Inditex
a fundamental analysis
By Manuel Maurício
July 24, 2020
Symbol: ITX (Bolsas y Mercados Españoles)
Share Price: €22,6
Market Cap: €70,4 Billion
Inditex: Share Price History
Source: Google
The mother of Fast Fashion
The way traditional clothing retailers work is they design the collections 6 months in advance, outsource the manufacturing of the whole collection at once from some asian country, ship it in containers to stores across the world, sell what they can at full prices and then if people don’t like their models, they will mark them down after the season is over to try to get rid of it.
Needless to say, this model is suboptimal and was ripe for disruption. Retailers must have the foresight to predict what people will want to wear 6 months in advance, while also needing high amounts of working capital in the meantime (inventory, receivables and payables).
The guy who turned this model upside down back in 1974 was the Spanish Amancio Ortega. After a German client failed to take delivery of a big batch of lingerie pieces, Amancio immediately understood that he needed to have “5 fingers in the client and 5 fingers in the manufacturing“.
Today, Inditex has 7.412 stores making it the largest clothes retailer in the world. The group is composed of 8 brands: Zara + Zara Home, Pull & Bear, Massimo Dutti, Bershka, Stradivarius, Oysho and Uterque. Each one targets a different audience.
To understand Inditex, one has to understand the secret to its success: its operating model.
They call Zara the mother of Fast Fashion, and its model is studied in business schools around the world. Speed and effectiveness are the 2 pillars of Fast Fashion. Instead of commiting to the whole collection 6 months in advance, Inditex will commit to only 25% of its new season’s line. At the start of the season it has commited 50%. That leaves 50% of the collection to be designed and manufactured within the actual season, adjusting to the trends and tastes of its customers in real time. For that, it relies on an masterfully operated system of supply chain, distribution and feedback on a global scale.
It all starts at “El Cubo”, the company’s headquarters in Arteixo, Galicia. (the main building is a cube, hence the name).
Source: Google Maps
That’s where 300 designers will brainstorm around what they’re going to design for their customers. With 10 factories on its premises, they are able to rapidly prototype whatever garment they wish.
The company has an army of people dedicated exclusively to trend researching, be it by attending fashion shows, going to nightclubs or navigating through social media. With this fresh information, the designers will design several different pieces of clothing, manufacture small batches on one of the 10 factories, ship them to the stores and then wait for the stores to send feedback back to the headquarters.
It takes Inditex about 3 weeks from spotting a new design on the catwalk to copying it and start selling it in its stores (6 months for the rest of the clothing industry).
Each store then feeds information back to the headquarters on what has been sold daily (remember the 5 fingers on the customer?). This way the designers will know in real time whether the Portuguese customers are buying more of the listed patterns or the checkered patterns; if the Chinese customers are more into pink shirts or yellow blouses.
With this feedback, the designers back at the headquarters can immediately iterate on their designs and fine tune the collection. On top of that, the stores are also independent to order what is selling the most, so the customer’s needs are the constant focus all around the organization.
Supply Chain
This flexibility is obviously impossible to achieve if your whole collection has already been manufactured in some distant country. This is why Inditex uses a mixed model of traditionally long distance factories together with proximity factories.
The simpler and more classic products (think basic colored sweaters) that sell in more stable volumes are usually made by suppliers spread across Europe, North Africa and Asia where the lead times are longer.
The trendiest and more complicated clothes (think women’s suits in new patterns) are manufactures in its own factories or in nearby factories where it has a high degree of control (like joint ventures). It comes as no surprise that 54% of its manufacturing facilities are in Spain, Portugal, Morocco or Turkey, and the remaining 46% in long distance factories. This allows it to receive the trendiest clothes much faster at its distribution centers and ship them to the stores immediately.
Some of the benefits of this model are that it allows to sell more items at full prices and to lower the amount of excess inventory at the end of each season, leading to lower discounting, and higher margins.
And if a design doesn’t sell well, that’s no big deal. Inditex just stops manufacturing it and shifts production to more trendy pieces.
I have a Spanish friend who tells me that the best quality pieces are the first to reach the stores. These ones are handmade by highly specialized seamstresses at the Arteixo complex and will go through a higher level of quality control, while the bulk of the production is much more industrialized.
Distribution
The supply chain is tightly connected to the distribution network. The fact that the company manufactures small batches of clothes, allows for deliveries to the stores TWICE every week. Store managers in southern Europe place orders on Wednesdays and Saturdays. The rest of the world places them on Tuesdays and Fridays. If a store misses a deadline, it will have to wait for the next deadline day.
This constant flow of new but few items creates a feeling of scarcity and novelty that ensures that clients will buy the items on the spot and they will come back on a regular basis to see what’s new.
Every single piece of clothing, regardless of where it is manufactured, will come to Spain before being shipped to the stores.
Each concept has its own Distribution Center, the largest ones being the original one in Arteixo (see image posted previously) and a massive one in Zaragoza called Plataforma Europa, right next to the airport.
Source: AiS
In Europe everything is shipped by truck. What can’t get to the stores by truck in 36 hours of being ordered, is transported by air. Just so you get a feeling for how massive this is, Zaragoza airport has already surpassed Barcelona Airport regarding cargo freight. To Mexico city alone, 5 cargo airplanes fly out from Zaragoza every-single-week.
Plataforma Europa, Zaragoza
It’s important to have a nearby airport not only for the convenience of the company’s executives, but for a more important reason. The company ships its clothes from Spain to around the world by airplane. This is – or better yet – this was considered madness before Inditex began doing it. The costs to fly its clothes twice a week to dozens of countries are obviously huge and there aren’t that many companies that can do it. What many considered lunacy is actually one of the most important cogs on the wheel of the best clothes retailer in the world and something that adds to it competitive advantage over slower competitors.
Toyota is widely regarded as the pioneer of the just-in-time inventory management. Inditex has partnered with Toyota to improve on that model. That’s why it’s one of the most studied companies in the world.
Inditex has perfected this model so much that the garments get to the store already on the hanger and with the price tag fixed to it. Just think about this. The company had to think about manufacturing similar hangers for all of its stores and how to ship them back to the suppliers.
But traditional supply chain theory says that clothes on hangers take up a lot of space. It would be preferable to pack them into boxes. Although some of Inditex’s clothes go into boxes, the women’s dresses and and several other “important” pieces go on hangers. Even if that means that the airplanes and trucks will be running half empty. What the company spends on transportation, it saves on time at the store level. When the clothes arrive to the store, they don’t have to be ironed or unpacked. They can be sold immediately. For Inditex, speed and efficiency are more important than cost.
This whole journey culminates in the store. That’s where the customers interact with this well-oiled machine. The stores are thought out to the smallest detail. The company has its own mock-stores in the Arteixo headquarters where it tries out new layouts, the routes that the client will follow, the height of the hangers and even the music.
The store is everything for Inditex. It’s the store that feeds the information back to the headquarters on what customers want. It’s the store/client that commands the colors of the clothes to be manufactured. It’s the store that says how much of each item will be manufactured. There are even employees who report back to the headquarters on what pieces of clothing were tried the most in the fitting rooms at each store. And which of them weren’t sold.
Tech and Online
To handle all of the data that comes out of the stores, the company has invested huge amounts on machine learning, online shopping, and technology in general. I’ve heard a famous Spanish money manager say that “Inditex is a tech company which is highly advanced in logistics“.
Every single piece of clothing is tagged with a Radio Frequency Identifier (RFID) so the company knows where every! single! item! is anywhere in the world. This allows the Machine Learning algorithms to come into play and help managing inventory, both at the distribution level as well as the store level. If a given store has been selling more yellow t-shirts than red, the Artificial Intelligence will automatically suggest the store manager to order X amount of yellow t-shirts.
Then there’s the online. There is the widespread belief – or should I say misconception – that the online retailers will eat the world and there won’t be any space left for the brick-and-mortar retailers. This is obviously not true. We’ve been seeing several success stories where both channels mix and work together. That’s where Inditex is heading to. A symbiosis between the online and the “real world”.
You see, for a pure online player to ship something around the world, customers will have to wait for it. Inditex already has the distribution centers close to its customers. They’re the stores. Inditex’s stores are already working as fulfillment centers for the online. This is a huge advantage.There are several ways this works.
You can order online and pick up later at the store.
You can check on the APP in which store you can find your favorite piece.
You can be in the physical store and buy an item you’re holding on your hands through the APP and then leave without going through the cashier.
You can book a fitting room when you’re in the store and there’s a cue; you can just keep on looking at clothes and it will let you know when the fitting room is available (yes, I know. But it seems that sometimes there are really big cues to the fitting rooms).
You can even choose items on the APP and when you’re at the store it will guide you to where the items are located.
And if you want to return something, you can do it in the store. I believe this to be one of the most important differentiators from the pure online retailers. First, because it gives you optionality (return via physical mail or going to the store) and second because when you go to the store, well, you buy more. 75% of the people that go to a Zara store to return something, buy something else.
In 2019 the online sales grew 25% to become 14% of the total sales. On top of that, the management has said that the online sales aren’t margin dilutive, which means that the margins are more or less the same. The 2022 plan is to grow the online sales up to 25% of the total revenue figure. I don’t doubt for a second that that’s achievable.
Revenue by distribution channel
Source: Company data
To reinforce its online presence, the company has recently set up a 64k square meter facility just for studios. Remember that Inditex so far, almost had no budget for advertising.
Management and Ownership
Amancio Ortega still owns 59% of the company. He stepped down as CEO back in 2005 when Pablo Isla took over as CEO. In 2011, Isla became the Chairman of the Board as well. Recently, Pablo stepped down as CEO in favour of Carlos Crespo, but he’s still the Chairman and the running man.
Amancio still wanders around the headquarters helping people. He just can’t stay away from the business.
Geography
Spain and the rest of Europe still account for 65% of sales. The roll out of new stores in new markets is slow because the company doesn’t spend in advertising, so in a new market where it is unknown, it relies on word of mouth. This makes it so that new stores can be unprofitable and opening too much unprofitable stores, well, we know where that might lead.
For instance in the USA, the company has a meager 99 stores. That’s because the Americans have different taste from the Europeans. This has led the company to design looser clothes for this market, which in turn added complexity to the manufacturing process.
I’ve contacted a Mexican friend who lives in Miami and she tells me that she loves Zara and that the stores are always full.
Revenue by Geography
Source: Company data
Stores, Concepts and other metrics
Although Zara in Europe are seen as an affordable brand, the company has been positioning the brand as a premium brand in many countries around the world. The same piece of clothing will have different price tags depending on where it’s sold. Inditex is actively trying to place Zara as a more high end brand in many countries such as Brasil, China or other “emerging” markets.
And that also reflects on its stores. The company has been pursuing the goal of having less stores, but bigger ones – like flagship stores – in important parts of the city (think Champs Elisées in Paris or Times Square in NY). The goal for 2020 is to have around 6800 stores compared to the current 7469.
Stores by Concept
Source: Company data
As the number of new stores is decreasing, the area of each store is increasing.
Area per Store
Source: Company data
And although Zara accounts for 38% of the number of stores, it accounts for 69% of the total revenue.
Revenue per Concept, €Million
Source: Company data
But as Pablo Isla, says, what matters isn’t the revenue per store, but the revenue per area (an important metric in brick and mortar retail). And this has been growing (with some setbacks along the way, that’s for sure).
Revenue per m2, €
Source: Company data
Another metric one can’t miss when looking at physical retailers is the Like-for-Like growth (also known as Same-Store-Sales Growth or Comparable Sales Growth). It’s nothing short of amazing to see that there hasn’t been one negative year of Like-for-Like growth. Not even during the Great Financial Crisis.
Like-for-Like growth of 6,5% is very, very good.
Like-for-Like Sales Growth
Source: Company data
Revenue
The company has been able to grow its revenue to $28,3 Billion dollars in 2019 and its Operating Income to $5,2 Billion dollars.
Revenue + Operating Income, €Billion
Source: Company data
This translates into a growth rate that has been decreasing for the past 10 years. Given the company’s size and reach, this was to be expected. I’m actually quite surprised that the company has grown 7%, on average, for the past 3 years.
Source: Company data, AiS estimates
Margins
There are several competitors, but I believe two of the most relevant ones are H&M from Sweden and Uniqlo from Japan.
All three of them have seen their gross margin decline over the years (especially H&M), which leads me to believe that the competition is fierce. Inditex is clearly the leader here.
Gross Margin
Source: Company data, AiS estimates
And if we go down the Income Statement, we get the confirmation that Inditex is the clearly the mother of Fast Fashion.
To be fair, the conversion rate between Euro and Swedish Krone has penalized heavily H&M, but hey, that’s how it is.
Operating Margin
Source: Company data, AiS estimates
Profitability
Inditex has been able to generate consistent profits and FCF over the years. Depending on how much the company has been investing in its operations, the FCF has lagged the Net Income, but the trend is obviously going in the right direction.
Net Income + FCF, €Billion
Source: Company data, AiS estimates
This in turn leads to what is probably the best Return-on-Invested-Capital I have ever come across. This is the reflection of one in a million company. With this ROIC, the company should be reinvesting every dollar it earns.
ROIC
Source: Company data, AiS estimates
Dividend
But unfortunately the company can’t redeploy all of that cash so it returns it to shareholders in the form of dividends which have been increasing since 2007. The payout ratio policy is to pay 60% of the profits.
Dividend per share, €
Source: Company data
Balance Sheet and Efficiency
The other thing the company does with its cash is to keep it in the bank. The company has net-cash of €6 Billion euros. In fact, the company went into this crisis in the best financial position it has ever had.
Net Debt, €Billion
Source: Company data, AiS estimates
It is when we compare the efficiency ratios of Inditex with its competitors that we finally understand the utter superiority of this company.
One of the classic ways retailers get killed is because of bad inventory management and high fixed costs. While its competitors hold inventory for an average of 125 days and 136 days, Inditex holds inventory for an average of 73 days. Add to that the fact that it will take 113 days, on average, to pay its suppliers, while H&M takes 24 days and Uniqlo, 62.
This leads to a Cash Conversion Cycle of negative 34 days for Inditex and 110 days for H&M and 82 days for Uniqlo. This means that Inditex is paid 34 days before it has to pay its suppliers.
Efficiency Ratios
Source: Company data, AiS estimates
Valuation Ratios
Looking at the historical Price-to-Earnings ratio, the company has only been cheaper in 2008. We might argue that at 20x earnings, for such a good company, we’re not paying that much.
I would like to caution readers regarding paying too much for a company, however good that company may be. The investors who bought Inditex back in 2014 at 38x earnings, haven’t had great returns, even while the company increased its profits. Investors are now paying less for each dollar of profit then they were back then, which tells me that they believe that the company will grow at a slower rate.
Price/Earnings
Source: Company data, AiS estimates
Let’s put this into perspective by looking at some of the peers/competitors. I would say that the most comparable peer is H&M which is a worst business, hence the lower valuation. Fast Retailing (Uniqlo) and Asos (a pure online player) both are trading for really high valuations. I believe that Uniqlo is trading at such high valuations because its clothes are well manufactured and the company still has a lot to grow physically.
I would say that Inditex is able to beat anyone, even Amazon, in the online retailing space, so should we not attribute a similar multiple to its online business? Maybe we should.
Source: Company data, Morningstar, Marketscreener, AiS estimates
Risks
- Slower economy
- Failing to meet customer’s taste
- Quality issues
- Wrong commercial strategy
- Smaller more nimble competitors
Conclusion
After researching the company, I have no doubt in my mind that Inditex is one of the best companies in the world. But that might not necessarily translate into a good investment opportunity.
The company is positioning Zara as a higher end brand, investing heavily on its online business, and if it weren’t for this virus, I would expect it to be highly successful with its strategy.
What we have to ask ourselves is how well the company will fare in the coming economic downturn. I believe people will still want to go to Zara, but will they be able to afford the increasing prices, or will they opt for lower end competitors?
You see, with a strong percentage of fixed costs, when the Like-for-Like sales start to decrease, the profits will decrease even more. We see it happen all the time with famous retailers that go bankrupt (not that Inditex is anywhere near that situation).
Let’s say that the company doesn’t grow its revenue until 2022 and that the online business reaches 25%. If we apply a 30x multiple to the online business and a 20x multiple to the “brick and mortar” business, we would get to a €89 Billion market cap which would lead to a rate of return of 8%. Add a 3% dividend yield and that would be 11% return.
Source: AiS estimates
But how likely is the revenue to keep flat for the next two years? That’s the million dollar question to which I still don’t have an answer. But I will keep my eyes and ears wide open.
Going forward, I’ll be looking at:
- The evolution of the online segment
- The evolution of the competitors (especially the online players)
- The acceptance of the higher-end products
- The evolution of sales
Further research material
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