Hennes & Mauritz: Difficult To Justify The Valuation (OTCMKTS:HNNMY)

The onset of COVID-19 and ongoing social distancing efforts does not bode well for apparel retailers such as H&M (OTCPK:HNNMY), which mainly operate across city-center stores. Even with a turnaround effort in place, uncertainties around tighter controls and a stalling footfall recovery into stores make the H&M investment case especially difficult. Yet, at current valuations, the market seems to be factoring in a much quicker recovery from COVID-19 than is likely, and therefore, I think shares could be vulnerable to significant downside revisions in the coming quarters.

Promising September Numbers but Caution is Warranted

From the FQ3 results, I think the better than expected improvement in September trading numbers was perhaps the biggest surprise. The fact that sales only declined c. 5% in local currency terms despite c. 3% of the store base remaining shut was impressive in context, and certainly better than the c. 10% decline consensus was looking for heading into the print. The numbers also compare favorably to peers such as Inditex, which reported early September sales declining at a c. 11% pace.

The September numbers would seem to signal continued improvement ahead, but I would note comps are tough for FQ4 considering prior-year sales were up 8%. Additionally, the recent spike in COVID-19 cases in Europe is also a concern. And finally, I think it’s also worth remembering that FQ3 net sales decreased by 19% Y/Y to SEK 50,870m (-16% in constant currency terms), as a result of the COVID-19 situation. By geography, Russia and Switzerland were the only markets with positive growth, while the largest declines occurred in key markets such as the US, the UK, and in Italy.

Source: H&M Nine-Month Report

Continued Markdowns Weigh on the Gross Margin

As of FQ3, gross margins declined by c. 200bps Y/Y to 48.9%, as markdown-related costs negatively impacted margins, in addition to the net sales decline. The USD performance also likely had a small negative impact on sourcing costs, with the under-absorption of fixed costs adding to the Y/Y decline. While products purchased for FQ3 suffered from adverse impacts such as FX, raw materials, and underutilization charges, we should see this reverse in the fourth quarter. According to H&M, the expectation is for the overall market situation, with regard to external factors, to be largely neutral going forward.

Source: H&M Nine-Month Report

Opex the Key Driver Behind the FQ3 Earnings Beat

For yet another quarter, the business has positively surprised on the opex front, with FQ3 opex down 17% Y/Y on a constant currency basis. The decline was steeper at -19% Y/Y, adjusted for c. SEK486 million of impairment charges. But more importantly, the extent to which recent quarters have benefited from temporary COVID-19-related savings such as lower rents, furloughed staff, and closed changing rooms, remains unclear.

In addition to the cost savings, operating profit was also boosted by c. SEK400 million of government assistance. Once these one-off benefits fade, however, the underlying operating profit growth trajectory remains uncertain, with H&M likely needing to step up inducements to Club members (now up to c. 90 million), along with marketing spend, to grow the basket size and revitalize growth.

A Closer Look at Guidance

Looking ahead, FQ4 purchases are guided to be neutral in gross margin terms, while markdowns are expected to increase by c. 100-150bps. Meanwhile, a net decrease of 50 stores is expected this year, implying 180 store closures, while for fiscal 2021, 250 net store closures are planned (350 gross closures). This represents an acceleration relative to prior guidance at the half year when H&M guided to a net closure of 40 stores for fiscal 2020. Whilst not unexpected, the targeted 250 net store closures next year is also very significant, considering it represents c.4% of the store base.

While the stores earmarked for closures are unlikely to be the most productive, they should still lead to a drag on EPS in fiscal 2021. Admittedly, the COVID-19 impact on online penetration has played a part, but I think it also reflects landlords being unwilling to accept variable rents, in addition to a challenged store-level profitability outlook.

Speeding Up the Transformation

During the conference call, management also stressed the need to accelerate its transformation plans, from digital initiatives, the integration of the store and online channels, to ‘store optimization’ efforts. Physical stores will nonetheless play a role – management stressed the importance of a physical presence for feedback from customers, enabling the H&M experience across different channels.

Encouragingly for bulls, despite the uncertainty, the company believes the ‘worst is behind’ it. I am not sure I agree – while these are sensible strategic actions considering the accelerated digital shift and the importance of an adaptable supply chain, it is still hard to gain conviction that future footfall will return anywhere close to pre-COVID-19 levels. Nonetheless, the flexibility the company has shown in managing its cost structure is encouraging.

Difficult to Justify the Valuation

Admittedly, FQ3 was better-than-expected, and September numbers are showing early promise. But hopes of a margin rebuild story at H&M has already been translated into expanding multiples. If the experience in US retail is anything to go by, the multi-channel journey will be a challenging one, especially for a business operating at lower price points and relatively meaningful fashion content. I acknowledge the near-term strength, but I see little in this statement to suggest that full-year forecasts will move enough to justify the valuation.

In sum, I think consensus might be a tad too optimistic in its recovery assumptions on H&M’s sales performance in the upcoming months. With branded retail set for further share losses in Europe, I see a challenged sales outlook and little cost leverage once the COVID-19-related cost savings normalize. Therefore, it is hard to see where medium-term margin expansion will come from, with any further disappointments likely to drive a de-rating.

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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.

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