2023-07-05 11:36:26 ET
Summary
- Ermenegildo Zegna, an Italian luxury fashion house, has shown strong resilient financial performance in the face of Covid-19, inflation, and interest rates.
- The Ermenegildo Zegna and Thom Browne brands are growing extremely well currently, with the outlook suggesting further improvement.
- ZGN's future success is expected to be driven by the rising trend of "Quiet Fashion".
- Relative to its peers, ZGN performs respectively but is weakened by its lack of scale.
- Although the company is not cheap, we believe a well-run business with a positive outlook such as this will rarely be so.
Investment thesis
Our current investment thesis is:
- ZGN owns two businesses that are growing well and are positioned perfectly to achieve outsized growth due to industry trends and improving demand from China.
- Despite the impact of Covid-19 (and the impact in China) and current economic conditions, ZGN marches on impressively.
- Relative to peers, ZGN performs moderately well, comparable on profitability and growth, but lacks the fundamental scale to make it a leading business.
Company description
Ermenegildo Zegna ( ZGN ) ( Pronounced: air-men-uh-JEEL-doh ZANE-yuh) is an Italian luxury fashion house founded in 1910. The company specializes in men's clothing, accessories, and fragrances, offering high-end products with a focus on quality, craftsmanship, and timeless style. It produces goods under two brands, Ermenegildo Zegna and Thom Browne. Zegna operates globally and is known for its attention to detail and commitment to sustainable practices.
The company is a subsidiary of Monterubello Societa' Semplice (c.60% ownership).
Note: Any reference to Ermenegildo Zegna within this paper refers to the brand, whereas "ZGN" refers to the stock.
Share price
ZGN's share price has performed well since listing, with almost 20% gains, compared to the market losing ground. Given the bearish market sentiment, especially during much of this period, the performance is commendable. This is driven by improving financial performance and resilience post-Covid.
Financial analysis
ZGN financial performance (TIkr Terminal)
Presented above is ZGN's financial performance for the last decade.
Revenue & Commercial Factors
Although it is a small dataset, ZGN's revenue has grown at a healthy CAGR of 6%, during a materially disrupted period as a result of the Covid-19 pandemic. As a luxury brand, it was hit hard by the various global lockdowns, with revenue down (23)% in the year. Despite this weakness, the company bounced back incredibly well, significantly exceeding its FY19 level in FY22.
Business Model
Ermenegildo Zegna and Thom Browne design and manufacture a wide range of luxury men's clothing, including suits, shirts, knitwear, trousers, and outerwear, along with accessories such as shoes, belts, and leather goods. The company follows the traditional SS/FW fashion cycle, with a gradual increase in the size of their collection, and the range of products, as the business seeks rapid expansion.
The company operates a network of directly owned and franchised stores worldwide, allowing it to maintain control over the customer experience and brand presentation. This is vital in the luxury market, as customers expect both a continuation of the brand's aesthetic in-store, as well as a luxury experience.
Following the sale of Tom Ford to Estee Lauder ( EL ), ZGN has lost its licensing agreement to sell under the brand (held since 2006), which will contribute to a reduction in performance associated with that business. This is quantified below. We are not overly concerned by this, as investors have priced in the impact and it was always the weakest performer of the three.
One of Ermenegildo Zegna's key selling points is the quality of its products and sustainability considerations. ZGN controls the entire production process, from sourcing the finest materials globally to manufacturing the finished products in Italy, ensuring quality and consistency. This is underpinned by its ownership of the "Luxury Textile Laboratory Platform", allowing the business to produce the highest quality products while maintaining its Italian heritage and partaking in the textile business. This is at a time when many of its peers have faced criticism of their use of cheaper labor.
ZGN's brands have a long-standing heritage and a strong reputation for craftsmanship, quality, and Italian luxury. This has been developed through its supply chain but also the quality of its designs, remaining true to its design language while developing for current tastes. ZGN's management team comprises Mr. Ermenegildo Zegna di Monte Rubello (Grandson of the namesake) and Mr. Thom Browne (Founder of Thom Browne). Although it is impossible to forecast the success of future designs, we believe this structure is critical to success as research has found that founder-led companies outperform. This is especially the case in fashion due to the unwavering focus on heritage as opposed to short-term profits, which the customer subconsciously sees (See LVMH for the most famous example). This provides us with a level of confidence that ZGN will continue to develop quality products.
The rise of quiet fashion
Fashion is cyclical. A brand can be at the top of the world one day, and unpopular the next. What is important for brands to do is focus on what their customers like (maintaining their heritage), while attempting to align new releases with what is popular.
Following a period of loud, rebellious, and opulent fashion (such as from Balenciaga), we are now seeing the rise of "Quiet Fashion". The definition of this is subtle and toned-down clothing but with the classic characteristics of luxury, namely tailored designs and high-quality production. Essentially "low-key luxury". This perfectly illustrates the cyclicality of fashion, with quiet following loud.
This trend has hit the mainstream we believe following the final season of the TV show Succession, whose wardrobe is described as the "epitome of quiet luxury". ZGN even signed Succession actor Kieran Culkin as a brand ambassador . This has contributed to an increased number of celebrities embracing this trend, as well as other brands, creating a self-fulfilling prophecy that is now spreading among the masses. Especially in this current social media generation, people are highly aspirational based on what they see as popular. With such fashion trends, the final cycle is usually once things go "mainstream", which looks to be this year. For this reason, we suspect the Quiet Fashion trend will drive outperformance in the coming 12-24 months at the least, with the potential for longer.
Fashion Industry
ZGN's competitors include other luxury fashion brands such as Brioni, Canali, Kiton, and Tom Ford. Businesses generally compete based on factors such as brand image, product quality, design aesthetics, and customer experience.
A key factor in the fashion industry is China. It is the largest market for luxury fashion and so we have seen brands adapting their marketing strategy to better target this audience, with ZGN being no different (38% of Q1 revenue from China). For this reason, the end of the zero-Covid policy in the country should act as a noticeable tailwind for the company in the coming quarters.
Further, there is an increasing demand for sustainable and ethically produced fashion items, which ZGN is positioned well to exploit given the quality of its supply chain.
Finally, the development of digital marketing and e-commerce platforms has allowed businesses to increase target direct-to-consumer sales, as opposed to through retailers. This provides the potential for superior margins. ZGN currently generates 64% of its revenue from its DTC channels, leaving further scope for improvement.
Economic & External Consideration
Some have suggested current economic conditions represent a risk to luxury fashion brands, as consumers reduce large purchases following the impact of inflationary pressures and high interest rates. In our analysis of LVMH ( LVMHF ) from May22 , we suggested luxury would actually perform well, as the key demographic is not overly impacted. Since then, the LVMH share price is up >45% and luxury firms continue their march. In the most recent quarter, ZGN experienced a Tom Ford-adjusted revenue growth of 19.1%, with all regions and brands up (Particularly Thom Browne, which has performed extremely well recently), including an outperformance in the DTC channel. ZGN is showing no evidence of slowing down despite the conditions.
Margins
ZGN's margins have been relatively flat across the historical period (excl. Covid-19), with a GPM of 59% and an EBITDA-M of 13%. The main factor driving down margins is S&A expenses, with a large operational investment required to achieve sales.
We expect margin improvement in the coming years, as ZGN has likely been restricted from accretive pricing action due to market conditions, as well as economies of scale. With such a large DTC sales ratio and trend tailwinds, S&A growth can begin to slow.
Balance sheet & Cash Flows
ZGN is conservatively financed, with an ND/EBITDA ratio of 1.1x. This provides the company with sufficient flexibility to raise if required, although equity was used more recently to pay down debt.
Distributions are minimal currently, as Management has focused efforts on deleveraging. We do not believe the current debt balance poses a concern, suggesting distributions could improve.
Outlook
Presented above is Wall Street's consensus view on the coming 5 years.
Analysts are forecasting continued strong growth in the coming years, as the factors discussed above contribute to a strong performance. Further, margins are expected to improve in the coming years, although not to a substantial degree.
Overall, the coming years look to be strong, inevitably supported by an improvement in economic conditions. One must remember that post-listing, ZGN has faced Covid-19, inflation, and high-interest rates.
Industry analysis
Apparel, Accessories and Luxury Goods Stocks (Seeking Alpha)
Presented above is a comparison of ZGN's growth and profitability to the average of its industry, as defined by Seeking Alpha ( 3 2 companies).
ZGN's growth rate is forecast to exceed the market average, although lags behind on a historical basis. The size of the delta is partially distorted by high-growth businesses but is a relative weakness of the business.
ZGN is currently at margin parity with the industry, although lags the larger conglomerates. Given ZGN's smaller scale, this represents a strong performance.
Valuation
ZGN is currently trading at 17x LTM EBITDA and 8x NTM EBITDA. This is a slight premium to its historical EBITDA average.
A premium relative to its historical trading range is warranted, given the resilient performance during market weakness and the improvements forecast.
The premium relative to the market is similar to that of its own trading range, although we would imply a slight discount to this given the lack of margins relative to the larger players.
For this reason, the near-term upside is likely limited, however, the company looks extremely attractive over the medium term.
Further, given the attractive brand, we see ZGN as a potential takeover target, especially if ZGN trades at <13x EBITDA. For this reason, there is a degree of downside protection, as the business would be quickly acquired if it became attractively priced. Any suggestion of this would require the approval of the majority shareholder.
Key risks with our thesis
The current risk to our current thesis is Monterubello Societa' Semplice. With the majority shareholder's position, they have unchallenged control over the business. This is a risk to shareholders should they make ill-informed decisions.
Final thoughts
ZGN is a fantastic business that owns 2 strong brands. Both have grown well and we believe the trend of quiet fashion will contribute to over performance in the coming years. Its margins could be better and its structural position is a disadvantage, however, overall, we see this as a good business.
The valuation implies large upside is not available but rarely does a good business run well trade at a discount.
For further details see:
Unveiling Ermenegildo Zegna's Competitive Edge In Fashion