Monday, 20 March 2017

A tale of two retailers - Thoughts on Value; ASOS Plc (ASC)

I have no problem with the underlying business at ASOS. It is modestly successful. Maybe ASOS will take over the world and become the Amazon of clothes. The top line growth is impressive but it is also risky as the company looks to expand into multiple markets at the same time. Fashion is difficult to gauge and take across borders and many UK retailers have failed in the past to repeat successes at home abroad.

Not all UK retailers are suffering poor share price performance. ASOS is an online catalogue retailer with an exceptionally high valuation at 94x past P/E. ASOS has very low net margins ~3.5% which have actually been falling for 5 years despite the company growing revenue 3 fold in that time period. Note the Amazon comparison again as they also have chronically low net margins. The low and declining net margin of ASOS suggest that the company has limited pricing power.

Insubstantial information; when a company posts on the 2nd page of its annual report its Twitter followers, global reach and Instagram data rather than its profits you may be seeing something of a red flag. Also see this chart from a recent presentation. 

Absolute growth:
Asos Presentation

But my graph of the margins looks like the opposite:

It is noteworthy that the founder Mr Nick Robertson has been substantially selling down his shareholding,  reducing his holding by around 1% and no wonder given that in the last 12 months he has sold down that stake of shares worth £60m. More than the net profit for 2016!  This is not really an analytic but when the founder of a growth business wants to and can sell 1% of the company for more than the net profit it does seem rather steep.

ASOS is a classic growth stock and is expanding rapidly internationally but one is paying a serious premium today to own a company that gets bigger and increasingly less profitable; an internet business is supposed to be highly scaleable.  

ASOS has a substantial international offering and margins are remarkably similar across regions although growth varies markedly:

This may help to explain the strong share price performance. UK retail sector stocks are generally homebirds with little substantial revenue from abroad (unless they are themselves luxury brands.) Therefore ASOS is offering the chance to expand top line growth through aggressive international expansion and given the consistency in margins they seem to be fairly good operators. Therefore top down the mix of growth and diversification may seem attractive to investors.

However note that there are currency hedging derivatives to protect from movements in GBP such that the majority of currency gains are currently being offset by a derivative liability (recognised through equity):

ASOS Annual Report

Share options outstanding are of limited interest with around 0.3% of current shares outstanding being dilutive options. However given the low profitability of ASOS the share based payments charge of £4.5m in 2016 amounted to 9% of continuing PBT. Pension costs are the usual DC scheme costs with no legacy DB scheme.

I was one of the 13m 'active' customers of ASOS - except I bought and returned an item - for free - so I cost them money. I got free delivery followed by a free return. This may explain why SG&A is so high and difficult to scale. Selling clothes online is not like selling standardised items like books or electronics as the fit is incredibly difficult to ascertain and without a high street presence to return and/or exchange items and check the fit in store the logistics costs are huge. I gather anecdotally many customers pay for free next day delivery then order cycles of 20-30 items to try and return many of these. Again a pricey logistics base. 

Distribution costs are 15% of sales and rising with most of the margin expansion in 2015-2016 being generated from warehousing which of course is a scaleable area of the business albeit a chunky one.

Valuation today looks extraordinarily expensive. I assume revenue growth at 27% this year falling linear to 12% by 2022 (5 year revenue CAGR is 24%). If they can retain a 51% gross margin long term and grow revenue as  % of  SG&A over the future period (which is a steep ask as this metric has deteriorated over 2011-2016) then maybe a long term operating margin could be 6%+ which it has struggled to be since the 2012-2013 period. 

At that level I get a range of valuations from £25 per share DCF to £38 per share at 30x 2018E profits. On a DCF basis I see a value around £25 per share at a 9% WACC (due to the lack of debt in the balance sheet). This valuation could be higher with some modest gearing in the capital structure to reduce WACC.

To interpolate the current price we are paying around 46x 2018 estimated (i.e highly uncertain) profits which is steep for a retailer going into a cyclical downturn. The highest analyst estimate I can find is 2018E EPS of 104p below my own 128p for that year. This is how generous I am being and I am giving this basic forecast on a consensus 'buy' rated stock. 

Essentially ASOS needs everything to go right for it and at the present valuation any kind of let up in the growth rate or any deterioration in the margins could see a similar precipitous drop in the value of the shares as was witnessed in 2014. ASOS is flying high but when margins and earnings last fell in FY2013 the stock lost 60% of its value over the preceding 9 months:

Google Finance

I think investors are overpaying for growth in this environment. When one compares the lofty price of the future potential of ASOS with the lowly valuation of Next (who it should be noted retail 50% online) it is anathema to me that such a huge differential can exist in valuations. I suspect this is a case of sentiment - Tech bubble 2.0 combined with the substantial foreign revenues and growth of ASOS in a Brexit based devaluation climate.

I think ASOS has a future but I would be super cautious on the present entry point. Long term I reckon the stock is worth investigation for a growth investor at the £35 per share level (a 35% downside from today) IF they can improve margins in the next 24 months and keep headline revenue growth high. But for a value investor the polarisation of the UK retail sector offers an interesting  view on mispricing. 

Disclaimer: I have no interest in ASOS plc shares at present
These are opinions only, not investment advice. If in doubt read my disclaimer.

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