Hugo Boss (OTCPK:BOSSY) is a market leader in the upper premium segment of the global apparel market. It focuses on developing and marketing premium fashion and accessories for men and women. More importantly, Hugo Boss has a powerful and recognized brand and the scale to create efficiencies that are hard to replicate. Retail investors should also appreciate that the company has critical attributes which protect it from the ongoing retail transformation such as its own proprietary products, focus on upscale consumers and control of pricing and distribution, largely through its own retail channel.
Hugo Boss’s brand, scale and effective positioning and management have allowed it to produce strong fundamental metrics over time such as an impressive level of return on equity, complimented by a strong financial profile. The company’s strong fundamentals, advantaged position in retail and now its attractive valuation should tempt investors looking for a core retail holding.
Source: Company Website
Retail pain, Hugo Boss gain
Shoppers are replacing malls with cell phones. More importantly, they can price-compare with a few clicks from anywhere at any time, and then consummate a purchase without even looking up, and increasingly without the inconvenience of waiting more than a day to receive their goods. Evolving shopping habits have obvious effects on brick-and-mortar retail, but the critical aspect is how easy and immediate price comparison combines with convenient ordering to essentially eliminate the advantages location and physical product display used to provide to general retailers. The end result is that pricing power evaporates and convenience favors strong omnichannel players that may not have the fixed costs of stores. It’s doubly painful when online players, such as Amazon (AMZN) or Wayfair (W), are willing to accept little to no margin on much of their retail business. We all know the familiar outcome, decline and bankruptcy for even iconic brands such as Sears (OTCPK:SHLDQ) and J. C. Penney (JCP).
But some retailers are thriving in the new retail reality and have plenty of weapons to fend off online usurpers. Perhaps the most effective of defenses is proprietary products, which are usually combined with strong brands. Proprietary products and brands cannot easily be copied by competitors, and critically, cannot be price-compared on sites such as Amazon. Any product that can be found and price-compared on a competitor’s platform essentially becomes a commodity, and will generally be purchased at the cheapest price. Branded products simply aren’t available from competitors and therefore have a fighting chance at providing producers with some pricing power and customer loyalty. Branded products have aided the success of various retailers from Target (TGT) and Lululemon (LULU) to a previous holding of ours, V.F. Corp. (VFC). Companies like Lululemon have proprietary, branded products that essentially require consumers to come to the company to get what they want. And Lululemon controls not only the distribution of its products but also pricing and brand image to a large extent. Controlling distribution, pricing and brand image are critical for retail success and give ominous giants like Amazon little chance to steal business.
Hugo Boss has a globally recognized, powerful brand and control of much of its distribution and pricing. As such, the company has little to worry about when it comes to new entrants trying to steal market share or pricing power. Hugo also has solid control of its supply chain, with a combination of self-manufactured products and tightly controlled outsourcing combined with its own scaled distribution. The company produces 17% of its total sourcing volumes at its own facilities, allowing it to keep quality high while still benefitting from more flexible and cost-efficient third-party production. Much of retail is struggling, but Hugo Boss has plenty of protection from the pain.
Middle class retailers suffer the most
Transformations in the way people shop and consumer preferences are often cited as the main challenges to traditional retailers, but there is another powerful headwind for a particular cohort of industry participants. The middle class is disappearing, and with it, the middle market customer so many retailers rely on. In the US, income inequality at an all-time high has decimated the middle class and helped doom stores catering to the demographic. Companies from Toys“R”Us to Macy’s (M) have all felt the pain. But the middle class decline is not limited to the US and is largely a global phenomenon, with important markets for Hugo Boss such as Germany suffering the same fate.
The result has been success for low-cost scaled department stores like Walmart (WMT) and Costco (COST) as well as online retailers like Amazon that appeal to budget consumers, and for premium retailers with own brands that cater to upscale consumers, like the aforementioned Lululemon. Everything in the middle has been dealing with a monstrous headwind as their targeted consumer has vanished. There will be something left for a handful of survivors, but we currently see companies like Pier 1 Imports (PIR) and Bed Bath & Beyond (BBBY) fighting for scraps and survival.
Re-focusing on Hugo Boss, we see a clear premium brand with high-quality products targeted to an upper-class consumer. Hugo thus avoids the headwind resulting from a disappearing middle-market consumer and places itself in a more protected part of retail. Investors can feel confident being backed by a more stable demographic.
Moving onto fundamental strength and competitive positioning
Retail trends aside, we prefer to invest in companies with strong fundamentals, proven value-creation and sustainable competitive positioning. Hugo Boss offers the scale to create purchasing efficiencies and a strong distribution network that is hard to replicate, strengthening the sustainability of the company’s competitive position. Having said that, the fashion industry rarely provides insurmountable hurdles to competitors. But we view entry into the premium end of the market where brands are built up over decades of effort and high-quality execution as more difficult for new entrants. And we also see the fashion risk to Hugo Boss as manageable within its core business of men’s suits and formal wear where style shifts are perhaps less dramatic. The company’s stated strategy to “Be the most desirable premium fashion and lifestyle brand” also demonstrates management recognizes the importance of protecting the company’s market position.
Importantly, we can see the power of Hugo Boss’s brand and competitive position come through in its financial results. We particularly look for consistent and sustainable value creation as demonstrated by strong return on equity (ROE) and return on invested capital (ROIC) metrics over time. In these categories, Hugo Boss makes a strong case for being a core holding in our portfolios as demonstrated by the impressive figures below.
It is a competitive industry, but Hugo Boss is a proven leader in the space, and we believe the company has the proper focus and strategy to continue creating value for years to come.
Before moving on from fundamental strength, it’s good to review the company’s financial position. The company’s balance sheet looks impressive at first glance with essentially a net cash position, but we can’t ignore the company’s leases. But even including capital lease obligations, debt metrics look solid, and the company has long been transparent about its balance sheet even before new lease-related accounting regulations, as shown in the chart below.
Growth is more challenged, but may also lead to strong outperformance
Revenue growth has been very respectable over the last decade averaging around 5.5% a year, with earnings per share advancing at a faster clip. The company has grown through the expansion of selling space, largely through the increase in its own retail selling locations and more recently from the growing online channel. Economic growth and consumer spending growth may be supportive, but growth going forward might be more challenging if new markets don’t pan out as expected. The company is leaning on Asia, in particular China, for double-digit growth in the coming years, but there are several risks to those projections, not the least of which might be the Wuhan coronavirus. Hugo Boss temporarily closed some stores in China due to the coronavirus which certainly will not help sustain the current double-digit growth rate in the geography. Mid-term, however, the company does appear to have enticing growth drivers through recent initiatives in the online business, its contemporary fashion brand Hugo, and indeed Asia where the retail footprint is being expanded. The Hugo brand, a more casual offering, may be critical as the company contends with an apparent structural move away from formal wear.
On the revenue line, recent results do show signs of improved growth as store revamps have driven foot traffic up and online sales growth accelerated to 52% in the fourth quarter of 2019. Profit growth may also benefit from a return to more impressive margins. The company expects operating margin to increase in the coming years, from near 12% to 15%. High single-digit growth may be in store for Hugo Boss, but we suggest investors don’t pay for it today and let any upside surprises lead to strong outperformance, which leads us to valuation.
Source: Company Investor Day Strategy Update 2019
Valuation is attractive
The average financial analyst will tell you that the company is worth over EUR 50 per share which implies an upside of about 15%. Multiples look attractive in absolute terms and in relation to historic averages. A forward price to earnings ratio of 11.8x is well below the market average and the company’s longer-term average multiple near 16x, and that is for a company with a high double-digit return on invested capital capable of growing at a high single-digit pace. How many companies of this quality can be purchased for an enterprise value to EBITDA multiple of about 5x? We can’t find many. Our own valuation models give us a fair value of over EUR 60 per share, providing an upside in excess of 40%. The market seems to be pricing in a zero growth scenario with no margin improvement. If the company executes on its plan for mid-single digit growth and reasonable margin improvement, the upside gets dramatic.
Hugo Boss from a dividend perspective
We didn’t want to leave readers without a quick note on the company’s dividend profile. Dividend investors might be tempted by the yield above 6%, and perhaps they should be, but dividend safety is something to consider. It’s likely that Hugo Boss will continue to pay an attractive and growing dividend over the long term, but the company applies a profit-based dividend policy and has heavily cut the dividend in the past. Enjoy the dividend, but don’t count on it.
Source: Company Investor Day Strategy Update 2019
Conclusion: Hugo Boss is a quality retail company at a bargain price, but…
We own Hugo Boss with an average size position in our portfolio, having increased our position late in 2019 at approximately EUR 40 per share (on European exchanges). We consider Hugo Boss to be a core holding in the retail space with its leading brand in the luxury fashion industry, combined with levels of scale and expertise to provide reasonable barriers to entry. The company has proven that it can achieve a high level of ROE sustainably over time, and we see little reason why that shouldn’t continue. The company is largely protected from pressures in retail with its own proprietary products and control of distribution and pricing. A strong balance sheet and multiple growth drivers complement the investment case, as does the attractive valuation. However, we have flagged some shorter-term risks such as store closings in China related to the coronavirus outbreak. Long-term investors should feel comfortable picking up a starter position now and look to increase the position should shorter-term pressures push the price back below EUR 40 per share.
Disclosure: I am/we are long BOSSY, BBBY. 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.
Additional disclosure: The information enclosed in this article is deemed to be accurate and reliable, but is not guaranteed to or by the author. This article reflects Oyat’s views and does not constitute investment advice.