Major, and rather unwelcome news hitting the airwaves today is that online fashion retailer ASOS has cautioned on growth and guided profits lower for FY19. The fact that fashion is struggling is no surprise: in recent times Bonmarche, Superdry, and Quiz have cited difficult trading conditions. However, ASOS operates a largely different business model to all of these, mainly retailing online. Growth here was spectacular, with revenues increasing almost 400% in the last 6 years. The news today was not digested well by the market and the shares dived by almost 40% in early trade:
This should act as a cautionary tale that massive losses in share price are not restricted to small-caps. Arguably, ASOS’ slowdown has been predicted by the share price. After nearly touching £80 in March, the shares stand at a near 2-year low and have lost well over half their value. Any holders late to the party would be disappointed.
The ASOS price crash perhaps could be understood by the extremely high valuation put onto it by the market. At the peak, the market valued the company at more than Marks and Spencers and a value approaching that of Next, an amazing achievement for an online only retailer delivering a lower level of profits on lower margins. But the real story was the future, and with ASOS attempting to replicate their operations worldwide the potential was seen to be massive, with the online market growing at a fast rate.
The bad news came out in a trading update:
ASOS today announces a trading update for the first three months of the financial year. Although we delivered solid growth in sales of 14%, we experienced a significant deterioration in the important trading month of November and conditions remain challenging. As a result, we have reduced our expectations for the current financial year.
There are some helpful pointers to regarding what these expectations are:
Revised guidance for the current financial year to August 2019:
· Sales growth: c.15% (previously +20-25%)
· Retail gross margin: c.-150bps (previously flat at 49.9%)
· EBIT margin: c.2% (previously c.4%)
· Capital expenditure re-phased down to c.£200m
And some reasons behind the decline, in short ASOS cite warm weather, economic uncertainty (while avoiding the Brexit word), and a high level of discounting and activity by competitors: this is a common theme across the industry with firms citing one or more of these reasons for their own decrease in sales.
In terms of global performance, the UK and Europe have seen the best levels of growth – perhaps reflecting the expertise of the company. US operations are growing at a healthy rate, albeit from a much lower base and the roll-out of improved logistics. The Rest of the World segment shows some difficulties, with a decline of 3%.
ASOS is one of the great growth stories of recent times. Founded in 2000, the acronym actually stands for ‘As Seen on Screen’, fulfilling a demand for items that were seen being worn on TV. Since then, the site has evolved massively to be an internet retailer of branded clothes as well as developing its own brands. Growth has been spectacular since and the company could be seen as one of the pioneers in internet clothes shopping – offering innovative marketing content, low prices and fast logistics way ahead of most other players.
These initiatives have driven huge growth over the past decade. With many retail shops being rather conservative in their own marketing methods, ASOS was left relatively unchallenged. The combination of low price with perceived quality and good logistics led to the site becoming very popular and able to shift more and more products to its target market. In recent years this has showed little signs of abating but economic headwinds have been blowing against fashion retailers for a while: potential trade barriers, changing consumer tastes and decreasing incomes are some of the factors companies have to work with. Other competitors are also re-assessing their approach to their online operations with many increasingly turning to social media to drive sales.
The financial story so far is that of investing for growth: there are no dividends for investors, with the company re-investing profits for further growth. They are profitable in headline terms, but that does not reflect that they are also spending heavily on capital expenditure: £161.5m in 2017, £213.0m in 2018. The latest profit warning has guidance for this item:
We have reduced capital expenditure for the current year to c.£200m. Capex as a percentage of sales will continue to fall as previously guided. We have significant headroom within our existing banking facilities and continue to anticipate returning to a free cash flow positive position in FY20.
Previous estimates for capex were £250-260m so this is quite a reduction. Nothing is given for the current cash position but as of FY18 it was £42.7m. There is a £150m revolving credit facility in place, which should not be in too much danger unless trading undergoes a significant long-term downturn.
However, it is clear that capex is vital at this point. In recent years we can see it as such (2013-2018 left to right):
This paints a picture of declining operating margins (due to increased activity by competitors), which have recovered in recent years with an expansion to other markets where higher margins can be gained. This requires an increase in spending though. It would be difficult to compete effectively in these markets in another country if a site has not been localised, and if customers have to wait a long time for a shipment which is then difficult to return if it doesn’t fit properly. It is expensive to set up facilities elsewhere, and as ASOS note, they are in ‘transition’, although it is difficult to tell if these capitalised costs are not hiding things that should appear as routine expenses.
But cash is king, and as we can see free cash flow is currently negative. The last drop is not necessarily alarming as it reflects a working capital adverse movement. To sell more items, more needs to be spent on products and inventories increase at the expense of cash.
ASOS has some intangible assets: virtually no goodwill but mostly software costs. At the previous year end the total cost was £281.3m on this item, with a depreciation charge of £28.6m, the main item being a new retail planning system for internal use.
Today’s news is hugely significant, as the themes are often read-across to other similar firms. Sosandar and Boohoo have seen modest reductions in their share price today on this news (c.15%) despite the latter putting out its own RNS trying to reassure the market that all was well.
The fundamental thing to think about is whether this profit warning by ASOS can be attributed to one-off factors, or whether this large decrease in November could be a sign of further worse things to come. Recent years have seen a rise in what is called ‘disposable fashion’ – with firms like Primark producing clothes that supposedly are so cheap they could be thrown away after one use – but could it be the case that fashion spending could simply be postponed in tough times?
It is also fair to say that while ASOS are spending a large amount of money on capital expenditure, this on its own does not generate competitive advantage. For instance, an overseas retailer could spend big money setting up a supply chain to target the UK market, but in effect this only gets it on a level playing field with firms located here that have it already set up. The same goes for making country-specific websites. The reduced capex spend demonstrates that ASOS cannot be totally gung-ho about this, as they may have to seek additional funding.
That being said, it is definitely demonstrable that they markets they are serving (the online apparel market) is still growing. It seems unlikely that this growth will be checked by evolution of other channels, the only threat being a decrease in demand. The question is how to expand that reach into other territories. Without that, I feel the current trend will be that sales growth can only come at the cost of cutting margins. Currently that is less of a problem because ASOS are particularly good at churning – its turnover ratios are very high.
The problems might arise if margins decline too much, and costs keep on rising – that is the way both metrics are working at the moment. In that case, ASOS might become a story like AO – a retailer turning over close to £1bn but making pennies from it. Fine for the people that work there, but not as an investment case.
Comment relative to the share price cannot be ignored either. The share used to trade at an incredible multiple of profits unseen since the dot-com era. Even on current valuations this is still punchy, but it should be forgotten that despite the bad news today ASOS are still on a growth curve, albeit a smaller one than before.
I feel that with the current volatility of this segment, there could well be another profit warning in store here. ASOS are better placed than many others to ride out the downturn, but a lot is riding on their investments elsewhere. Long-term I feel the prospects are decent. 4/5.