Hennes & Mauritz AB Case Study – is the mighty H&M a turnaround?
H&M is a global ‘fast fashion’ powerhouse. The franchise arrived in Victoria Australia in 2014 and the media reported over 3,000 Australians lining up for the grand opening of its first store, an amazing outcome for a brand most Australians should have been assumed to be unfamiliar with. By the middle of 2016 H&M operated 10 Australian stores, by July 2017 that had become 22 and at the time of writing in February 2018 H&M was operating 26 Australian stores. In 2017 H&M’s operating margins from Asia and Oceania were nearly double what it earns in the Americas – H&M does very well from its Australian franchise and given out small market and its limited time here the only conclusion can be the H&M mass appeal is immediately relevant to Australians.
The exponential growth in Australian stores is illustrative of how this company has already operated in other countries for many years. From 1068 stores in various countries in 2004 the company expanded to 1738 by 2008. H&M seems to have completely ignored the GFC. By 2012 the global store count was 2776 (a 60% increase in the 4 years other retailers found the most challenging of the last few decades) and by 2016 the number of stores had grown to 4351 (a further 57% expansion over the 4 years from 2012). The H&M supply chain coped well with this growth, with various evolutions including regional logistics hubs being introduced. The machine worked, H&M management nailed it.
Behind this explosive growth in geographic footprint is the over-riding imperative to ‘grow the storebase’. In recent years that singular focus has come at the expense of other metrics investors look for; most visibly profit margins have been declining since 2011 and free cash generation has, aside from a few spikes, generally remained at 2008 levels. I think this can mostly be explained by the expensive costs of rapid expansion into multiple new and unfamiliar markets. Management distraction and structural shift to online (where H&M has historically lagged some competitors) are also possible contributors.
Until the end of February 2015 the market loved the H&M expansion story. Since early 2015 however fear has taken hold of investors and the share price has fallen from its February 2015 high of ~364 Swedish Krona (SEK) to 142 SEK at market close on Friday 2 February 2018.
In 2016 management changed its tune slightly and informed shareholders that while the company would continue its aggressive expansion never the less its growth target would soften somewhat from ‘store growth of 10-15% per year with continued high profitability’.
The high profitability bit of this target always appeared of lesser importance. In the 2010 report investors were told this by the CEO as his intent for the business:
“…to offer customers fashion and quality at the best price – and in that way increase the opportunities for us to continue to take market share..”
(extracting CEO Karl-Johan Persson from the 2010 H&M financial report, my italics and bolding).
In the same 2010 report the CEO calls out what appears to be management’s real focus: enhance the brand for future growth, invest in the customer proposition and expand the store footprint quickly.
Going back to the 2009 and 2008 company reports the previous CEO nominated the following similar growth aspiration: “H&M’s target is to increase the number of stores with 10-15 per cent each year and at the same time increase sales in existing stores.” (Rolf Eriksen, CEO, 2008 full year report, my italics). For a very long time this company’s singular focused strategy has been to grow its store footprint with a complimentary secondary intent to pave the way into new markets for future new stores. A tertiary goal was to try and sell more in existing stores.
It should be not surprise therefore that in 2017 the balance between sales growth (including via new stores) on one hand and profitability on the other was again missing. The company opened a further 388 stores (an increase in stores of 9% from 2016) with sales growing 4% from 2016 levels. Operating margins fell from 14.9% to 12.4% which in turn cascaded to earnings per share declining from 11.26 to 9.78 SEK.
For 2018 the company notes it plans to continue its aggressive growth with approximately 220 net new stores, concurrent with ongoing heavy investment in digitization and online sales channels development. To put this in context each year over the 5 years from 2011 to 2016 the company grew its physical stores over 10%,yet in 2017 store count grew 9% while in 2018 store growth has been guided to 5%. Assuming management guidance on store growth is accurate the pace of H&M store growth (relative to the size of the existing enterprise) is slowing. Perhaps this is market imposed discipline however more likely this is management’s intent playing out.
To be clear this investment in growth via new stores is positive. While investing in growth does depress current reported earnings due to 1) the expenses incurred in expansion (especially hiring the specialist expertise needed to enter new and unfamiliar countries), 2) the ramp up of the brand in a new market and 3) the time it takes for each new store to find its own operating rhythm (staff, systems, customer familiarity from innovators to early adopters etc) and become as productive as mature stores. Having said that, provided the expansion has been done well the company stands to benefit from its heavy investment program for many years. For a business model as powerful as H&M this makes investing in growing the business a very rational decision.
So let’s look at where we are on Sunday 4 February 2018:
The share price is 142.22 SEK. The recently announced 2017 earnings per share of 9.78 SEK places the company on a trailing PER of 14.5 times. The dividend of 9.75 SEK to be paid over 2018 equals a dividend yield of 6.85%. While this dividend payout could not be considered sustainable (its virtually the entire accounting earnings per share being paid out and of course the company’s extensive growth and transformation plans still need to be funded) 142 SEK is a cheap price for one of the world’s best fashion retailers. The company’s balance sheet is very strong; it has no net debt, 106.5m SEK of assets (of which half are tangible assets), against total liabilities of 47m SEK, management experience (particularly the Chairman) is exceptional and the group remains profitable and cash generative.
From here management has stated it wants to control the pace of growth better (already built into the store rollout guidance for 2018). Although management guidance is the company is unlikely to make its sales target for 2018 (10%+ sales growth with high profitability) I would say the company managing its existing sales better would make all the difference for the company’s share price. Were H&M to have delivered the same 8.36% profit margin in 2017 as they did in 2016 then earnings per share would have been 11.71 SEK, an improvement of nearly 20% to the actual 2017 result. As recently as 2010 H&M was consistently delivering net profit margins of 16-17%.
When H&M opened in Australia in 2014 the H&M country manager Hans Andersson was quoted on ABC saying the company targeted Australia because it was the “last part of the world [they] had left over”. In 2018 H&M’s new markets will be Uruguay and Ukraine. Surely if Australia is the ‘last part of the world’ then three years on the global expansion is mature and done. The next phase of growth would then logically be consolidation and efficiency improvements – getting the best from all these new assets H&M has invested in. In addition to improved efficiency helping profit margins even just ceasing the expensive new market expansion requirements – the specialist expertise to enter a new market successfully and in scale as H&M does is not cheap – will remove a heavy expense.
Were H&M to improve sales by a further 4% in 2018, and concurrently it delivered 2016 profit margins, the company would be expected to deliver earnings per share of 12.18 SEK. At today’s price of 142.22 SEK that equates to a PE of 11.7 or an earnings yield around 8.6%; an outstandingly cheap bargain for a great retail franchise. Is returning to 2016 profit margins so hard when you are the biggest cat in your jungle? My view is no.
In the ‘rivers of gold’ scenario – were the company to deliver 15% profit margins (which it achieved or beat every year between 2005 and 2010) then the company priced using today’s share price would suddenly be trading on a forward PE of 6.5 times earnings or a staggeringly attractive earnings yield of 15.4%. Clearly the share price would explode upwards if the market expected margins would improve back to those levels. The company has delivered 15% profit margins previously while it was concurrently growing aggressively – why not again? The only explanation I could think of which would make sense would be a structural shift online and we know from recent reported earnings even from US companies directly competing with Amazon (for example Kroger and Walmart) that well run retail stores are delivering improved revenue and stable or even improving margins.
So our key question is this: Can H&M management transform this rapidly grown global store footprint to an efficient retail cash generator? The answer to this question rests with the third generation of the founding Persson family, Karl-Johan Persson, who has been running H&M as its CEO since 2009. In addition Karl-Johan’s father Carl Persson remains the Chairman of H&M having worked in the company since 1974 (including CEO from 1982 to 1998). The Persson family has voting control of H&M as well as a very substantial economic stake in the company. I would say the experience driving H&M strategy is first class. If anyone knows the future of H&M it’s the Persson family so if we can imply their view from their actions that can help us align with this remarkable family of retailers.
My view is that the Persson family fully understand the expensive H&M global store expansion program is coming to an end and that the next stage of the company’s life will be extracting better returns from its in-place assets (and perhaps expanding into adjacent business opportunities). Assuming that is the family’s view then the recently announced Persson family intent to reinvest the very substantial (oversized?) 2018 dividend into the newly offered dividend re-investment plan makes sense. For every investor that does not take up their entitlements the Persson stake is slightly concentrated.
So all up I believe owning a piece of this business at this price makes sense. However position sizing for the Balmoral Fund has been very difficult because I believe the H&M business model is in transition. The current valuation is compelling and there is substantial upside if the company settles down and does its knitting well. On the other hand it’s impossible to know if I am reading too much into this and current management is simply not as skilled as H&Ms management teams of the past in navigating the current competitive environment. For the time being we have a small stake and are monitoring it closely so we could scale up that position quickly.
As always if anyone wants more detail please contact me.