Description

Introductory notes 

Salvatore Ferragamo SpA (“Company” or “Salvatore Ferragamo”) is an Italian luxury brand active in the creation, production and sale of luxury goods for both men and women: footwear (40%), leather goods (42%), apparel, silk goods, jewels, other accessories and fragrances. The product range also includes eyewear and watches manufactured under license by third parties. Please refer to the website for details on the products https://group.ferragamo.com/en.

The Group is present worldwide (40% Asia, 20% both North America and Europe) and sells its products mainly through:

• a network of over 600 single Salvatore Ferragamo brand stores (with leadership positioning on travel retail), managed both directly (DOS) and by third parties (TPOS) generating nearly 70% of annual turnover;

• a wide presence in department stores and multi-brand specialty stores (30% of annual turnover).

The Group's strategy is based on (i) the consolidation of its positioning in the luxury market, (ii) the expansion of the distribution structure in emerging markets and optimization of retail and wholesale performance globally (iii) the optimization of the products’ offer and the composition of the collections. 

Salvatore Ferragamo is one of the most diversified players in the luxury space in terms of products’ range, geographical footprint and retail network extension. The Company benefit of this diversification of the source of revenue. On the other hand, the situation is a source of potential issues too: (i) potential brand dilution among a number of categories (ii) high costs and complexities in managing a large retail network (operating leverage).

The Company is listed on the Milan stock exchange since 2011 (SFER.MI) with the founding family retaining the control. There are around 169m outstanding common shares with Ferragamo Finanziaria having 66% of voting rights (corresponding to 54% of outstanding common shares). 

The CEO of the Company is the recently appointed Marco Gobbetti, previously CEO at Burberry with experiences at Moschino and LVMH. This is only the most recent change in the top management of the Company following (i) the exit of Paul Andrew last April, the externally picked creative director appointed in 2016, while officially an in-house team took the responsibility on the collections (ii) the exit of Eraldo Poletto as CEO occurred in early 2018 after just 2 years in the role. Marco Gobbetti is expected to appoint a new creative designer soon. The top management shakeup and the engagement of an experienced and regarded CEO highlights the credible willingness of the family to maintain control and bet on the relaunch of the brand after the 2020 crisis, although repeated speculations over time about the disposal of the business. 

This analysis is not aimed at questioning the value and awareness of the brand, a typical successful family-controlled made-in-Italy luxury house. The short position and the related recommendation is done purely on valuation.

Certainly, the pandemic strongly hit the business but I will not take the 2020 financial performance as a basis for the analysis and the valuation. Being the pandemic an exogenous one-off event, I will treat the 2020 results accordingly. 

The performance of the stock

Since listing in Milan at nearly €10 per share, the stock peaked in April 2015 slightly below €30 a share and then again in May 2017.

The brilliant performance of the stock in the first 4 years appears consistent with the evolution of the underlying business with revenue jumping from nearly €1bn in 2011 to €1.4bn in 2015-16 and improved profitability with Gross Margin soaring to 66-67% and Operating Margin rising from 16 to 18%.

The below 3-year chart shows that before the news about the pandemic, the stock traded at €19 euro per share and then collapsed slightly above €10. The stock remained depressed throughout most of 2020. Since the end of 2020, it skyrocketed close to €20 a share in just a few months. 

Below I discuss the historic figures in order to set my expectation about the normalized profitability of the asset.

Financial performance

In FY2020 revenue declined by one third. Gross Profit margin fell to 61.8% from the previous 64.9%. Despite the steps taken to reduce costs, operating income turned out to be negative.

As anticipated above, I would like to focus on the key drivers of the business in the last 10 years excluding what happened in 2020, which is truly unprecedented. The business, before the 2020 crisis, had already reached a plateau in terms of volumes/revenue and the profitability was deteriorating.

Revenue peaked in 2016 following a 5-year growing streak. Nonetheless, in 2015 progress was almost entirely attributable to the appreciation of the foreign currencies in which the company recorded sales (RMB, JPY and USD) while 2014 was the last real growth year. The evolution of DOS (see the chart below) confirms that: the Company progressively shifted distribution from TPOS to DOS (the latter moved from 54% of total to 60% of total stores) but the expansion stalled since 2017. Then, revenue started to slightly decline. Being the retail network very large for a company like Ferragamo, the management could focus on increasing the sale density of its network. For the time being, any effort to boost sale per DOS has not been successful with the annual average revenue per store stable at €2.2-2.3m (like 10 years ago).

According to the management, Gross Profit margin got a boost in 2015/2016 from the appreciation of the relevant foreign currencies but then gave back the progresses and turned to the historic value (64%). The corollary is that operating profitability (EBIT) peaked in 2016 too (18%) and since then weakened, ahead of the 2020 crisis.

As far as the cash flow is concerned, appended below is a summary net operating cash flow calculation. 

Starting from FY2019, the Company reports operating leases (rental of properties where are the stores) in accordance with IFRS16. The different accounting treatment affected positively reported EBITDA but determined a widening of the invested capital (inclusion of fixed assets as “Right-of-use” assets in relation to long-term rental contracts) and a correspondent increase in net debt as per the estimated financial liability in connection with the rental commitments. 

In order to be consistent over time, appropriately comparing 2019-2020 with the past performance, I have carried out a desktop exercise to adjust historic data and report what could have been past figures for invested capital, EBITDA, EBIT, NOPAT. I then calculated the return on invested capital for the business accordingly.

ROIC appears to be in a deteriorating trajectory since 2015 and halved to 8.7% in 2018-2019. The waning profitably (discussed above) triggered the ROIC’s fall since 2016/2017 while the turnover was in a sinking trend since 2013. Two possible explanations: (a) with revenue per DOS stalling (it is more complicated to gauge an effect from TPOS due to limited information available), the increase in invested capital did not bring satisfying return in terms of increasing volumes and/or average products price declined.

Investment case

I have tried to assign an economic value to the asset in order to ascertain whether the remarkable recovery in stock market price ​​in the recent months is sustainable in light of the guessed intrinsic value of the business.

I found that based (i) on the historical performance and (ii) the realistically predictable future results (mostly taking into account consensus estimate) the current market value of the asset is far from a reasonable estimate of its intrinsic value. It appears as an interesting short opportunity given the risk/reward asymmetry. 

Appended below is the market value of the business in the last 10 years (stock price at year-end):

Current market price is €16.9 with an Enterprise Value close to €3.3bn. 

Consensus projects a 21% turnover recovery in 2021 and then a further growth in 2022/2023, it seems somewhat reasonable. In accordance with that, EBITDA/EBIT should get back to 2019 level in 2023. It is not projected a full recovery of past highest profitability (2014-16 period).

The business is trading at a forward EBITDA multiple similar to 2017 but highlights a significantly higher multiple on profitability (nearly 31x EBIT and 44x NOPAT!).

Overall, I notice a business whose sales flattened well ahead of the pandemic. With a normalized Gross Margin at 64%, the Operating Profitability deteriorated sharply over the period 2017-19. According to the management, the negative trend was attributable: (i) to the costs associated with the change in the Group’s management and the actions undertaken starting from the second half of 2016 and carried out throughout 2017 aimed at relaunching the Group, (ii) recourse to the secondary distribution channel (outlet) to smooth the inventory management. However, the benefits of the claimed restructuring actions did not emerge in 2018 and 2019 with the EBIT margin continuing its fading path.

A further re-rating of the stock might be possible only in the case the newly appointed CEO successfully carries out a remarkable relaunch of the business sufficient to regain the past top profitability and improve expansion prospects. The existing predictable economics of the business does not support the market price and my understanding is that the stock went too much further by discounting implausible turnaround scenarios.

According to my analysis, a fair valuation of the business is in the region of €12 per share highlighting a huge downside potential coupled with minimal risks on the upside for a short positioned investor. 

To value the stock at €12 with a 9% discount rate, I am adopting the consensus evolution of EPS (€0.18 in 2021, €0.38 in 2022 and €0.55 in 2023) and then applying further significant growth in the ensuing years in order to recoup nearly €120-140m Net Income over the mid-term. 

€12 price for the stock would mean forward 2022 and 2023 multiples as follows: EV/EBIT 23x/17x EV/NOPAT 33x/25x P/e 32x/22x.

I conclude remarking the compelling risk/reward framework for the short positioned investor with limited upside for the stock following the extraordinary market performance of the last few months.

Catalyst

Change in the market mood and/or economic performance in the coming periods.