Inditex Is Priced for Perfection
Late last year, Inditex (ITX) shares broke the psychological barrier of €100, an event that coincided with buy ratings from all major international brokers. Inditex was the only Spanish stock recommended by many of them. The situation represents a dangerous pursuit-of-prices behavior, considering that Inditex was one of the three best-performing stocks in 2012 in Spain’s IBEX 35 index.
Since Spain’s market peaked in 2007, the biggest drops in price have happened in small-cap companies, a sector of the market with plenty of opportunities. Over the last five years, the IBEX 35 lost 24%, including dividend, whereas the medium-cap index lost 30% and the small-cap index lost 70%. This article is meant to illustrate how, depending on the price, the stock of a great company may not be a great investment.
The Inditex story
Inditex is a leader in the textile industry, one of the biggest growth stories in Spain, and the subject of a Harvard Business School case study in operational efficiency. The company opened its first store in 1975 and now boasts 5,887 stores around the world. At the same time, Amancio Ortega, its founder, has evolved from the owner of a little housecoat manufacturer to, according to Forbes, the third-richest man in the world.
Inditex’s operating strategy is a perfect example of quick response. Although the fashion business has traditionally been based on forecasting trends for the year ahead, Inditex tries to spot what customers currently demand and replicate those trends in the shortest time possible. A new product can be imagined, designed, completed, and available for purchase in four weeks. For modifications of existing designs, the time period is reduced to two weeks.
To implement this strategy, the company trains and encourages its sales force to continually generate high-frequency feedback, which is analyzed by the design team daily thanks to a sophisticated IT system. A high degree of vertical integration allows for a reduction in the bullwhip effect—that is, the tendency for fluctuations in final demand to be amplified as they are transmitted back up the supply chain.
Two other distinctive features of Inditex’s strategy are its continuous renewal of the merchandise available at its stores and its low level of inventory (stores receive new items twice a week), which help create a sense of scarcity and motivate customers to avoid deferring their decisions to purchase. The average customer at ZARA (the main brand of the group) visits the store 17 times a year, a rate four times higher than that of competing brands.
In terms of its promotion policy, Inditex’s advertising spending is minimal and is restricted to specific campaigns made at the beginning of the sales seasons in September and December. The company’s image is transmitted mainly through ZARA stores situated in landmark locations.
The company’s customer focus and cost control through operational efficiency have enabled it to achieve a perception of high fashion at a reasonable price.
The effectiveness of Inditex’s overall strategy has resulted in gross margins in the low 50s, with operating margins in the low 20s and net margins in the mid-teens. Thanks in part to its lower advertising costs, Inditex marks down fewer products compared with its competition (15%–20% versus 30%). The quick response cycle and the low level of inventory have helped the company maintain a negative working capital, which has made it easier for it to finance growth. In some senses, Inditex is the textile sector’s Dell.
At current prices, Inditex is trading at a P/E for 2012 estimated earnings of 27.12, which represents a premium of 31% over the average P/E for 2004–2011 (when the company was one-third smaller and had more room for growth) and is 21% above that of its peer H&M, which has a similar growth profile for 2013 and 2014.
In an article I wrote about Inditex last December, I did some calculations involving fourth grade arithmetic to find out what the market was discounting and concluded that, using Graham’s formula based on the P/E, the market was discounting future growth of 12%. So, assuming one like for like (LFL) 6% (a figure that has averaged 3.9% from 2004 to 2011), it would take a pace of 550 store openings per year to achieve that growth. For 2012, the figure would be around 480.
Indeed, if we take a look at one of the most bullish reports, we see that to justify valuations by discounted cash flow analysis above the current price, analysts rely on estimates 3%–4% above consensus, further momentum LFL 15%–20% EPS growth per year through 8%–10% growth and operating leverage space from mid-single-digit LFL sales growth, and a discount rate for free cash flow of 8%—entirely inadequate for a company with no leverage. From all these figures, we arrive at a valuation of €120 (16% above its current price). We can conclude that valuations above the current price consider only extremely rosy scenarios for the company and that Inditex is priced for perfection.
Not only is Inditex’s stock expensive compared with its historical price and the price of its peers in the industry, but the stock also has a massive following of institutional investors that possess a 36.85% stake. Only 3.85% is in the hands of small investors. In addition, technical factors reveal a parabolic share price with deteriorating relative strength and slowing momentum—very similar to the situation of Apple before its correction.
I think those who invest in the company at these prices have little money to make. Assuming that the more bullish analyst predictions turn out to be correct, investors can expect a return of 10.59% per annum ex ante.
The downside risk is considerable if the company does not meet market expectations, which it will do unless it improves significantly on its already very good performance in 2012. In a market such as the Spanish market, in which many investors have thrown in the towel, much better opportunities exist.
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