN is poised for meaningful downside given 1) its weak brand standing within the stealth wealth category, 2) 30%+ topline exposure to China (more than double the average of other luxury brands) and 3) execution risk from its acquisition of Tom Ford International. Given that it reports earnings next week, this write-up will be relatively succinct. ADV is ~$4.5mm, SI is LSD and Borrow is GC.

ZGN has a century+ history as a family-owned clothing brand in Italy that specialized in made-to-measure formalwear for men. In 2021, ZGN folded its three legacy brands into a single high-end collection as it signaled for leisurewear to be the key growth vector going forward. It has pursued a vertical-integration strategy paired with a series of acquisitions focused on both premium fabrics/textiles and gaining exposure to younger cohorts. Of recent importance are Thom Browne in 2018 and Tom Ford Fashion in late 2022. For reference, ZGN’s FY ends on December 31.

If you do not live under a rock, you have probably witnessed the dramatic rise in popularity of the “old money aesthetic”/“quiet luxury”. COVID propagated WFH culture + casual office attire and people sought out leisurewear. During this time, Succession became a cultural phenomenon and fans sought to cosplay as their favorite Roy sibling with the money they had made in a low interest rate environment. Kieran Culkin became an official brand ambassador for Zegna, and influencers on TikTok (i.e. Gstaadguy, Iman Gadzhi) preached the glory of the stealth wealth look. Once the niche preference of tech execs and actual “old money”, the trend went so viral that you can spot many GenZ teenagers unironically wearing linen pants from Zara and knock-off summer loafers. As growth soared, ZGN went public in late 2021 via SPAC and raised ~$761mm, of which a whopping ~$546mm was used to cash out the Zegna family’s stake.

You don’t have to look hard to see this generational windfall within ZGN’s numbers. In 2019, the Core Zegna segment was ex-growth. The growth they posted was entirely from acquiring Thom Browne in November 2018 and Dondi in September 2019. Coming out of 2020 (COVID had decimated sales), the broader Zegna segment has grown at a 16%+ CAGR to an H1 run-rated figure of €1.3bn for FY23, surpassing its 2018/2019 high of €1.15bn. Another way to look at it is as follows: Excluding the Tom Ford acquisition, ZGN’s run-rated topline for FY23 is ~€1.7bn vs. the €1.5bn target laid out in their 2020 SPAC presentation. From a time where obscene hockey stick projections were the norm, ZGN is the only de-SPAC I’ve seen that actually beat their initial estimates. I am inclined to believe that this was not due to management’s astute forecasting, but rather a pull-forward of years of demand.

Most recently, management laid out its goals for >€2bn in revenue by 2025 excluding Tom Ford, or a ~10% CAGR. Adj. EBIT margins are projected to expand accordingly. The sellside has taken this at face value given the recent performance. The lazy bull thesis is as such: with its strategic pivot into ultra-luxury leisurewear, ZGN is in the early stages of becoming the next Brunello Cucinelli (i.e. a secular compounder with a best-of-breed brand name).

Let’s start with ZGN’s grand slam in recent years: the Triple Stitch Sneaker, which is their response to Loro Piana’s Summer Walks. Management disclosed that in FY21 they had sold ~100,000 pairs of these, representing ~400% growth YoY! Management has since not disclosed any sales figures concerning this (though they frequently cite its “exceptional” success). Why? I think it is very reasonable to assume the number of pairs sold in FY22 was up ~100%. Let’s say the ASP in FY21/22 was ~€650 (varies based on material, customization, geography). Zegna Branded Products did €924mm in Sales in FY22 vs. €847mm in FY21 (+9% YoY). That means incremental sales of Triple Stitch Sneakers were responsible for nearly all of the core segment’s growth! Outside of this one product line, ZGN’s core segment grew LSD at the peak of an unprecedented hype cycle!

The reality is stripping out the brand’s one homerun product (kudos to Succession, TikTok and low interest rates) implies ZGN is not seeing meaningful brand traction. Compare this to Brunello Cucinelli (BIT: BC), which saw its topline accelerate from a ~10% organic CAGR to a 25%+ clip during this hype cycle. ZGN’s growth engine is consequently receiving far too much credit in the market. I will emphasize again this was an ex-growth name through 2019 and ZGN’s historical “growth formula” was predominantly from acquiring brands.

My guess is it could spook investors if they knew a product line as fickle as shoes has been the critical growth driver (hence why it was no longer disclosed). This is by no means recurring revenue (how many different colored Triple Stitch Sneakers do you need?), yet management is touting a secular growth story around its brand! Understated is in vogue now, but I wager it is a matter of time before fashion trends change once more. It wasn’t that long ago when Allbirds was seen as stylish and convenient. Moreover, the Zegna brand simply does not have the staying power/cult following of Loro Piana and Brunello Cucinelli. This is especially true as we head into a recessionary environment/as the consumer wallet finally starts to crack.

Valuation:

ZGN has five segments: Zegna Branded Products, Thom Browne, Tom Ford, Textile, and Third-Party Brands.

As a recession hits and key markets (i.e. China) unravel, I think Zegna Branded Products (excluding shoes) should shrink LSD. I project the Shoe segment to grow at a 20% CAGR through FY24 and FY25. This seems more than fair after the hyper growth it has seen and accounting for an economic slowdown. This would mean the core brand decelerates to a 3-5% growth clip in FY24 and lower in FY25. We are already seeing the early innings of this in recent quarters.

Next we have Thom Browne (~30% of Sales). Thom Browne CAGR’d at a 30% clip through FY22 in part due to expanding into China via ZGN’s network. It has decelerated two quarters in a row and most recently posted ~11% YoY growth. To be generous I assume this brand decelerates to a HSD clip and normalizes there.

As for Tom Ford (<10% of Sales), neither management nor the sellside places much emphasis on this in their forecast targets. That segment is basically an OTM call option: capital injection required, margin dilutive, in the process of onboarding a new CEO, and riskier as it prepares for its seasonal launch/new vision board.

The Textiles segment (~8% of Sales) relates to the sale of ZGN’s fabrics to other brands/tailors. It houses ZGN’s internal R&D team, which focuses on developing new fabrics and manufacturing techniques. It grew 30% in FY22 but has gone ex-growth this quarter after decelerating in the prior quarter as well. This is literally a commodity business and past growth is mostly a testament to the popularity of leisurewear/cashmere in recent years.

The Third-Party Brands segment (~2% of Sales) refers to their supplying of men’s apparel to Gucci and Dunhill. Product quality varies significantly; this is a commodity type business as they are simply producing other brands’ clothes within their factories for a fee. Tom Ford sales used to be housed in this segment until they acquired it outright recently. Stripping that out, this segment modestly shrunk in H1FY23.

Neither of these segments moves the needle in my valuation, so after allocating corporate overhead, I will say Textiles and Third-Party Brands are worthless. 

How do you value the core Zegna segment, Thom Browne and Tom Ford? The Zegna brand is a cyclical, LSD grower at best that the market has mistakenly viewed otherwise due to one viral product. I think in-store sales productivity will weaken going forward, especially given its recently expanded footprint. It would not surprise me if margins get hit, especially if inventory (at a 3-year high) is discounted. After allocating corporate overhead and stripping out the one-time addbacks related to going public, I get to an Adj. EBIT of ~11% in FY24 for the Zegna segment. All things considered I think an 11X multiple is fair and within its historical trading range. Thom Browne is smaller but grows slightly faster, with similar EBIT margins. I’ll give it the same multiple. Tom Ford gets a 7X (though this barely moves the needle regardless, so there’s no need to nitpick). Zegna Branded Products is ~$1.35bn, Thom Browne is ~$540mm, and Tom Ford is ~50mm. ZGN used up its SPAC proceeds to acquire Tom Ford and now has a small net debt position on its B/S along with a minority interest. That gets us to an equity value of ~$1.87bn, compared to the ~$3.10bn market cap it has today. That is roughly ~40% in downside from here within two years.

I think management will inevitably have to lower guidance as the macro weakens further and the hype cycle gradually moves on to the next big thing. Given the commentary we are already seeing among luxury names, I think the risk/reward is skewed in our favor here.

Catalyst

Earnings