Description

Thesis

H&M is an intriguing short trading at all-time highs with a healthy valuation at 15-16x 2014 EBITDA, 25x P/E for a business with deteriorating returns on capital, margins, and store productivity.  This is priced for perfection and any hiccup in its growth and/or margins could potentially cut the stock by 30-40%.  We believe the increasing competition from other fast fashion retailers and store growth that is penetrated in the high value locations will lead to a lower topline and margin degradation over time – potentially for a double hit with operating deleverage.  We think the stock is worth under 200SEK, down 33% from close to 300SEK today, based on, what we believe are generous assumptions, a 2015 EPS of 11.50SEK at a 17x P/E multiple.

Background

H&M is a fast fashion retailer (Europe’s second largest retailer) offering collections for women, men, teenagers and children which include shoes, accessories, clothing, cosmetics , etc.  The Company’s target is to increase the number of stores by 10-15% (that’s quite a feat – it means they have to open more stores every year to keep up with the growth targets in what we believe to be in locations that are not as good).  H&M is controlled with 70% voting and close to 40% share ownership by the Stefan Persson family – which is clearly why the dividend is extremely important to them.

Investment highlights

Growing new store base but we believe will be at sub-tier locations (in lower GDP countries – in many cases emerging markets) and provide for lower returns

• The total number of stores globally is 3,314 (feels fairly penetrated despite Zara – 6,340 stores -550sqm but the store size for Zara’s is half the size of the average H&M store – 1,300sqm) in 54 markets around the world as of 7/31/14 (up from 3,132 at the beginning of the year) with a total number of stores to be opened this year at 375 and over 3,500 by the end of the year.  They opened in Australia and the Philippines and India in the back half with South Africa and Peru in 2015.
• New space productivity – peaked in the first half of 2012 at around 81% and is now around 75% and we wouldn’t be surprised if it goes much lower given the locations where they are opening new stores
• It’s not a surprise that they have stopped reporting same store sales earlier this year – as it’s been relatively flat the last few years; you would expect as those stores enter the comp base that they would help the comp as they are relatively immature but it doesn’t help the comp because they are in worse locations then the existing store base
• Return on capital employed (including capitalized leases) also peaked in 2007 at a healthy 31% range and have subsequently gone down every year to 21% most recently.  We think this is going to go to the mid-teens.

Margin pressure as they rollout online

• Increasing investments should continue to drive margins lower
• They rolled out online this year in France, Spain, Italy and China towards the end of the year with another 8-10 markets next year.  Last year was the US as their biggest rollout.  They charge $5.95 for shipping in the US – we think they will eventually go to a free shipping model.  We continue to expect this will lead to additional margin pressure and added costs for shipping, IT and infrastructure to support this move.
• We can see this as we look at their operating margins which peaked in 2007 at 23.5% and have come down every year since then now at around 17% (2010 was an anomaly due to some currency hedging programs that helped operating margins that year); given the significant investments being made – there is no reason to believe operating margins have troughed and yet that’s what is baked into consensus (actually showing op margins rising over the next 3 years
• Expect continued gross margin pressure
• Cotton prices have risen recently and the Company is adamant on not passing these through and maintaining their pricing; the last two years have been a great benefit to apparel retailers (take a look at Hanes in the last 2 years) and now this is reversing
• Wage inflation – the Company is seeing higher cost inflation with China as a dominant source for the Company had 8.4% 3yr  inflation CAGR; labor is around 20-25% of COGS

Dividend – potentially at risk if the operating deleveraging continues

• 90% of cash flow is paid to dividend - that could be at risk considering the trajectory we have been on since 2007
• We sensitized our model – a 2% movement in GM and a 1% movement in op expenses would mean that the Company could not pay its dividend from retained earnings

Competition increasing with global expansion – Forever 21, Uniqlo, Zara, Asos, Topshop, Mango, Primark

• Most of these comparables are sourcing the same materials from the same factories going after the same customer base all with great ambitions to grow very rapidly – we don’t think H&M is a zero but do believe the glory growth days of the past are going to be harder to come by in this world of excess liquidity 
• Primark specifically could hurt H&M in their home territory.  Primark is a fast fashion retailer that offers 20%-30% lower prices than H&M and has gross margins that are 2000bps lower; what is interesting is H&M’s sales/store is about 40% lower in the UK (where Primark has scale). Primark is now operating in 7 countries in Continental Europe and could pose a real risk to H&M’s gross margins and sales productivity in their most important markets (Germany, France, Austria, Benelux, UK and Spain).  We know in speaking with management that they have very ambitious goals in Germany in particular – this is H&M's most profitable market

Difficult comps in the back half – Consensus at 2.25% (we think there is a good chance it could be negative)

• They launched the H&M US online store last August and, having anniversaried it, are no longer benefiting from the boost it provided.
• The Company comps against a +3% comp in the back half of the year versus the front half of this year was against a -4% comp.  Same store sales have ranged from -1% to positive 1% the last 3 years

China Bull story – seems a bit suspect

• Due to increasing competition, HMB is expanding into smaller tier 2/3 cities . Competitors such as Fast Retailing Co. (over 200 locations already)  and The Gap are also adding stores in the market. Local competitors, such as Meters Bonwe Group Shanghai Co. (one of China’s largest apparel companies by sales and store count ~4,000 stores) are significantly larger with brand name recognition and market share.
• Plan to open 80-90 new outlets this year
• However, since 2010, the sales/store have been below group average (37% below average in FY 2012/2013) and falling; this is not what you’d expect
• Planning to launch online later this year; significantly behind competitors such as Fast Retailing who have been online in China since 2009 and Inditex who opened up online last year
• Online will come at a cost as tech related expenditures are expected to grow between SEK 600m and 800m in 2014

Valuation

With the Company trading at almost 16x FY 2014 EV/EBITDA, an almost all-time high despite increasing competition, weakening gross margin, increased technology expenditures , continued lower store productivity and declining returns on capital.   Not only do we believe that the out year consensus numbers are too high, but also the multiple should reflect this lowered earnings trajectory, and arguably trade below the  10-year average forward multiple of 12.8x.  Our bullish estimate is already 10% below street consensus on Ebitda for 2015 and we believe the Company is ripe for multiple compression at these levels.  Our price target is under 200SEK.

Risks

• The company supports a healthy balance sheet with no debt and 3.5% of the mkt cap in net cash with minor pension obligations – gives them a lot of flexibility – however given the conservative family ownership I don’t think this changes anything
• Western Europe recovery – they have a high concentration of stores in Europe (73% of sales in Western Europe) and specifically Germany so to the extent that Europe continues on it’s fast recovery – this could boost sales for longer

Catalyst