Description

Inditex is trading at roughly 16x forward FCF, which seems cheap for such a high-quality business. Over the last few decades, Amancio Ortega has built the largest apparel retailer in the world offering fashionable merchandise at affordable prices. The business is a money machine producing +20% ROEs and the family, through its 60% ownership, has become one of the wealthiest in the world.

Inditex has usually traded at 25x earnings, reflecting many of these solid characteristics. In 2015, it even got to 35x and since then, the multiple has contracted significantly. Over the last few months, stock price has declined for various reasons, presenting an opportunity to invest in a great business at a decent price.

Obvious question is why is this stock suddenly cheap? 3 main reasons:

-Russia/Ukraine: Roughly 10% of EBT comes from these markets. The stock is down 25% since January, so seems like it has been already discounted. No insight on Russia, only will say that if these markets are “lost” forever the impact is significant but manageable. There is upside if eventually some of these markets come back. Horrible and sad situation.

-Management: In late 2021, Inditex announced some management changes. The successful Pablo Isla retired as CEO (think he was pushed out). The company named Marta Ortega, daughter of the founder, as new Chair. Oscar Garcia was named CEO. The move upset investors as Isla was widely considered a solid executive. The company is family controlled and many considered Marta Ortega stepping in as something bound to happen, but the move was abrupt. On calls, new management has mentioned the idea is to maintain the same strategy, so we will see. My guess is nothing will change, although this is a complicated business with stores in multiple countries, logistics and technology involved. There is significant room for error and risks to the operation. It is something worth keeping an eye on. My bet is the special culture the Ortega family has engrained, will remain for many years but is no sure thing.

-Shein: This Chinese competitor has gone from 0 to +$20bn in sales basically out of nowhere. Now is the largest fast fashion company in US, with 30% share. For years, the fast fashion industry was quite stable. Inditex dominated with H&M and Uniqlo (Fast Retail) as the two other large global players. This new entrant has proved that there is room for disruption, having implemented the model of quick design and production that made Zara so effective. The company relies on social media especially TikTok and algorithms to see what is trending, and adds these items to their App/online store in days. The model so far is dangerously efficient relying solely online instead of physical stores, producing quickly at scale…and at very low prices. If this model keeps working, then business durability comes into question with a valuation cut being appropriate. The market is large enough for both companies to succeed and keep growing, but this is a big new entrant. There are questions around merchandise quality, reasons for the low-costs, etc...it is a chinese private company so we will learn more over time.

The first of these risks is quantifiable at 10% of EBT. The other 2 are qualitative and important. I can live with them but will pay close attention. Reality is that these businesses only become “cheap” when there are issues, hopefully these dissipate over time.

Inditex: The Business

Amancio Ortega opened the first Zara store in Spain in 1975. Since then, he has built a fashion empire with close to 7,000 stores in 95 countries. Inditex brands include Zara, Zara Home, Pull&Bear, Massimo Dutti, Bershka, Stradivarius and Oysho.

The strategy is simple and it is based on being agile and efficient. The company designs and produces all its merchandise in/near Spain. It also has all the distribution centers in the same country. Stores are replenished twice a week with small batches. Shipments are done via plane for faraway markets. It takes them 15 days to design and produce a new item. The company observes what is “in” and quickly ships to the stores. The model reduces the risk of inventory obsolescence, deep discounting, etc. Another benefit of this model is the low need for working capital, which results in high cash generation. Accounts payable are constantly higher than inventory and AR.

Other retailers have tried to implement something similar but have not succesfuly done so (including Gap). It is a complex operation, in design and production. Also, those that rely on Asian manufacturing, and ship via sea, take many months to get the products to the stores and have to order months in advance. This can be a “killer” in a business where consumer tastes change by the day. The model is not easy to replicate.

The company also has built tremendous scale being the largest apparel retailer in the world (even 30% larger than H&M). This helps in negotiations with suppliers. Finally, brands such as Zara have gained global recognition as quality at a decent price, reducing the need for high marketing expenses.

The company has also been quick to adapt to the changing retail landscape and so far they have set an example for strategy and execution. The model has relied on building a new inventory system which they name RFID that let´s them know where each item sits at any time. This way they know what is selling, what is “cold”, etc. Also helps with returns and ecommerce. They have built an omnichannel platform that leans on its store base, so customers can pick up and return items. Already 25% of sales are through the online channel and growing. They expect to continue integrating he physical stores with online, and see it as a whole consolidated offering (not different services).

Over the last few years, they have focued on productivity reducing 10% of stores. The bet is that they can keep growing sales through the current store base and eventually become more efficient. Capex is expected to decline to $0.9bn a year compared to +$1bn over past years.

The combination of a global solid brand that reduces the need to spend on customer acquisition, logistic, design and manufacturing efficiencies, with a base of profitable well-located stores is key to the company´s success.

I believe there is still ample room to grow given how advantaged the model is. While Europe is highly penetrated and accounts for 2/3 of the company´s sales, I believe Americas and Asia have still ample room to grow. The industry is still highly fragmented with Inditex being the largest player but only 2% global share.

Why it is a good investment?

The way I see it playing is over the next few years, sales recover as the Covid headwinds are no longer in place. The Russia hit will be significant but I expect sales will be much higher in 2022 than in 2019. My guess is multiples will stabilize higher than current 16x, maybe lower than the historic 25x. If they are producing $1.50/share in FCF 3 years from now, we can get to $30 a share with $4 returned over that period. Seems like a possible +60% return. If things don`t go as planned, the risk seems moderate with a low starting valuation, net cash on balance sheet and certain large markets with dominant share and significant profitability.

In an upside scenario, the omnichannel approach leads to higher profitability and penetration in newer markets. Inditex reaches $40bn in sales by 2025 and gets to a higher EBT margin of 19%, yielding $6bn in FCF and they earn their historic 25x multiple. That gets us to a $50 stock in 4 years with $5 returned over that period.

All figures quoted in $, are really in Euro.

Appendix

Catalyst

-New management executes same strategy.

-Manage to defend themselves against Shein and other disruptors

-Sales and profitability stabilize after Covid