Hugo Boss: Strong Momentum In China, Digital Strategy Bears Fruit

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About: Hugo Boss AG (BOSSY)
by: Vasily Zyryanov
Summary

Q1 results of Hugo Boss were generally expected; considerable growth in Asia bolstered the top line while the weakened position in the US and Canada took a toll.

Inventory level is still too high, as repercussions of sweltering 2018 summer in Europe and weak 9M FY18 sales have not been overcome yet.

IFRS 16 was a tailwind and a headwind at the same time.

Normalization of trade net working capital is essential for solid FCF generation and shareholder rewards coverage.

On May 2, the Metzingen-based fashion company Hugo Boss (OTCPK:BOSSY) presented its Q1 results to the investor community. There were both inspiring and disenchanting matters inside the report. First and foremost, it appears that Hugo Boss is moving in the right direction leveraging on the digital strategy (its online business was up 26%) and gaining momentum in the Asia/Pacific market, where the brand desirability strengthens. In my first article on the stock, I pointed out that further digitalization and strengthening of the position in Asia would likely invigorate sales growth, and now, I am glad to see that this thesis appeared to be correct. At the same time, its revenues in Europe and the Americas (especially in the US and Canada) did not truly impress compared to successes in Mainland China. The major disappointment was FCF. While the group's inventory slightly decreased, FCF was pummelled by unfavorable trade working capital again (mostly caused by the change in trade payables). This time, the firm was barely quarterly FCFE-positive (after IFRS 16 adjustments) and even net OCF-negative (before IFRS 16 adjustments). However, I expect all the issues to be resolved during the rest of the year, as re-opened stores (e.g. in Woodbury, near New York City, and Bicester, near London) will boost sales, while one-off items that suppressed margins would be eliminated. Speaking about the stock price trajectory, I should say that my outlook is moderately bullish.

Chart Data by YCharts

Sales and profit

At the moment, Asia/Pacific (especially Mainland China) is the company's essential growth driver, while Europe is the bulwark, as it brought 64% of Q1 sales. Momentum in Asia/Pacific was strong (4%) compared to more tepid growth in Europe (2%) and even decline in the Americas (by 8%). It is worth mentioning that growth in Asia was far from homogenous. Mainland China impressed with double-digit sales increase spurred by "repatriation of local consumption" mentioned by CFO during the earnings call. Japan delivered a low double-digit increase. Contrarily, the top line growth in Hong Kong (store renovations and closures slightly took a toll) and Macau weakened in 1Q19. In other regions, the US and Canada considerably disappointed, while Mexico and Brazil showed mid-single-digit growth. The UK, despite Brexit-related concerns, surprised with a 5% currency-adjusted sales increase. In sum, lackluster performance in the Americas offset prodigious growth in Asia, and ultimately, the group's top line rose only 1% on a currency-adjusted basis. However, during the earnings call, CFO assured that sales in the US would "gradually pick-up over the course of 2019," and I hope his optimistic prediction will come true.

While BOSSY has been stoically fighting to secure profitability and expand margins, IFRS LTM EPS dropped to €3.19 from 2018 EPS of €3.42. Both adjusted (€0.49) and unadjusted (€0.57) for the impact of IFRS 16, 1Q19 earnings per share look literally bleak compared to the year-ago result of €0.72. Among the main culprits were the higher cost of sales and operating expenses (both selling & distribution and administration). They put pressure on margins and led to the quarterly bottom line decline. Fortunately, pressure on profitability was mostly caused by one-off items that would not mar Q2 performance. The firm's Chief Financial Officer explained that higher operating expenses were the consequence of the timing of marketing spend. Also, administration expenses were impacted by digitalization-related items. CFO shed light on the reasons, explaining that:

during the first quarter, we started to work with our new online marketing agency in China to fully leverage our digital capabilities and to accelerate growth in the marketplace ... in the U.S., we have completed the roll-out of omni-channel services across the entire market and upgraded the back end system to our European standards.

In sum, the change in overall opex should not be regarded as a sign of weakness or a long-lasting issue. All those additional costs were "one-off in nature" and further in 2019 margins will normalize.

Cash Flow Analysis

IFRS 16 appeared to be a tailwind for the cash flow statement, as mostly because of its contribution, the firm turned quarterly net CFFO-positive and also showed FCF. Without the impact of the standard, net CFFO equaled € (30) million, while FCF (net CFFO minus CF from investing activities) dropped to € (60) million. This implies that in Q2-Q4, the company has to literally exert its muscles to deliver promised full-year FCF (unadjusted for IFRS 16) of €210-260 million. Capital expenditures were not impacted by the standard, at all, and equaled €30 million. The company increased investments (1Q18 capex were only €18 million) as expected, pouring funds into stores renovation and IT infrastructure. I see that step as necessary and inevitable for securing future growth.

Hugo Boss FCF. Source: 1Q19 statement

Source: 1Q19 statement, p. 22

Speaking about the inventory, I should highlight that Hugo Boss still has to deal with the onerous impact of sweltering 2018 summer in Europe that hammered sales, led to inventory build-up, and pummelled cash flow. However, as in Q1, inventory was reduced by €11 million, it appears that the firm sticks to the promise to normalize it.

Financial position

While the cash flow statement enjoyed a few favorable effects of IFRS 16, the balance sheet was hammered. In 2019, Hugo Boss booked its lease liabilities (€837 million in non-current lease liabilities and €227 million in the current) and total debt immediately soared to €1,249 million. As a result, net worth was overlapped by debt. In my first coverage, I highlighted "minuscule debt" because 2018 financial statements have not been impacted by IFRS 16 yet. Now, net debt/EBITDA ratio jumped to 2.2x (from 0.6x in September 2018). That level is not ideal, as I prefer companies with leverage of less than 2x; however, Hugo Boss is still not so heavy burdened by borrowings and leases.

Valuation

As I have already pointed out in my previous coverages, Hugo Boss's closest peers are Ralph Lauren (RL) and PVH (PVH). In this coverage, I intend to focus on RL. There are a few matters I should address:

  1. Earnings yields of the companies are slightly different; Hugo Boss's yield (based on the share price on Xetra) is 5.5%, RL's is 4.6%. Hence, the German company is undervalued compared to its American peer.
  2. Debt-adjusted earnings yields of the companies (IFRS or US GAAP EBIT/EV) are also different, but in this case, RL is ahead, as Hugo Boss has a yield of 6.6% and RL has 7.2%.
  3. BOSSY has higher cash return on equity (FCFE/average shareholder equity), 21.2% compared to 17.4% of Ralph Lauren.
  4. Ralph Lauren has a higher free cash flow margin, 9.3%, while Hugo Boss outperforms RL regarding operating margin, which is 12%.
  5. Hugo Boss's FCF yield of 5.5% is lower than 6.4% of RL.
  6. As BOSSY's FCFE yield (ttm) is higher than dividend yield, it appears that coverage of shareholder rewards is on the acceptable level. At the same time, RL's C-Suite prefers to retain the bulk of cash, as the stock yields ~2.16%, while FCFE yield is 6.4%.
  7. EV/EBITDA ratios are similar: 9.8x and 9.3x.
  8. In sum, Hugo Boss is reasonably valued compared to its closest peer.

Also, if BOSSY manages to achieve 2019 EPS of €3.76, anticipated by analysts, it might be valued ~€67.7-82.7 in 2020, which represents at least a 19% upside from the current share price on Xetra. Given that analysts currently project EPS to gradually grow at least until 2022, even without P/E expansion, Hugo Boss has significant potential.

Conclusion

Hugo Boss does not look like a typical value stock or exemplary growth stock. However, its sure merit is a quite generous dividend yield, 4.7%, while Ralph Lauren yields only 2.16%. I hope in Q2-Q4, BOSSY will manage to turn levered FCF positive and deliver promised yearly free cash flow of €210-260 million. If that does not happen, dividend coverage and sustainability of shareholder returns will be under question. I also hope that in Q2 further unfavorable one-off effects will be eliminated, and the firm will enjoy more solid operating margin and, thus, EPS. It is ultimately worth highlighting that if the impetus of growth in China burns out, Hugo Boss's revenue growth will be under strain. However, I suppose China will continue to propel the firm's sales, securing cash generation, and stimulating investor confidence.

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.