Zara has been a trendsetter in fashion for decades. Their “Fast Fashion” model has delighted customers around the world, and propelled their parent company Inditex (OTCPK:IDEXY) from a tiny regional fashion company to a major multinational retailer with 8 distinct brands that operate 7,448 stores in 96 countries. This success has made Amancio Ortega, Zara’s founder and current majority shareholder, one of the wealthiest people in the world. Naturally, one has to wonder if investing in Inditex will do the same for me. To that end, I began to research Inditex as a potential investment opportunity. After completing my research, I concluded that, while the company is financially strong and will likely continue to grow modestly going forward, its valuation is a little too high for an investment right now.
About the Company
Inditex is a clothing and fashion company headquartered in Spain, with its main listing on the Madrid stock exchange under the ticker ITX. They operate 8 brands total; seven different fashion brands – Zara, Pull&Bear, Massimo Dutti, Bershka, Stradivarius, Oysho, and Uterque – as well as Zara Home, a trendy, home goods style brand. Each of the seven clothing brands have very different fashion lines catering to different types of customers. Zara Home, while an independent subsidiary, relies on the Zara brand name and shares the same type of fashion sense as Zara to sell its products. The flagship brand, Zara, is by far the largest and most mature brand. According to the most recent earnings transcript, Zara accounts for two-thirds of Inditex’s revenue. Zara is also the most profitable brand, with an EBIT margin of 18%, according to the most recent annual report (see figure 1). While the other 7 brands are considerably smaller, they are also much younger and earlier in their growth phases. Further, since all 8 brands are owned by Inditex, they enjoy synergies from an integrated global supply chain and workforce while offering customers distinct choices.
The Business Model and Competitive Advantages
Inditex’s biggest competitive advantage lies in its “fast fashion” approach. Traditionally, fashion and apparel companies create “collections,” which would be designed, manufactured, and sold over a period of 3-6 months before being replaced by a new season’s collection. This can lead to huge volatility in a company’s results, as an unpopular collection can weigh on sales for multiple quarters, eventually leading to huge discounting on the products just to get the inventory off the balance sheet.
Inditex built their entire supply chain- and business model – to solve this problem. Everything starts with the customer – they take customer feedback from each store, as well as analyzing sales data trends. This information goes straight to the design team, which is using this data to constantly build new designs or improve existing ones.
Once designs are complete, they go into production. Inditex has an extensive, well-built system of control over their production process. 57% of production happens in Spain or nearby countries (Portugal, Morocco, Turkey), and the company owns 11 of their own factories near their HQ in northern Spain. Overall, 95% of production happens in 12 countries across Europe, Asia, and Latin America. Production decisions are based on both time and cost considerations. For example, a time-sensitive or new “higher risk” item is more likely to be produced in a factory closer to the store – in small batches – to be tested in-store. Field-tested products, products in which demand is easier to forecast, or less time-sensitive products are more likely to be mass-produced in factories based on cost rather than proximity.
After production, products end up in one of Inditex’s 10 logistic centers. From these logistic centers, Inditex can refresh any of its stores (both physical and online) anywhere in the world within 48 hours. Once products are in stores, and eventually in hands of the customers, the entire process starts over – designers receive feedback on their new designs and use that feedback to start new production runs. The entire process for a single product takes only 3 weeks – from customer feedback to new designs to store delivery/refresh. Typically, new styles arrive in-store twice a week. Consequently, the entire Inditex supply chain could be described as simply one giant iterative, customer-centric feedback loop (see Figure 2). More information on how Inditex’s supply chain works can be found on their website.
This approach is great for the customer. It means that Inditex can offer customers the freshest styles and guarantees that any visit to an Inditex brand is going to be unique. It also allows designers to cater their designs very specifically to the tastes of the different markets served by Inditex. This leads to a viral shopping experience, as customers know when they walk into a Zara or Stradivarius, it’s likely everything that they will see will be new. Customers feel as though they need to purchase now or never and are enticed to come back regularly to see the new merchandise. This gives the Inditex brands a unique position in the minds of consumers, creating die-hard brand advocates who go to their Inditex brand of choice 2 or more times a month.
What perhaps best reflects Inditex’s success with this approach is the fact that Inditex does not have, nor have they ever had, an advertising budget. Instead, they rely on providing a customer-centric experience through well-located stores, a unique in-store experience, and quick response to customer feedback to create high customer retention rates and strong brand affinity. Of course, that is not to say that Inditex does not market at all. Rather, they have successfully leveraged inbound marketing and social media to help build brand awareness without much marketing spend.
These competitive advantages have also translated into tangible advantages on the financial statements. Figure 2 compares Inditex to three similar fashion companies – H&M (OTCPK:HNNMY), The Gap (GPS), and Fast Retailing (OTCPK:FRCOY) in 5 different categories – Gross Margin, Operating Margin, Net Income Margin, Inventory Turnover 1 (Revenue/Avg. Inventory) and Inventory Turnover 2 (Cost of Goods Sold/Avg. Inventory). All 4 of these companies are large multinationals that operate numerous fashion brands, and as such, they have significant overlap in customer demographics, making them direct competitors. All 4 of them also have some fast fashion capabilities (most notably H&M). However, Inditex is the only one whose entire business model and supply chain was built around the concept, and they still have the advantage in getting products from design to store in the shortest time.
Looking at the data, we can see that Inditex has significantly higher margins and inventory turnover than its competitors. This advantage is largely a result of the “Fast Fashion” model. By slowly committing new styles to production and rapidly adjusting their styles based on customer feedback, they are able to forecast demand much more efficiently. This means that they are able to significantly cut back on discounting and carry less excess inventory, both of which have huge effects on margins. It’s also worth noting that inventory Turnover Ratio 1 (rev/avg. inventory) is significantly better than the competitors, while Turnover Ratio 2 (COGS/Avg. Inventory) is much closer in line with competitors. This is evidence that they are more efficiently pricing and selling products according to demand and avoiding the dreaded discounting.
Opportunities for Growth
Undoubtedly, the biggest opportunity for growth for Inditex is in online sales. In fact, it seems that Inditex has been incredibly slow in expanding its digital footprint. This seems to be deliberate and in fact is typical for Inditex’s approach to expansion for their physical stores as well (more on that later). While they have brick-and-mortar stores operating in 96 different countries, they have only managed to roll out e-commerce in 46 of them. Major markets, such as Australia and New Zealand, have only been expanded to this year. Overall, online sales accounted for 12% of all Inditex sales in 2017 – which was still a 41% year-over-year increase. Prior to 2017, online sales as a percentage of total sales weren’t even reported by Inditex. Still, while they are late to the game, Inditex’s high customer retention rates, fast fashion business model, and integrated supply chain should translate very well into delivering strong online sales growth.
To penetrate the digital market, Inditex is working on what they call the “full integration of store and online.” In some ways, this strategy seems to be more of a good soundbite than an actionable plan. However, there are a few key parts of the idea of “full integration” that will be growth drivers long term. Most importantly, Inditex is working on integrating the various stockrooms through RFID technology. What this means is that no matter where a customer is purchasing an item, they should have the entirety of the Inditex inventory to choose from. An online order could be fulfilled by a local Zara store, a central distribution center, or really anywhere where the correct item is. Conversely, in-store customers who like a particular item, but whose size is out of stock, could order the item online for delivery to their house. All of this means a few things for the business. First, it helps limits stockouts. Next, it allows Zara to better guarantee quick and rapid shipping – currently, Zara offers same day delivery in major cities and next day delivery as the global standard. Both of these boost sales and improve the customer experience.
Despite its promise, online sales alone won’t be enough to sustain long-term revenue growth. This is because, over time, they will likely cannibalize physical sales to a significant degree. Rather, where Inditex can really find sustained growth is by expanding their brand footprints, which are still relatively small in many major markets. This link shows the number of stores that Inditex operates in each market. When we look at the United States, Zara only has 89 stores. Of the other 7 brands, 4 have no presence whatsoever, and 1 only has an online presence (Zara Home). The other two brands have a combined total of only 4 US stores. By comparison, The Gap operates over 2,000 stores in the US across its 5 brands, and H&M operates over 500 stores. Considering Inditex’s small footprint in major markets, it seems that there is plenty of room for growth. Indeed, in investor presentations, management has guided towards 4-6% store growth for the next few years. Combined with online sales, this should give Inditex decent mid-single digit revenue growth over time.
Weaknesses and Risks
Like all companies, Inditex has its fair share of weaknesses. An obvious weakness relates back to their current market penetration in the US. The Gap is a US-based company, so it makes some sense why they have so many more stores than Inditex. However, H&M is Swedish, and H&M didn’t even open their first store in the US until 11 years after Inditex. So, why does Zara – and the other Inditex brands – have such a small footprint in the US and so many other major markets?
The answer to this relates back to their overall strategy. First, by emphasizing the customer experience and the fast fashion approach, they spend more time than most companies ensuring that every new store is able to integrate into the supply chain seamlessly and provide a similar level of service as other stores. Second, because they have such a small marketing budget and rely so much on word-of-mouth, new stores will often be unprofitable when started. Thus, from a financial perspective, they have to expand their footprint slowly to maintain strong profitability. Further, from an operations perspective, this means they have to take great care in site selection for any new stores, as its unlikely people are going to go out of their way to go to a store they’ve never heard of. All of this means that Inditex has little choice but to move slowly when pursuing new growth opportunities.
While there are many upsides to a slow and controlled approach to expansion, there are downsides that investors should keep in mind. It does leave Inditex vulnerable to disruption in their business model through new competitors or products. It also leaves them vulnerable to losing market share in major to faster-moving competitors such as H&M.
There are three other disadvantages to the business worth mentioning. The first is that their fast fashion approach sometimes causes them to lose revenue on bestselling products, which could be replaced too quickly instead of being refreshed. However, based on historical results, it seems that the negative impact of this is significantly outweighed by the positives of fast fashion. More concerning are the macro risks that Inditex faces. First, and most notable, is currency. Of course, this is something that affects all multinationals. Currently, it seems to be significantly dragging down sales for Inditex. Last quarter, reported YoY sales growth was 2%. However, on a local currency basis, that same number was 7%. Hopefully, over time, currency fluctuations will even out and be a net neutral for the company – however, there is no guarantee of if or when that could happen. The last risk factor worth mentioning for Inditex is that, as a fashion company, it behaves relatively cyclically and will likely be heavily affected by an economic downturn. During the great recession, Inditex actually posted relatively strong financial results. They maintained positive revenue growth, stayed cash flow positive, and continued to expand their store count. Despite that, it wasn’t enough to stave off the broader market selloff, and the stock dropped nearly 50%. Investors should be prepared for this to happen again in a downturn.
The Financial Fundamentals
When evaluating Inditex’s financials, there were many positives. Figure 4 shows a few financial highlights from the past 10 years. As noted before, the company posts strong margins and a high inventory turnover. Its Operating cash flow is closely mirrored to its net income, showing that its income is backed by cash. It boasts an ROE of 26%, with a 10-year average ROE of 27.73%. It manages inventory very well, with minimal inventory buildup outside of what would be expected by typical growth. It carries very little debt. It also pays a dividend. Overall, the financial statements paint the picture of a very healthy company in a strong financial position.
Valuation with a Three-Statement Model
To estimate a valuation, I created a three-statement financial model that projected cash flows from 2018 through 2024. I then used these cash flows for a DCF. You can find the entire model in excel format here. To build this model, I made a few key assumptions. First, I used revenue growth projections of 7% for the next 3 years and 5% for the following 3 years. These numbers are derived from the growth in online sales, as well as the projected growth in store count of 4-6% annually. They reflect the slow but sustainable growth strategy of the company. I projected a terminal growth rate of 2%, the rate of inflation. I kept expenses, depreciation, and taxes growing consistently with revenue to maintain historical profit margins. I maintained the same dividend payout ratio, and targeted management’s stated target CapEx goal. For simplicity, I kept most of the line items on the balance sheet static, with the exceptions of inventory, receivables, payables, and PPE (CapEx). Finally, I used my personal investment return objective of 8.5% as the discount rate. I use 8.5% because – depending who you ask and how you measure – the historical market return on equities is between 7 and 10% – so shooting for at least 8.5% gives you a good chance of beating the market. With these inputs, the estimated valuation for Inditex is 63,925 Euros. This comes to a target share price of 20.51 Euros. For the ADR shares (2/1 redemption rate), this translates to a price of $11.90. This implies 34% downside towards the current share price of 27.52 Euros, or $15.98 for the ADR shares.
Considering the state of the market, it makes some sense that the valuation for Inditex is so high. The company has great financials and pays a decent dividend. However, the current valuation implies that it’ll be hard for Inditex to beat the returns of the historical stock market over the next 3-5 years at this current price point. With a sensitivity analysis, I found that the market’s implied return for the current share price would be 6.9% – just below the historical range of returns of the S&P 500. My takeaway from my analysis is that an investment in Inditex at today’s price point probably won’t keep up with the market. This is especially true considering that as interest rates continue to rise there’s a good chance that huge dividend-paying companies such as Inditex will see their valuations compressed as money flows from them back into fixed income assets.
While I don’t think Inditex is a buy today, the underlying fundamentals are very strong. The business is healthy; financials are strong, there are clear and executable growth strategies in place, there’s a good and experienced management team, and the company offers a decent dividend yield. Considering these fundamentals, I will continue to follow the stock and wait for a market pullback to begin building a stake. If the stock falls into the range of 18-23 euros, I will likely initiate a position.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.