ZLDSF - Zalando: Still Unsure If Guidance Can Be Fully Achieved At This Stage

2023-06-15 04:08:01 ET

Summary

• Zalando's ability to achieve its growth guidance is uncertain due to a mixed outlook and challenges in the current macro operating environment, including a potential slowdown in e-commerce penetration growth.
• Despite a decrease in gross margin in 1Q23, Zalando's margin outlook is more positive, with the potential for a return to normal levels and achieving FY23 EBIT goals.
• Strategic initiatives and improved order economics contribute to the overall improving EBIT margin, but further data is needed to draw firm conclusions.

Thesis

Zalando ( ZLDSF ) is an online fashion retailer in Europe. Its custom- built, proprietary IT systems enable efficient, data-driven decisions across the business. The business has a very large range, including over more than 5,000 brands and a focus on customer convenience. I mentioned previously that there is a possible path for ZLDSF to improve margin and growth GMV in the double digit range as guided. However, the timing was difficult to predict, and ZAL's share price dropped as I believe the market became concerned about the company's ability to reaccelerate its growth. This makes management's guidance for margin acceleration in the second quarter less reliable. Remember that the bull case for ZLDSF is that it meets its guidance; as such, credibility is critical. Given the increased uncertainty following 1Q23, I my recommend a hold rating. Below, I discuss management guidance and my business outlook for the future.

Unsure if the business can hit growth guidance

I am less assured of ZLDSF guidance moving forward given the mixed outlook. There are two key parts to the guidance: Growth and margin.

In terms of expansion, management has stated that 2Q23 has gotten off to a slower start with a drop in trading in April compared to 1Q, and that they anticipate Q2 demand to remain subdued. Nonetheless, management remains confident in a mid-term return to GMV growth in the tens of percentage points. If we do the math, we can see that this requires a rapid increase in sales in the coming quarters if ZLDSF wants to reach its goal. There are two main reasons why the current macro operating environment makes me doubtful about this recovery. First, I anticipate a slowing in ecommerce penetration growth, thereby reducing the impact of the secular tailwind that ZLDSFY was expected to enjoy, because MOVs (minimum order value), order bundling, and returns charges have significantly reduced the value proposition of ecommerce to a typical buyer (I am sure there are still people that enjoy it, but these changes would impact the less hardcore buyers that wants to buy 1 or 2 small items irregularly). Telling evidence that the business is facing some form of headwind can also be seen from them reducing SKU counts (1Q23 earnings call). Second, while I find it promising that ZLDSF is taking steps to boost wallet share growth - such as by increasing localization and improving search functionality through the use of AI - I do not see these steps as ones that can move the narrative for the stock just yet because of how difficult it is to quantify their effects.

Margin seems to be on track

As for margin, the outlook is cleaner as 1Q23 margin supports FY23 EBIT guidance. Even though the company's gross margin fell by 80bps in 1Q, I do not believe this is a major problem because Fashion Store inventories were actually down and wholesale buying was in line with guidance. Overstock therefore appears to be less of a problem, and going forward, gross margin should return to normal, which will help achieve the FY23 EBIT goal. In particular, enhanced order economics and greater marketing leverage drove adj. EBIT to significantly outperform projections. What caught my eye was the decrease in fulfilment cost ratio of 310bps, which is both a positive and negative. The good news is that this demonstrates ZAL's ability to manipulate this ratio downward. On the negative side, since Offprice is responsible for the bulk of the size reduction, the steep drop in this cost ratio may level off. However, I do believe that management's strategic initiatives, which were continued from 4Q22 and are expected to be sustainable going forward, have contributed to the overall improving EBIT margin. I see a much clearer path to profit improvement this year, as management anticipates a similar absolute improvement in profitability as in 1Q23 compared to last year. However, this also means that the success of the ZLDSF in 2H23 is crucial to the accuracy of its hitting guidance. So, while things appear promising on the margin front, I think it's prudent to wait for additional 3Q23 data before drawing any firm conclusions.

Valuation

ZLDSF valuation continues to deteriorate, with a forward revenue multiple of only 0.6x, the lowest it has ever been in the last eight years. When compared to Farfetch (FTCH), ZLDSF trades at a discount, which I believe is due to the expected growth rates in the short term. According to consensus, ZLDSF will grow at a mid-single-digit CAGR over the next two years, while FETCH will grow at a rate of more than 20%. If ZLDSF meets its guidance for double-digit growth, I believe the valuation gap will close. That said, I don't see a path for valuation to re-rate today until there is concrete proof of this.

Conclusion

The future outlook for Zalando's growth guidance remains uncertain. While management expresses confidence in mid-term GMV growth, the current macro operating environment presents challenges, including a possible slowdown in ecommerce penetration growth. On the other hand, the margin outlook appears more favorable, with 1Q23 supporting the FY23 EBIT guidance. However, the success of Zalando in the second half of 2023 is crucial for achieving its targets. The company's valuation has deteriorated and trades at a discount compared to FTCH, reflecting market concerns about short-term growth rates. To close the valuation gap, Zalando needs to deliver on its double-digit growth guidance and provide concrete proof of its performance. Given the uncertainties, it is prudent to wait for additional data before making firm conclusions about the company's prospects.

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