IDEXF - Inditex: Zara Has A High-Quality Business Model Trading At A Discount

Summary

• I cover Zara, one of Inditex's companies, and it's a high-quality business model.
• Inditex is trading at a discount through Discounted Cash Flow analysis.
• Zara has downsides if fashion trends remain stagnant and they are late comers to the ecommerce scene.

Thesis

Industria de Diseño Textil, S.A. ( OTCPK:IDEXF ), also known as Inditex, is a Spanish multinational clothing company. One of its largest and fastest growing companies is Zara. I believe Zara has a very high-quality business model and its parent company is trading at a discount through Discounted Cash Flow analysis.

Marketing Data

Zara offers a wide and unique selection of 30,000 items per year, compared to competition like Gap and H&M, who only tout around 2,000 to 4,000 items per year. Because of this selection, Zara can collect a large sample size and extremely accurate marketing data to help cultivate ideas for the next popular design quickly. They can implement this in real time, by having employees hold smart phones and tablets, and asking customers how they would feel if Zara tweaked the design of the product a bit. Furthermore, the driving force to motivate the employees is by rewarding those with 70% salary bonuses if they perform well. In other words, Zara set up an ecosystem where the company drives to find the best marketing data possible.

Designing Products Based on Marketing Data

Once the data is collected, they can analyze to quickly design, manufacture, and implement the product in less than two weeks. This decimates lead times compared to competitors. The main reason they can effectively do this is through vertical integration of manufacturing. Zara owns their suppliers, so they can implement their systems to make the value chain more efficient. This has allowed Zara to invest upstream how they choose, rather than hoping their suppliers invest correctly. This has allowed them to invest in supreme automation in fabric cutting and dyeing robots and drive efficiency and speed. It also helps to implement their RFID scanners to track products through their entire lifecycle before the customer. This is something their competition struggles with as they tout thousands of suppliers who they rely on, rather than outright owning.

Using the Products to Generate More Marketing Data

Combining these pillars helps to create a cycle of growth. Essentially, a wide selection drives accurate market data. Accurate market data drives the most effective products. The most effective products are quickly manufactured and sold to customers, which then drives the wide selection and market data. This feedback loop has helped rocket their market dominance against competitors but there are other advantages too, especially with inventory management.

If Zara finds one of their items didn’t quite sell the way they wanted to, they can quickly dismantle the idea and replace it with something else. Competitors who inaccurately predict what the future trend is, are stuck with obsolete inventory in which they either must mark down or throw away. At that far point down the chain, this is an extremely expensive fault which has led to a saying in retail: Inventory equals death. This also means Zara doesn’t waste time on deals, which pressure customers. Once they see an item they like, they had better buy it right now, or it might be obsolete in a couple weeks. There are no customers waiting for deals for Zara as this is slow or not cost effective.

Why is it counter intuitive?

The story reminds me of a couple of different businesses. The first being Amazon ( AMZN ), who have built themselves on a similar model of wide selection, vertical integration, and just overall customer obsessiveness. The other being Spotify ( SPOT ) , who again, offers a wide selection, and uses that data to tailor the most profitable songs and playlists to the customer. The use of technology has allowed these companies to grow by not guessing what the customer might want, but by using data to effectively understand what the customer wants. This does seem counter intuitive when I think about how Ford became the giant it is today. Back then, it was about offering one style, one color, and forcing the customer to deal with it. This is because it was the cheapest way for Ford to manufacture the vehicle. It wasn’t about choices; it was about making the car affordable. Zara doesn’t have to use this model, nor should it. With the expansion of technology, creating a single affordable product is quite easy. It is when you expand the product line to tailor the customer, when things get a bit tricky.

I also compare Zara to the 3D printing of manufacturing. Today, customizability in manufacturing is still very expensive. I could envision a company who uses a similar business model to design, manufacture and create a product for the customer in very short lead times. Also, like Zara, this would help reduce wasted inventory, along with a great deal of other advantages. Though the business model seems counterintuitive, the modern era of technology has almost led to an expectation of wide selection, speed, and quality.

Valuation

The valuation will consist of a discounted cash flow model ("DCF") using Worst case, Base Case, and Best Case scenarios.

The full table can be found here:

DCF_-_INDEXF.xlsx

Feel free to download and mess with the assumptions in the tan boxes and let me know your results in the comments.

Assumptions

The following assumptions on revenue growth and free cash flow ("FCF") margin are in the tan boxes. These are based on historical averages and analysts' estimates. We also apply a weighted average cost of capital as a discount factor and a terminal growth rate.

The Model

The model has historical revenue inputs in the tan boxes along with Net debt and Shares Outstanding. All inputs come from Seeking Alpha financial statements.

The Results

We display the results as a sensitivity table. The average of these results is shown as well.

Based on these results, IDEXF seems to be trading at a discount.

The Downsides

Zara’s business model has a couple of drawbacks. The first is if a single style, product, or theme becomes popular for an extended period, they will have to markdown items to compete with price. Zara is built to test out protype designs and mass manufacture them until they subside, but if they remain popular for some time, other manufactures will eventually catch up.

They were also a little late to the e-commerce trend, where companies like Amazon have perfected and could potentially compete for those ordering from home. The biggest issue is since their items are a little pricier than competitors, its economic cycles and recessions may push customers to buy from cheaper alternatives such as Walmart. Although, since Zara already has very high margins of 60%, compared to other retailers of 39%, they may be able to survive some of these cycles by periodically reducing prices to sell products.

Conclusion

Zara has successfully integrated tech to create an ecosystem where a feedback loop helps grow the business. We are at the age where the customer values selection and speed, and quality. Although there are some downsides with pricing power of other retailers, Zara’s business model allows them to quickly adapt on the fly, such as cutting prices to compete during a cyclical downswing. A clear example of the strength of Zara’s business model is from one Gap exec, “I would love to organize our business like Inditex, but I would have to knock the company down and rebuild it from scratch”.

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