Inditex - Equity research

Inditex’s recent updates

• Q2 results: Inditex has beaten almost the analyst consensus, demonstrating strong resilience due to online sales boost and the reopening of physical stores (98%).

- 2Q21 EBIT: €310mn vs €126mn estimated by Visible Alpha consensus

- Q2 Sales: €4.7bn, -32% compared to 2Q20

- Q2 Net income: €214mn vs €58mn estimated by Factset consensus

- H1 online sales: +74% compared to H120 Business description

• Activity

Inditex was founded by Amancio Ortega in the 60s as a small family business selling women’s garments. It is today one of the largest fashion groups in the world, owning a portfolio of eight different brands: Zara & Zara Home, Bershka, Stradivarius, Pull&Bear, Massimo Dutti, Oysho, Uterqüe.

Revenues for the year 2020 amounted to 28.286 billion euros with a net margin rate of 12,9%, broken down between its eight different brands. Inditex’s two main brands in terms of sales remain:

- Zara & Zara Home with 69,6% of revenues, i.e €19.685bn.

- Bershka: 8,4% of revenues, i.e €2.385bn.

• Geographic

48,8% of Inditex sales are in Europe (€13.682bn), excluding Spain, representing a 10% increase in sales volume in the region compared to the prior year. Spain alone accounted for 20% of sales volume, with a growth rate of 4%. In recent years, Inditex has bet on a high market potential in Asia. This market remains modest for the moment in terms of sales but is enjoying a high growth rate of 4%. North America is the region with the lowest sales but whose growth rate suggests good prospects.

• Competitive landscape

The apparel industry involves many actors that directly compete with Inditex’s brands. - Inditex (SP): €28.286bn revenues in FY20; 16.9% of EBIT margin.

- H&M (SWE): €21.9bn revenues in FY19; 7.5% of EBIT margin.

- Fast Retailing Co (Uniqlo’s holding): ¥2,290,548mn revenues in FY19; 11.2% of EBIT margin.

- Boohoo: €1.722 bn revenues in FY19, 8.76% of EBIT margin.

- Abercrombie & Fitch: €2.531 bn revenues in F19, 3.86% of EBIT margin.

- American Eagle: €3.160 bn revenues in F19, 8.39% of EBIT margin.

- Gap Inc.: €11.478 bn revenues in F19, 8.21% of EBIT margin.

- URBN: €2.927 bn revenues in F19, 9.74% of EBIT margin.

• Competitive positioning

Inditex positions itself as real global player, using omnichannel retailing. The group will extend online retail presence to cover every country by 2020. It aims to create a unique customer experience through the combination of instore and online shopping.

Inditex is currently committed in a sustainability-driven, digital transformation programme. The objective is to make the digital transition now in the face of declining physical store sales, providing a seamless customer experience. Leveraging the growing influence of Millenial and Gen Z digitally savvy consumers, as well as social media to shape fashion trends, strengthens the fast fashions hand over other fashion groups. However, Inditex can count on a vast network of physical stores with 7,490 locations in 2018.

Inditex benefits from its leading position in fashion retailing. It can count on a solid portfolio of brands operating at different levels of the range. It has succeeded in establishing a highly vertically integrated supply chain that enables it to adjust its production quickly. Inditex seeks to be one of the pioneers of responsible fashion distribution. However, conversely to H&M and Uniqlo, Inditex’s business model (especially Zara) is to offer a higher number of available products from lower to upper garments, meant to mass consumption.

The use of new technologies that improve operational efficiency is part of the group’s strategy. Big data management and IA analysis are likely to provide a better overview of the market and customer expectations. We can think that Inditex has the sufficient financial base to operate this transition.

Industry outlook

The global apparel market is worth $445bn in 2020, and estimates show that the demand for clothing and footwear is steadily increasing but at a decreasing rate, which is quite worrying. Information, convenience and entertainment have become three key metrics for retailers to consider. Information must be collected through improved computer programs and must also be provided to customers.

The fashion industry is facing a worrisome year. The players, including the larger ones, still do not clearly understand where value will be created and when they do so, investment levels are hard to swallow. Digitalisation is essential to address growing consumer concerns about sustainability.

Macroeconomic uncertainty, political upheaval and the continuing threat of trade wars could have a negative impact on economic growth. In North America, tariffs impact both imports and exports. Emerging Asia-pacific markets are still growing at a high CAGR but growth is slowing (mainly due to retail sales). In Europe, growth in fashion retailing is suffering from the continuing uncertainty around Brexit. Fashion retail can rely on emerging countries with a high demographic rates such as Brazil from where the middle classes is rapidly expanding.

Sustainability is at the top the list of the biggest challenges facing the industry and has also been identified as the greatest opportunity. The theme is becoming increasingly dynamic, with fashion players on the front line experimenting with the possibilities of extending the life of clothing. The shift from a focus on generating value for shareholders to companies becoming purpose-led more broadly is reflected in the importance attached in part to last year’s « Getting Woke » which suggested that consumer demand for workwear would have a major impact on fashion players.

Alongside sustainability and digitalisation, the third major opportunity for the industry next year was innovation. No wonder then, given the investment needed to meet these challenges, that small and medium-sized players are nervous about what lies ahead. The industry may evolve towards a big player only industry.

Financial analysis and estimates

• Inditex’s like-for-like sales growth has been steady since FY18. However, a deeper analysis focusing on a long-term trend shows a growth slowdown. Likefor-like sales growth was surrounding 10% before 2015 and declined by an average 5%. We think Inditex’s decline in growth will remain at 4.1% over the long term. The substantial gain observed for the group’s EBITDA margin in 2020 is misleading. This is due to the €1.7bn decrease in rental expenses, now recorded in depreciation and interest expenses with the new IFRS 16 accounting standards. However, the nearly 21% EBITDA margin in 2019 remains above the one of its mains competitors.

• The group has a strong and stable operating cashflow generation due to growing sales and operating costs containment. Same as for EBITDA, cash flows from activities are boosted by the €1.7bn increase in D&A, causing naturally a similar rise for FCF. This is compensated by an increase in CFF. Neutralizing the impact of change in accounting standards, we estimate that the group’s cash-flow generation will continue this trend, with limited growth of FCF, due to the maturity of the business.

• Inditex has decreased its Capex level in FY20, from €1,621mn to €1,152mn, supposing they are entering into a divestment phase. The capex on sales ratio of the Spanish group is worth 4.07% in FY20 (prior 6.2%) but the decline seems to be in line with its main European competitor H&M, which has a ratio of 4.4% (prior 6.10%). It means that potential profitable investments remain limited for the apparel industry, which is not a pretty good signal. We think Inditex’s capital expenditures to sales ratio will continue to decrease, from an average of 0.1% each year.

• Inditex capital structure is very healthy, providing strong guarantees for liquidity and solvency. Net debt is negative, due to big cash reserves with €8.1bn CCE and ST investments in 2020 and a nearly zero debt before IFRS16 standards on leases. Please note that the diagram on the right considers these new accounting standards. The Spanish group’s capital structure is composed of 47% debt and 53% equity. The Ortega family has a significant power in the company, owning 64.35% of the group. Other traditional investment funds have shares in Inditex (Baillie Gifford & Co (1.35%), Capital Research & Management Co (1.26%), The Vanguard Group (1.04%) as this business is still part of asset managers.

• Inditex dividend policy reflects a relative stability, with a traditional 50% payout ratio, which was revised upwards in 2018 up to 60%. It also traduces the fact that, as said earlier, the group cannot reinvest earnings in profitable investments, preferring redistributing cash to shareholders. The dividend policy has been logically suspended for 2020 due to crisis conditions.

Valuation

• Our 12-month €26.2 price target is based on a DCF (DCF based on discount rate 9%, terminal growth rate 3%).

• We adopted a conservative approach for DCF valuation, betting on stable growth and margins. We followed Reuters’ consensus of analysts for Inditex sales and EBITDA until FY23 before opting for a 4.1% growth in sales and a 23.6% EBITDA margin as an average of historical data.

• We anticipate a gradual disinvestment phase, due to less opportunities in the fashion industry. To reflect this trend we decided to lower the Capex to sales ratio each year from 0.1% until FY30, giving 3.3% for the normative year. The working capital of the group should continue to decrease slightly after 2021, with constant receivables and inventories due to efficient operational management and increasing payables from business growth. We then set a 0.5% decrease in WCR to sales ratio.

• The conventional comps valuation could not be undertaken for Inditex since its main competitors have different business models (Uniqlo, Next PLC) and are exposed to different markets (Adidas, Marks & Spencer). H&M, may be the only firm that could be considered as a fair peer, is trading in line with Inditex multiples in LFY (resp. EV/EBITDA of 11x vs 11.4x; PER of 22.8x vs 26x).

Investment thesis

• We set an underweight recommendation for Inditex stock, with a 12-month target price of €26.2 vs €25.69 currently.

• We do think the apparel industry will suffer from costly restructuration due to online sales move, enhanced by the surge of e-commerce retailers which are positioning on the apparel business and by Covid-19 crisis restricting the access to stores. Moreover, Inditex’s brands (especially Zara) own a consequent number of physical stores located prestigious places in big cities that are subject to growing real estate costs.

• Inditex business model hinges on mass consumption and targets almost all categories of customers. It has the largest and most diversified portfolio of garments and tries to create fast-fashion trends by renewing constantly its series of clothes. It is a model in which the offer should shape the demand of customers, following fashion cycles. However, fast-fashion is more and more seen as a non-sustainable model by customers and the circular economy for the apparel industry, in which used garments could be refurbished, is likely to shortly replace fast-fashion industry. The industry outlook expectations clearly show a slowdown for the fashion market. Compared to Uniqlo and H&M for example, we think that Inditex, and especially Zara, is less flexible to adopt slow-fashion, despite its ambition.

• Finally, trading trendlines seem to remain weak for Inditex stock. The rise in Inditex stock price due to the announcement of unexpected positive results was not enough to break the €26.9 major resistance, since the 12th of March. As long as the stock does not exceed this threshold, we think it will evolve within a narrow range of prices, between €22 and €26.