The omnichannel fallacy

There are few things I fear more than a visit to a Zara store. Why so many people choose to spend time in such a crowded, messy and noisy place is beyond me. But it’s clear that Zara knows what it’s doing.

Although sales growth at established stores has fallen a bit this year, new-store and online sales have more than made up for it. Sales for the year just ended were €16.7bn, a figure that has grown at an average annual rate of 13% since 2002.

So we took notice when struggling apparel retailer Esprit (SEHK:330) announced it had hired Zara’s former supply-chain whiz Jose Manuel Martinez Gutierrez as its new CEO in 2012. Since 2008 Esprit’s revenue had fallen from €3.3bn to €2.9bn as the company lost market share to H&M, Mango and Zara. Martinez seemed the perfect person to reverse the trend.

His turnaround plan involved closing underperforming stores, reducing the time it took Esprit to design and distribute its clothes and selling these both in store and online. After decoding words such as ‘agile supply chain’ and ‘omnichannel distribution’, it all sounded sensible. Nevertheless, Esprit’s sales continued to fall and Martinez recently resigned.

Esprit’s share price is now down a staggering 98% since its 2007 peak. But the company’s balance sheet has €490m of cash and no debt. The market capitalisation is €530m. Subtracting the cash balance, is this an opportunity to buy a business generating around €1.6bn in sales for only €40m?

Growth addiction

Esprit still has a lot of revenue but whether this figure is growing or falling makes all the difference. When an apparel retail concept works, as in the case of Zara, sales can skyrocket for many years. Esprit itself grew at more than 10% per annum in the 15 years prior to 2007.

Yet this sales growth is seldom accompanied by outsized earnings growth. Profit margins are hard to increase as competition is usually intense and the marketing tap is hard to turn off. Since 2002, Zara’s operating profit has grown in line with its revenue at an average annual rate of 13%.

Growth also requires significant additional investment in new stores, distribution centres and inventory. Old stores also need refurbishing every few years. Shareholders often benefit from a soaring share price but collect few dividends as cash is reinvested in growing the business.

As long as growth continues, they can continue to cheer.

But you don't want to be left holding shares in a retailer when its sales start falling. Turning around a shrinking retailer is hard and Martinez is just one of a long list of CEOs who’ve failed at the task.

Hard to fix

Like most retailers, Esprit is a highly leveraged business even though it carries no debt. The company leases its stores on long term contracts and needs to pay rent regardless of business performance. So these lease obligations act in a similar way to debt. Esprit has non-cancellable lease commitments worth €740m, so its balance sheet strength is illusory. Shareholders couldn’t place their hands on that €490m cash pile even if they wanted to.

On top of rent, the company has other fixed costs. Staff costs are hard to cut as a deterioration of customer service will lead to further sales falls. Same goes for marketing spend. Costs associated with distribution and online sales are also mostly here to stay.

So investing in a troubled retailer such as Esprit is hard. Since 2008 the company has always looked superficially cheap, only to get cheaper as the years passed and sales kept falling. When the sales of a formerly hot retailer start going backwards, value is destroyed even faster than it was created. Think of Billabong (BBG) or Myer (MYR) here in Australia.

Prevention the best cure

It’s no secret that apparel retailing is tough. Consumers are fickle and the industry is both seasonal and cyclical. 'Unusually' warm or cold weather seems to happen each year. And what’s en vogue today may be passé tomorrow.

So volatile sales should be the norm in this industry. And something management teams should prepare for. Perhaps accepting a lower growth rate during the good times and targeting a smaller but more sustainable customer base would be a better long term strategy than a rapid store roll out with its associated long-tail lease liabilities?

Given management incentives are often skewed towards growth though, this might be wishful thinking. But once a retailer falls out of favour one thing seems sure enough – agile supply chains and omnichannel strategies won’t save the day.

While we continue to monitor Esprit, it’s unlikely to find a spot in the Forager International Fund anytime soon.

If you are interested in receiving the Forager monthly and quarterly reports, please register here.