Description

Summary:  Hugo Boss (ticker: BOSS) is a German brand of menswear that is contending with increasing fast-fashion competition, secular trends away from formalwear, a slow death of department stores, and e-commerce pressure.  At 22x LTM EPS / 18x consensus FY19 EPS, I think BOSS is an interesting short.  I see about 40% downside from current levels, with a target price of €45.

Thesis

1. BOSS is essentially a formal segment player.

50-60% of revenue is from formalwear i.e. suits. Less than 15% of revenue is from womenswear (management’s efforts to grow this have been relatively unsuccessful). Suit-focused comps such as MW/TLRD in the US or MOSB in the UK (which is a large market for BOSS) trade at FY19 EPS multiples in the 9-15x range vs 18x for BOSS.  I would argue that men’s formalwear is a relatively unattractive sector and commentary from LVMH confirms that formalwear is a declining area.  Sell-side such as C.Suisse notes that suit sales volumes in Europe are flat.  On a secular basis, the trend in the workplace is towards more casual, more comfortable clothing; this is amplified by the co-working trend.  Compared to Europe, the US tends to be ahead of the curve on behavioral trends such as this, and if the ongoing travails of suit-heavy US brands such as MW/TLRD, J.Crew and Banana Republic (GPS) are a precursor of what will be happening in Europe, then that is not a good sign for BOSS.

The steady increase in supply makes the sector structurally challenged from a pricing-power perspective.  An adjacent segment – tuxedos – has shown that the barriers to entry in formalwear are dropping due to better use of technology and e-commerce. Analogous forces are driving constant entry of new boutique menswear brands or suit specialists (e.g. SuitSupply in the UK).

2. Apparel retail turnarounds are hard.  Odds are not in BOSS’s favor.

BOSS sits at an interesting intersection of ‘mid-range’ and ‘affordable luxury’; in suiting, its price point extends anywhere from a J Crew / Brooks Brothers price, up to an entry-level end of an Armani or a Zegna.  The mid-range segment of apparel is notorious for the difficulty in reversing a string of negative SSS numbers.  J Crew, KORS, COH, ANF, GPS are examples of that.  Luxury retail tends to do better with turnarounds due to stronger brands and greater designer credibility (e.g. see Gucci/Kering/PPR and Burberry turnarounds).   BOSS just posted a positive SSS quarter after 2 years of negative SSS, but I do not believe that hopes of high long-term top-line growth are sustainable.

·       No credibility for the high-end.  In upscale casual menswear, it is generally best to be a French or Italian brand.  As a German brand, BOSS does not have this.  BOSS also does not have a storied, positive brand heritage that it can capitalize on, e.g. Hermes’s equestrian history, Chanel / Coco Chanel design credibility.  The way other German brands that were in a similar position solved the issue was via accentuating performance and engineering (e.g. ‘vorpsrung durch technik’ in the case of Audi) – not something immediately transferable to a general menswear brand that does not play in a narrow niche (e.g. winterwear / North Face / Canada Goose / etc).

·       No credibility for the low-end.  Cannot outcompete fast-fashion (Zara/H&M/Uniqlo) on time-to-market, merchandising expertise, and supply chain. Even those players are facing market saturation issues due to a large store base and declining penetration opportunities.

·       No compelling ‘killer’ product. Burberry is known for its signature beige plaid pattern and trench coats. BOSS does not have a comparable immediately recognized product, but only a certain, conservative aesthetic.

·       Equally importantly, top-line growth is harder to get once you’re at a certain size of footprint, and I believe BOSS is rather over-distributed.  BOSS has c.1,100 stores globally, of which half are freestanding stores & outlets and the other half are SiS (shop-in-shops); a third of revenue is from wholesale.  In contrast, Armani, Burberry & Zegna each have 500-600 stores.

3. Management’s action plan is not entirely convincing.

Management’s plan to restart growth is as follows: (1) reduce the 4 brand lines (Black, Red, Green, and Orange) to 2 (BOSS and HUGO), with a 30% pricing differential between them; (2) focus on growing the casual segment and move away from ‘luxury’ towards more affordable ‘premium’; (3) make pricing uniform across geographical theaters (e.g. prices in the Eurozone to be the same); (4) raise prices on suits; (5) keep the store count reasonably constant, but increase sales/sqm by 20%; (6) make the website better (especially the mobile version).

I think this plan is inadequate relative to the scale of the challenges facing this business due to the reasons outlined earlier in this note.  In the short term, this plan (along with reducing store space available to womenswear and refocusing on menswear) led to a 3% comp in the most recent quarter; I doubt that the bump will be sustained.

4. Risk-reward skewed in favor of the shorts.

Stock is currently at around €78, up about 60% from 52-week lows.  BOSS posted a positive 3% comp in 2Q, but for the reasons listed above, I do not believe that this will be sustained over the long term.  Other levels for the stock bump could have to do with the fact that the EBIT margin in the prior year’s 2Q was significantly depressed on a one-time basis; the EBIT comp during the last quarter was thus particularly ‘easy’ to lap.  Management communications may also have played a role; management has been on a relentless promo tour, presenting at least 20 times over the past 12 months at various NDR / conferences / investor meetings.

I assume retail and wholesale sales deteriorate at a low pace in the medium term due to structural formalwear issues +  broader competitive and secular e-commerce factors.  I also assume gross margins will decay due to an intended focus on lower-priced, casual items as well as a continuously competitive sector.  My capex is in line with management guidance.  Net-net, I expect EPS to decline by a 3% CAGR in the medium term. With a 14x LTM exit P/E multiple in 2019, this is a ~€45 stock, i.e. ~40% of downside from the current price of ~€78.

(Note: the model assumes a cash-build, no dividends in the interim)

On the flipside, if BOSS meets the FY19 street consensus and is priced at 19x LTM exit P/E (the average multiple since the 2012 IPO, at a period when BOSS was considered a new-openings and incremental womenswear-led growth story), it would be an €86 stock, which is about 10% upside from today.  This leads me to believe that the set-up is attractively skewed for a short vs a long.

Risks

Near-term comps risk. SSS numbers are the metric that the market is generally focused on.  If management can sustain a 3% positive SSS in the coming quarters, the stock could re-rate further.  However, I think that a 22x trailing P/E multiple should limit the room for a significant rally and the longer-term fundamental picture is challenged and favorable to the short.  To me, the risk-reward is sufficiently good to warrant at least a small short, with a gradual scaling up as conviction is corroborated/grows via events such as continually weak SSS or further dividend cuts.  

Reasonably conservative balance sheet.  The short would work better if BOSS had significant outstanding indebtedness, but to management’s credit, net debt is below 0.5x EBITDA.  FCFF generation in recent years was consistently sufficient to pay out at least 50% of earnings as dividends; the current dividend yield is around 3%.  However, like most retail businesses, the B/S is far more leveraged when considering the €1.4b of OBS rent liabilities.  A change in IFRS rules would require BOSS to put these operating lease liabilities on the B/S starting January 2019.

Superficially reasonable working capital management.  Inventories as % of COGS have expanded by 400bps in the past 3 years, but this was offset by a lower intensity of receivables and greater use of payables. As a result, net working capital as % of sales was fairly stable.  The setup for the short would be better if working capital worsened.   

Formalwear volumes rise.  The potential risk is that the trends in the workplace reverse, people abandon a more relaxed dress code and increasingly return to wearing suits.

Management generates a successful turnaround.  The risk is that either management’s existing plan works out, or management pivots and creates a new plan that is ultimately successful in generating sustainable EPS growth. Given the cards that BOSS has been dealt, I believe the odds of a successful turnaround are gradually dwindling. 

Buyout risk.  BOSS could be taken over by a PE, a larger house-of-brands, or a Middle-Eastern / Asian ‘prestige’ buyer.  Given the size and profile of the asset, I view this risk as reasonably low.

Data risk.  I do not have access to granular data on credit card purchases or website visits, data points that may give larger investors in the retail sector an edge.  From a paranoia-angle, this could potentially mean I am the less-informed investor/participant in the retail sector. 

Catalyst

Renewed quarterly disappointments (next earnings call release later this week).

Competition and secular factors in formalwear.

Multiple compression.