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We first profiled Prada (OTCPK:PRDSY) on December 13, arguing that the Italian luxury house was undervalued relative to peers, and that investors should consider opening initial positions ahead of the company's Q3 results (released on December 20, more detail to follow). Since then, Prada's Hong Kong-listed shares have fallen by 3.36% (Prada's ADR's have fallen by 2.68%) as the company's Q3 results were less stellar than expected, and management noted that fiscal 2014 consensus was "challenging." However, we believe that Prada's underlying performance during Q3 was better than expected and that a slowdown in Europe is less material than investors believe, provided that Prada can indeed make up the difference in other markets. In this article, we will discuss Prada's Q3 results, but before we do so, we wish to address several points raised by Bram de Haas in an article on Prada published on December 19.

In writing his article on Prada, Bram de Haas took an opposing view of Prada, arguing that Prada is far riskier of an investment than we have made it out to be, and that the relative upside we saw in shares of the Italian luxury house is in fact absent from the company's shares. While an investment in Prada certainly does carry risks, we believe that there are three assertions in the article that we wish to address:

  1. Inflated multiples: The core of our bullish thesis regarding Prada rests on two intertwining points: Prada's forward growth rates in revenue, EBITDA, and EPS, and its multiples, both on an absolute basis and in relation to its peers. In his article, Bram de Haas provided several multiples for Prada and its peers, arguing that in fact, shares of Prada do not trade at a discount to its peers on any conceivable metric. However, while we believe this assertion to be false, the fault does not lie with Bram de Haas, but rather with the data sources he used, namely YCharts. As an example, we note that Bram de Haas' article states that based on its fiscal 2012 sales, Prada trades at a price-to-sales ratio of 9.74. However, as Prada's financial statements will show, this is simply not the case. According to Prada's full-year 2012 financial statements, the company generated sales of €3.297219 billion. With 2,588,824,000 outstanding shares (per its 2013 interim report) and a share price of HK$67.65 (or €6.37), Prada's current price-to-sales ratio [based on fiscal 2013 (the 12 months ended January 2013) sales] is 5x, not 9.74x. Furthermore, Bram de Haas' article notes that Prada trades at a price-to-earnings multiple of 59.94x (based on its fiscal 2013 earnings). As Prada's 2012 financial statements show, the company posted EPS of €0.245 for the year, meaning that at its current share price, the company trades at a 2012 P/E multiple of 26x, a far cry from nearly 60x. In our research, we strive to limit our use of third-party financial data sources, Barring unique circumstances, the only data we source from third-party sources such as Yahoo! Finance, YCharts, or Reuters are consensus forward estimates for metrics such as revenue, EPS, and EBITDA. Where possible, we source all other figures directly from company financial statements. While this approach takes longer than sourcing data from third parties, we believe that on balance, it leads to more accurate results. We note that in Bram de Haas's article on Prada, the charts provided were based not on Prada's Hong Kong-listed shares, but on its ADR's, which likely skewed the results provided, for it is unlikely that YCharts accounted for the fact that Prada's core share price and its financial statements are reported in different currencies, and that to create accurate multiples, investors need to first translate its share price to euros, then input figures from its financial statements and forward estimates, and then apply that to Prada's ADR's. Given the fact that Prada is one of the few companies to have its share price and financials reported in different currencies, we believe that YCharts' software fails to recognize the unique nature of Prada's capital markets structure, which requires an extra step to generate accurate multiples.
  2. Competitive moat: In his article, Bram de Haas takes aim at Prada's brand, writing the following:

    I'm doubtful Prada really has a sustainable competitive advantage. A brand by itself offers no real sustainable competitive advantage. It takes continuous capital investments to sustain a brand. Limiting or destroying excess returns. I can imagine the value of the brand may have built up over time. There is unique history to the Prada brand that is not easily copied. Maybe that's sufficient to derive a minor competitive advantage, but I don't think it establishes a wide economic moat. Consumers more readily switch between a Prada and a Gucci bag than between Apple (AAPL) OS and Windows (MSFT) for example. Prada doesn't have any of the real sustainable competitive advantages such as: unmatched economies of scale, proprietary technology, unique know how, products that are addictive or have a high learning curve and there are no high searching costs for consumers when looking for an alternative. There is no real competitive advantage.

    When taken at face value, there is little to criticize in the comparison between Prada and Apple and Microsoft. Other than unique craftsmanship, there is little in the way of proprietary technology within a Prada bag or accessory, and the only economies of scale afforded to Prada are housed within the company's corporate structure and supply chain; for Prada's consumers such economies of scale are largely irrelevant. But we believe that the assumption that Prada has no economic moat is erroneous. In the above excerpt, Bram de Haas' criticism of Prada is in fact a criticism of all luxury companies, for the lifeblood of every luxury company is the quality and cachet of its brand. Consumers do not simply switch with wild abandon between Prada and Gucci bags. Luxury companies spend enormous sums to instill brand loyalty in their consumers and establish an emotional and sentimental connection between their brands and their consumers. When convincing consumers to spend thousands on goods that frankly, in the grander scheme of things, are mostly unnecessary it is essential to transform the process of purchasing a luxury product from a transaction into an experience. The process of doing so is an art, not a science, and each luxury company approaches it in different ways to cater to the unique qualities of their brands. Although it is impossible to deny that competition exists within the luxury sector, if it were unbridled, most luxury companies would fail to post any meaningful profits as rampant competition would force prices down to their lowest common denominator. But, if Prada is able to successfully charge $3,000 for a handbag, there must be a reason why, and there must be a reason why Hermes, Louis Vuitton, or Gucci do not simply price their own handbags as low as possible to stoke sales. The answer is that to do so would run counter to the very core of the theories that drive luxury goods purchases. High prices create an aura of exclusivity, and it has been argued that luxury goods are in Veblen goods (named after economist Thorstein Veblen), which are goods whose demand is proportional to their price; meaning that a reduction in their price leads to a reduction in demand, for it is the high price that imparts status onto a luxury good. Empirically, there is ample evidence for this. Burberry spent much of the first decade of the 21st century fighting to recapture its upscale image within England, and a myriad of industry analysts have pointed to Louis Vuitton's move into mass market luxury as a key factor in its sluggish growth in recent years. In most sectors, a company's brand is merely a portion of the business. In luxury, the brand is the business. Luxury houses such as Prada build their entire business around the equity of their brands, and the competitive advantage of each luxury house is based on the power of their respective brands to draw in new consumers, and more importantly, instill loyalty. Investors who do not believe that brands lead to competitive advantages should not only eschew an investment in Prada, but should also eschew an investment in any luxury company, for the issues argument that brands alone do not impart a competitive advantage can be applied to any luxury company, not just Prada.

  3. Takeover prospects: In our original article on Prada, we alluded to the possibility of a takeover of the company as the issue of who will succeed Prada's CEO and creative director begin to gain more prominence. However, we do not believe in investing in a company solely on the basis of takeover potential; for us to advocate for an investment in a company's equity, there must be a solid standalone thesis. Our thesis on Prada is not predicated on a takeover of the company; we discussed a potential takeover of Prada as a potential sweetener on top of what we saw (and continue to see) as attractive standalone prospects for the company. In his article on Prada, Bram de Haas states the following: "Helix [Investment Research] views LVMH Moet Hennessy Louis Vuitton Sa (MC) as the most likely candidate to bid for Prada." While we believe that our original article was clear on this matter, we will clarify it here as well: at no point on our original article on Prada did we state that we view LVMH as the top candidate to acquire Prada. We stated the following regarding LVMH: "This has left the company [Prada] without a clear succession plan, and if and when Bertelli and/or Prada step aside, this may create an opening for potential acquirers. Bertelli and Prada's 80% ownership stake is not as much of an obstacle as it appears to be, and for an example of this, we depart Milan (where Prada is based) and head to Paris, where LVMH (OTCPK:LVMUY) has turned acquiring family-owned luxury companies into a form of corporate art." This portion of the article (of which a portion is cited by Bram de Haas does not imply that we believe that LVMH will make an offer to acquire Prada. Rather, it was meant to illustrate that family control of a luxury company is not necessarily an impediment to its sale; we used LVMH as an example of this because the company has a long (and successful) track record in acquiring family-owned luxury companies, proving that at the right price, a deal can be struck.

We turn now to Prada's results for the third quarter of 2013, which we believe are more resilient than the headline figures suggest.

Q3 2013: Navigating Headline Volatility

Prada released its Q3 2013 results on December 20, and shares fell by over 4% on the back of the company's earnings release as Prada stated the following: "Unfavorable exchange rates and softening consumption patterns in some regions could weigh on results, and thus will require increasing attention by the management in order to ensure profitability and continue the retail expansion." In addition, CFO Donatello Galli also stated that, "consensus [estimates for fiscal 2014] at the moment is challenging." (However, Galli did not provide a degree to which the company believes it could miss estimates). The driver of this warning was weaker than expected Q3 results, results that were adversely impacted by elevated currency volatility that negatively affected Prada's revenue growth rates, as well as closures of several key stores. We present Prada's global growth rates (for the purposes of this particular analysis, the rates of growth are more important than the underlying numbers) for its various geographic markets in the table below:

Prada Revenue Growth by Geography, Q3 2013 vs. H1 2013

Market

Q3 2013

(Reported Growth)

Q3 2013

(ex-Changes in FX)

H1 2013

(Reported Growth)

H1 2013

(ex-Changes in FX)

Italy

+3%

+3%

+4%

+4%

Europe

+5%

+8%

+7%

+9%

Americas

+14%

+21%

+13%

+16%

Far East

+8%

+13%

+18%

+19%

Greater China*

+8%

+12%

+19%

+20%

Japan

-3%

+23%

-3%

+16%

Middle East

+89%

+99%

+245%

+253%

Other

-25%

-25%

+15%

+16%

Total

+7%

+13%

+12%

+15%

*Included within the Far East (Asia-Pacific)

There are several items of note within Prada's revenue growth in the third quarter. Within Europe, Prada posted a slight deceleration in pro forma revenue growth (when adjusted for currency swings); the company noted that while sales within its store network were up double digits within the quarter, wholesale sales fell by double digits, and it appears that the fall in Prada's European wholesale business was enough to offset the continued growth in its retail business. A similar pattern played out in the Americas. Although pro forma revenue growth accelerated in Q3 2013, it was driven by a 36% surge in Prada's retail sales; the company's American wholesale business contracted by double-digits as the division is undergoing what Prada has termed "a conversion strategy" to restructure its business. We expect results to improve in fiscal 2015 (the 12 months ended January 2015) as Prada restructures the business.

We turn now to Prada's performance in the Asia-Pacific region, arguably the company's most important market, given that it accounts for a plurality of Prada's sales. Within the region, Prada saw a noticeable decline in revenue growth, with total revenues growing "just" 13% in Q3, down from 19% growth in H1 2013. More importantly, greater China (defined by Prada as mainland China, Hong Kong, and Macau) revenue growth fell to 12%, down from 20% in the first half of the year. Much has been made in the press about this decline, with both Bloomberg and Reuters reporting on Prada's weakening results in the region. However, these headline results do not tell the whole story. During the quarter, Prada's flagship stores in Hong Kong and Macau, arguably the two most important stores in the region (if not the entire company) were undergoing renovations, which dented the company's growth. Within the luxury sector, flagship stores are often a material source of sales; Tiffany's flagship store in New York accounts for 8% of the company's sales (Tiffany has 283 total stores), and Saks' flagship New York store generates 20% of Saks' total sales. While Prada has not disclosed in its annual or interim reports the proportion of sales derived from its Hong Kong and Macau flagship stores, we expect that they form a meaningful portion of the company's greater China sales and it is unsurprising that below-average sales contributions from these stores due to renovations would dent Prada's sales growth in the region. In addition to the effect of flagship store renovations, there is another data point that serves to refute the argument that Prada's core revenue growth has declined. During the third quarter, Prada posted same-store sales growth of 7%, matching its performance during the first half of the year. Given that same store sales growth is arguably one of the most important indicators of a retailer's health, the fact that Prada's growth rate in same store sales has remained at 7% suggests contradicts the notion that the company is seeing a core slowdown. Given the fact that the Hong Kong and Macau stores are flagship stores, it is possible that had they been operating at full capacity during the quarter, Prada's consolidated growth rate for Q3 would have kept pace with its first half results.

It is true that Prada has warned of a further deceleration in Europe during the last two months of 2013, with CEO Patrizio Bertelli stating that, "we're still waiting for the final data, but there might be a small decrease [in year-over-year sales] compared to last year in Europe - not in global performance." While a decline in European sales is, on balance, less preferable than continued growth in the region, we note that Prada's CEO stated that the slowdown would impact only its European markets, not its overall revenue growth at the end of the year. Ultimately, it is Prada's overall revenue growth that matters, and we believe that a deceleration of its European business is excusable, provided that the company can offset it with acceleration in other regions. Based on its Q3 results, we believe that such an outcome is possible; Prada's pro forma revenue growth accelerated in the Americas and Japan during the quarter, and its same store sales growth showed no sign of decelerating. Furthermore, we note that softness in Prada's revenue growth was largely confined to its secondary brands, and was not apparent at Prada itself.

Prada Revenue Growth by Brand, Q3 2013 vs. H1 2013

Q3 2013 (Reported Growth)

Q3 2013 (ex-Changes in FX)

H1 2013 (Reported Growth)

H1 2013 (ex-Changes in FX)

Prada

+10%

+16%

+14%

+17%

Miu Miu

-2%

+5%

+4%

+8%

Church's

-3%

+2%

+5%

+8%

Car Shoe

-10%

-9%

-33%

-33%

Others

-51%

-51%

-54%

-54%

Total

+7%

+13%

+12%

+15%

When adjusted for currency swings, revenue growth within Prada's flagship brand declined by only 100 basis points during the quarter, with more pronounced softness within its secondary brands. The company's management is aware of the need to slowly but surely diversify its revenue base away from its namesake brand, and the company has pledged to ramp up investment in Miu Miu to rekindle growth, and CEO Patrizio Bertelli has said that he expects the results of this ramp up in investment in Miu Miu to begin showing up in Prada's financials throughout 2014.

Conclusions

We believe that Prada's Q3 results were stronger than expected; Prada's reported growth during the quarter was trimmed by heightened currency volatility and lowered contributions from two key flagship stores, and we note that same store sales showed no deceleration during the quarter, undercutting the narrative that Prada's performance deteriorated during Q3. Although European sales may decline during the fourth quarter, Prada did not suggest that consolidated sales would decelerate, and in our view, the luxury house is well positioned for 2014. Should shares decline further, we believe that investors should use such declines to add to or initiate positions in Prada.

Source: In Defense Of Prada: Parsing Q3 Results To Address Slowdown Concerns