CA - Hugo Boss: Decelerating Growth And Limited Upside From China Reopening

Summary

• FY12/2022 has been a strong year for Hugo Boss AG, driven by demand in Europe and the Americas.
• With high hurdles YoY, Hugo Boss has an unattractive decelerating growth profile into FY12/2023. Its relatively low exposure to China will place its peers in a stronger position.
• Valuations do look cheap, but with limited upside, we rate Hugo Boss shares as neutral.

Investment thesis

Hugo Boss AG ( BOSSY ) has seen robust growth in FY12/2022, but we have two concerns. With a high hurdle YoY, the company's growth rate will decelerate significantly which makes it less attractive as an investment. Secondly, the company's relatively low popularity in China means its peers could strongly outperform. We have a neutral rating on the shares.

Quick primer

Established by founder Hugo Boss in 1924, the company is a luxury fashion house that designs and manufactures both menswear and womenswear, footwear, and apparel. Based in Metzingen in Germany, there are around 14,000 employees and the business operates in 128 countries.

It sources 17% of stock from its own manufacturing plants, the most prominent being in Turkey - the majority come from external contract suppliers in Asia and Europe. Europe is the largest geographic market with 63% of total sales in FY12/2021, followed by the Americas at 20% and a relatively small presence in Asia at 15%. Brick-and-mortar retail sales made up 54% of FY12/2021 sales, with brick-and-mortar wholesale making up 23%.

Key financials including consensus forecasts

Our objectives

Hugo Boss shares have performed in line with market leader Ralph Lauren Corporation ( RL ) YTD and outperformed peers such as Kering ( PPRUY ) (with brands such as Saint Lauren) and winterwear specialists Moncler ( MONRY ) with its Stone Island brand and Canada Goose ( GOOS ). Burberry ( BURBY ) shares have outperformed in this group with its high exposure to Asia, as China begins to open up and normalize.

In this piece, we want to assess the outlook for the company into FY12/2023, and its approach to gaining market share in the key Asian market.

Strong recovery in FY2022 but set for deceleration

Q3 FY12/2022 results were strong for Hugo Boss, with 18% sales growth YoY (currency adjusted) and 8% EBIT growth YoY. Demand was firm in both Europe (sales growth 17% YoY) and the Americas (sales growth 18% YoY), and Asia Pacific was said to have reached double-digit growth YoY. Despite increasing cost inflation in freight, gross margins at 60.8% remained relatively stable YoY, falling only by 0.9%. Negative impact from regional sales mix was offset by full price selling activity, and the level of discounting has fallen YoY as well.

The slower pace of EBIT growth versus sales momentum was due to notable increases in selling and distribution expenses which grew 28% YoY, as well as marketing which increased by 39% YoY. The business remains in investment phase to continue executing its mid-term "CLAIM 5" ( page 39 ) growth strategy.

The company is said to have made a solid start to Q4 FY12/2022 and continues to set high hurdles YoY. Consensus forecasts denote a significant slowdown in both sales and operating profit growth down to high single-digits YoY for FY12/2023. An indicator for the outlook for H1 FY12/2023 is wholesale orders, which for the pre-spring and spring/summer are said to be up double-digit YoY. Consensus may be too conservative, but concerns over Europe's outlook without a post-pandemic demand hike temporarily boosting retail activity appears to be the key concern. We also think that despite management stating that there has been no slowdown in trading in October 2022, there is a risk that certain markets will see weaker retail activity such as in the UK and Japan where consumer activity is visibly falling. Whilst the high-end luxury sector tends to remain resilient in an economic downturn, Hugo Boss may be a victim of its recent success in market share gains as it has attracted a wider customer demographic - particularly in Generation Z and Millennials that would be impacted more directly in an economic slowdown.

Asian presence is not a strong point

Despite the tendency for luxury brands to be dependent on Chinese demand, Hugo Boss is an exception. Whilst all Western brands are currently affected by China's stringent lockdown policies and a slower pace of opening up, Hugo Boss stands out as being relatively unpopular in the world's second-largest luxury market after the US. The company has had a relatively checkered history in the Chinese market, with store closure in 2016 followed by renewed efforts to revitalize its presence. One issue may be that the brand is seen as more of a direct peer to brands such as Chanel, Balenciaga, and Dior, as opposed to in Western markets the peer group is less formal and at lower price points.

Asia Pacific was originally intended to make up 20% of total sales by FY12/2022 back in 2019, but this is unlikely to be met. Although there is a significant upside to the company's earnings outlook if it executes well in China going forwards, efforts made to date show that there has been limited success, and the company's high dependence on the European market remains. Consequently, the company's less-diversified geographic exposure poses some risk to earnings growth in the short to medium term, and peers could demonstrate significant relative outperformance as China comes back into the picture in FY12/2023.

Valuation

On consensus forecasts, the shares are trading on PER FY12/2023 16.0x and a free cash flow yield of 15.5%. These valuation metrics are quite attractive and do not appear overvalued. However, given a decelerating growth profile, a low dividend yield of 0.7%, and what is inherently a 10% EBIT margin business, the shares start to look fairly valued. There may be intangible value in the brand, but in the fashion industry, this can go up as well as down with trends and popularity.

Risks

Upside risk comes from a stronger-than-expected start to FY12/2023, with the company growing double-digit sales YoY with stable margins as demand remains robust in the key European market. China's re-opening could bring about a new growth driver, although the impact could be relatively small.

Downside risk comes from a major slowdown in European consumer activity, with FY12/2023 starting slowly as consumers spend less after Christmas. Shifting stock with higher-than-expected discounting will lower gross margins, whilst the company continues to manage cost inflation.

Conclusion

Hugo Boss executed well in FY12/2022 in its key markets, and its brand momentum has been strong. Our concern is that this is unlikely to be a sustainable trend, as the brand's more mainstream appeal will be impacted by consumers tightening their spending in an economic slowdown, and the brand's relatively low popularity in China which will place it in the shade versus more Chinese-centric peers. Valuations appear fair in our view and we rate Hugo Boss shares as neutral.

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