H&M: fortsätter växa, fair value kvar på 162 kronor

Although we still believe that Hennes & Mauritz (the world’s second-largest fashion company in terms of revenue) benefits from scale advantages and brand recognition, we think these are no longer sufficient to guarantee medium- to long-term economic profits in an increasingly competitive environment, hence our no-moat rating for the company. Further, the company's responsive supply chain initiatives seem to no longer be working, as sales faltered and inventory days grew from about 117 in 2015 to 138 days in 2018, while fixed store costs are becoming an increasing drag on profitability as store traffic falls in mature markets.

We believe some of the company’s recent troubles can be addressed by closing underperforming stores; speeding up the supply chain through 3D sampling and radio-frequency ID; introducing artificial intelligence to better detect trends and improve personalisation; and investing in improving the quality/price proposition. However, we don’t think the competitive environment is getting any more benign. While H&M can still gain share from weaker incumbents, we expect it to be harder than it used to be as fitter, more focused competition continues to emerge (low-cost companies such as Primark, discount firms, niche brands, and private-label offerings at Amazon or Alibaba, for example).

We expect the group to grow at 5.3% on average over the next 10 years (at constant exchange rates), with 3.9% growth in the core H&M brand (just marginally ahead of the industry’s low-single-digit increase) and 14% average annual growth for new concepts. We expect gross margins to remain flat, as discounting should abate through gradual product mix improvement, offset by needed increased investments in the quality/price proposition. Further, investments in technology, e-commerce, and operations for newer brands will dampen margin expansion, despite improved H&M store-base costs in the developed markets. We expect operating margins to improve to 2017's 10% level by 2023, after dipping to 7% through 2019-20.

Fair Value & Profit Drivers  |  26 Jun 2020

We are keeping our fair value estimate of SEK 162 unchanged for Hennes & Mauritz after incorporating the COVID-19 impact on 2020 results. We expect a low teens revenue decline on an annual basis with sales down 7% in the third quarter and up 4% in the fourth quarter.

Our long-term expectations for the group are unchanged, as we assume 5% average revenue growth over the next 10 years. We are encouraged by the recent sales acceleration to 6% at constant currencies (versus 3% in 2018 and 2017), with only 2% growth in store count, as well as stabilization in gross margin and improvement in inventory days from 138 to 125 in 2019. We are also encouraged by increasing closures of unproductive stores, which should help margins (175 stores are planned for closure in 2020).

Investments in faster product development through 3D sampling, AI for more effective merchandising and trend detection, RFID for faster product handling and better inventory oversight, in addition to investing in the quality/price proposition and some store closures, should help stabilise comparable sales. Nonetheless, we don't expect the H&M brand to return to prior high-single-digit revenue growth, given its maturity and intensifying competitive environment.

We expect newer brands to grow faster, with upside from both geographical expansion and online sales development. We believe that smaller brands benefiting from H&M’s scale can gain share by offering a better quality/price proposition in a higher price bucket compared with the core H&M brand.

Although we expect current inventory overhang and discounting to abate in the coming years, we don’t forecast gross margin recovery in an increasingly competitive market and given foreseeable quality/price investments. Operating margins would remain under pressure in the near term due to the COVID-19 outbreak and investment programs but should recover to 2017 levels over time. We forecast capital expenditures in the 5% range (down from 6% over the past five years) as retail expansion slows. They should be channeled to store refurbishments, retail infrastructure development for smaller brands, and technology.

Scenario Analysis  |  26 Jun 2020

Our bull-case scenario implies a return of industry outperformance for the H&M brand, with 7% average annual growth over the 10-year time frame, as turnaround efforts bear fruit and product improvements help regain both previously lost as well as new consumers. We would expect lower cannibalisation of offline sales by online and forecast average brick-and-mortar sales growth of 3% annually (versus flat in the base-case scenario), while online would grow at 16% annually (versus 14% in the base-case scenario). We also expect stronger performance of younger brands under this optimistic scenario (we see them growing at 15% on average annually, versus 13% under base assumptions). Better fixed-cost absorption and lower discounting would lead to operating margin improvement to 12% by 2028 (versus 10% in our base-case scenario) from 7.6% in 2019, still below 20%-plus historical levels. Under these optimistic assumptions, our fair value estimate for H&M shares would be SEK 223 per share.

In our bear-case scenario, we assume that the H&M brand will lose market share, as brand strength declines and cannibalisation of sales occurs. We assume negative 2% annual growth for H&M brand’s brick-and-mortar stores (flat under base assumptions) and 9% growth in online business (13% growth under base assumptions), which brings total H&M brand growth to flat (versus 3.8% under base assumptions). We also assume lower growth at H&M’s newer concepts with 5% 10-year growth versus 12% under base assumptions. Margins would remain under pressure through discounting and cost deleverage and would average 6.7% over the next 10 years. Were this pessimistic scenario to play out, our fair value estimate would be SEK 81 per share.

Given the range of possible outcomes and uncertainty over management actions to stabilise the main brand performance, investing in H&M shares currently comes with high uncertainty.

Economic Moat™

We believe H&M benefits from traces of two moat sources: cost advantages and brand intangible assets. However, we lack confidence that these sources are strong and persistent enough to allow the company to generate excess returns over the next decade, which leads us to assign a no-moat rating.

We believe H&M’s cost advantage arises from its production scale, which allows it to lower unit costs for carryover items, in combination with a faster supply chain for more fashionable items. While a globally known brand doesn’t ensure pricing power in this industry, it helps firms gain access to real estate at more favourable terms and lower marketing budgets while entering a new market.

Thanks to its size, H&M enjoys some purchasing power with suppliers, illustrated by its roughly EUR 20 billion in revenue in 2017 compared with EUR 12.7 billion-EUR 14 billion at Gap and Fast Retailing. Also, gross margins are at 53% even after the current high level of discounting versus the peer average of 46%. Further, product prices are the same as or lower than most peers, despite higher gross margins, further suggesting higher volumes and better scale. However, a bloated operating cost base, with store densities on the lower end of the peer range, makes operating margins comparable to peers. We think that H&M has room to use its scale advantage in a better way by investing in the quality/price proposition of its products while rationalising store footprint in the developed markets (two thirds of the store portfolio have contract clauses of three years). Nonetheless, it may prove to be a lengthy and challenging task in an increasingly competitive environment against scaled e-commerce retailers or more efficiently run brick-and-mortar retailers such as Zara or Primark.

H&M’s business model balances longer lead times and unit cost reduction for basic carryover items (lead times up to six months) with shorter lead times for high-fashion items, which can be delivered to stores in as little as several weeks. Store assortment is refreshed with new items daily, encouraging repeat customer visits. Despite not having precise figures, we estimate a relatively large part of assortment to be advance orders, given that around 80% is sourced from Asia and slightly less than 70% of sales are generated in Europe (sourcing is regionally matched to an extent). Thus, H&M likely incurs higher fashion risks through advanced inventory planning and ordering compared with peers that have faster and closer supply chains. This is seen in the company’s design mistakes in 2017, which led, among other reasons, to higher stock and discounting levels.

Most shipments from factories go directly to market-based logistic centers that support stores. The stores themselves do not have backup stocks but are replenished as required from these centers. We think this model enables inventory levels to be determined on a pull instead of a push system and removes some of the gross margin risk associated with promotional activity to clear excess merchandise.

The company can leverage its purchasing cost scale for the smaller brands in the group, which currently account for 10% of the group’s revenue and target different customer niches.

We believe that H&M can continue growing by taking some share from weaker midprice brands, department stores, and nonspecialised companies (which still account for around 50% of the U.S. market, according to Thredup Report, down from 66% 10 years ago). Nonetheless, we expect gains to be more difficult than they used to be, as fitter, focused competition continues to emerge (low-cost companies such as Primark, discount firms, and niche and private-label brands made available to wider audiences on platforms such as Amazon or Alibaba, for example).

Despite H&M brands’ high global recognition (it is number 23 by brand strength, according to the Interbrand ranking in 2017, down from number 21 in 2010), we don’t see brands yielding significant pricing power in the low-cost apparel industry, in contrast to luxury goods, where brand choice helps communicate the financial status of the wearer and sometimes provides storage of value.

Our view is supported by a few cases of market share losses and margin erosion for companies with strong globally or locally known brands, with recent examples including Gap, Abercrombie & Fitch, and Esprit, as well as general industry price deflation. Case in point, global apparel industry expanded by around 3% in terms of volumes but only 1% in terms of value annually over the past five years, according to Euromonitor, and apparel prices have been largely flat in the U.S. since the 1990s, running well below CPI inflation. Consumers are also becoming less brand-loyal and more price-sensitive, some studies show. For example, two thirds of millennials say they are willing to switch brands for a discount of 30% or more, according to McKinsey’s 2018 State of Fashion Report.

We do think that a recognised brand helps penetrate new regional markets with lower marketing costs (H&M’s marketing budget is around 3%-3.5% of revenue, lower than 4% for Gap and Fast Retailing, despite continuous new brand launches). Brand recognition also helps get better access to real estate at more favourable terms, which smaller and less-known peers may lack. Although the quality of real estate is somewhat lower for H&M brand than for peer Inditex’s Zara--given that H&M has more nonprime locations in the mix, store count is twice as big, and rental expense per square meter is around half that of Inditex--it is still present on the main shopping streets, which helps maintain the brand cachet.

Moat Trend

We believe that H&M’s moat trend is negative. Our forecast returns on invested capital over the next five years averages 9%, below the 12% average the previous three years, despite initiatives of speeding up the supply chain, closing select stores, and improving trend detection, as well as faster growth for smaller brands.

The company’s gross margin has declined from peak levels of almost 63% in 2010 to 53% in 2018, driven down by discounting. Inventory days have increased substantially from the mid-90s before the financial crisis to 138 currently, which compares with the relatively stable 80-90 days at Inditex. Operating margins shrank to 7.4% in 2018 from over 20% before 2010 and ROIC dipped to 7.7% in 2018 from midteens in previous years. We believe some of the company’s issues have been self-inflicted, such as continuing growth of its store base in mature markets, which resulted in cannibalisation and falling traffic as an increasing share of demand was shifting online.

However, primarily, we’d argue that competition has become substantially tougher recently with the emergence of more-focused companies like low-cost Primark (which operates at 20%-50% lower prices and lower gross margins than H&M, compensating for it with higher sales densities), other fast-fashion peers investing in the quality/price proposition, discount firms like TJ Maxx gaining ground, as well as online business models emerging (Asos and Boohoo, for example) and own-label or niche brands made available on platforms such as Amazon and Alibaba.

We also believe the apparel industry is undergoing significant changes driven by a shift to online buying. The emergence of platforms such as Amazon in the U.S., Alibaba in China, and Zalando and Asos in Europe lowered entry barriers for the smaller brands versus big players and increased choices for consumers. It also increased price transparency, making customers more fickle and price-sensitive, as shopping for a better price became easier.

Access to and the analysis of the many consumer data points that are available to online platforms can result in superior trend forecasting. In terms of basic apparel, bigger e-commerce platforms can scale their offerings quickly, given their vast addressable customer base and likely aggressive pricing policies, as they look to establish themselves in the category with little regard for near-term margins.

Risk & Uncertainty

We assign a high uncertainty rating to H&M shares. Correctly predicting fashions will always be a risk, and performance could suffer if designs or quantities do not match demand, as is the case currently. Brand strength could also suffer if fashion or quality misses were to become a pattern. Competition in the apparel space is always a viable risk. Many competitors are trying to implement the fast-fashion model in their businesses including Gap, making it more likely that other brands may be more competitive on price, which may hurt market share. Additionally, growth in online fashion platforms such as Amazon, Zalando, Asos, and JD.com provides broad consumer access to smaller, niche brands that can, as a group, take share from bigger companies over time.

Finally, consumer preference for more experiential things like travel may hurt discretionary spending. Margins may be hurt as the company invests in this growth, is subject to discounting pressure, or if mix shifts toward lower-margin products or brands. Broader economic factors also remain a risk for the company. Consumer confidence, high levels of student debt, global macroeconomic headwinds, and low wage growth make us concerned that consumers may pull back spending across the board, although this might also drive increased demand for low-priced products such as H&M's.

Financial Strength
We believe H&M is in reasonably good financial shape with a net debt/EBITDA multiple of 0.19 in 2019. Despite the shock of COVID-19 containment measures on sales and profits, we believe the company will preserve its liquidity position by skipping dividend. We see Hennes & Mauritz moving to net cash position at the end of 2020.

We expect H&M to restore the dividend from 2021, however, we note that for the years 2014-18 dividends were outstripping free cash flow, leading to leverage increase for the firm, which we didn't consider a sustainable practice. Over the long term as margins slightly improve and capital expenditures are scaled back due to