Hennes & Mauritz: Where Did My Operating Margin Go?

Company: Hennes & Mauritz AB, H & M ser

Written: Sep 2015, updated Sep 2016

Authors position: Selling short since Dec 2014

Average short sale price: 338.50 SEK


Overview of Investment Thesis

  • At 300 SEK+, H&M is priced for perfection and completely lack margin of safety. Any hiccup in its growth could potentially cut the stock by 30-50%.
  • The high growth still reported by the company hides the fact that H&M is running out of high-return investments and is resorting to investments in markets with a longer payoff.
  • H&M is used to operating with uncharacteristically high margins for a retailer, but has lost significant territory in this regard ever since emerging markets became an important growth driver.
  • While H&M’s business model still generates highly attractive returns, there is a significant amount of mean reversion at work in the margins. This mean reversion will significantly pressure cash flow and dividend growth into the future.
  • H&M’s growth is completely dependent on expansion in the company’s number of stores. The aggressive store expansion is burdening’s H&M balance sheet. The debt is hidden off-balance sheet from investors.

path3344*Diagram 1 displays H&M’s cash flow growth from 2005-2015. Operating Cash Flow Margin (OCM) is calculated by adjusting Cash Flow from Operations (CFO) for Working Assets, non-recurring items and certain misplaced items. Free Cash Flow (FCF) is calculated by subtracting OCM by CapEx. % YoY represent year to year growth and is calculated using an arithmetic average.

Growth At The Expense Of MarginsDiagram 1 validates that H&M has been producing impressive and consistent cash flows ever since 2005. Calculating H&M’s compounded annual growth rate (CAGR) from 2005 to 2015 shows that H&M has compounded an 8.6 % yearly growth in OCM. Considering the company’s size, it’s very impressive for H&M to be growing their cash flows just shy of 9 % per year. H&M’s cash flow production also appears very robust in its nature, as the fundamentals and cash flows barley noticed the 08 credit crunch.

Observing H&M’s impressive cash flow growth and consistency in operations, it’s no denying that H&M is a very successful business. But a good business is not always a good stock. The price has to be right. As Benjamin Graham taught us, the price you pay for an investment matters a great deal. In fact, price is the primary determinant of the return you earn on your investment.

Graham realized that investors tend to overpay for growth stocks. In H&M’s case, the company is needed to produce cash flow and dividend growth of around 10 % per year until around 2023 to justify its 300SEK+ valuation. These growth numbers might seem achievable looking at historical data, but there are several reasons why we cannot be sure that the trend of profits shown in the past will continue in the future. In the broad economic sense, there is the law of diminishing returns and of increasing competition, which must finally flatten out any sharply upward curve of growth. For H&M to be protected from diminishing returns, the company has to bear some kind of moat. A moat is a type of sustainable competitive advantage that a business possesses that makes it difficult for rivals to wear down its market share and profit. In other words, businesses with economic moats have sustainable growth. The wider the moat, the larger and more sustainable the competitive advantage of a firm.

By having a well-known brand name, a large portion of market demand, and economics of scale, H&M has possessed a competitive advantage for the last years, which has benefited the company with uncharacteristically high margins for a (fashion) retailer. But a competitive advantage is not a moat. A competitive advantage is any advantage that currently allows a company to earn premium margins over its competitors. But an economic moat is a sustainable competitive advantage–a competitive advantage that will last. Without sustainable competitive advantage, a company’s margins tend to revert back to the industrial average in the long run.


*Diagram 2 & 3 shows H&M’s Gross & Operating Margin for 2005-2016. Gross Margin is calculated by; Sales including VAT – COGS / Sales including VAT. The Operating Margin is calculated by; Operating Profit / Sales including VAT. The forecast for 2016 is calculated by a trailing twelve-month average; 2015 Q4 + 2016 Q3 – 2015 Q3.

Examining H&M’s margins, we can clearly see that the company is losing its competitive advantage. This is very visible in the company’s gross margin, which is down to 61 % this year from a peak of 68 % in 2010, but even more so in the operating margin. The latter has nearly been cut in half and is down to 11 % in 2016 which, while still fairly attractive for the industry, is significantly below its peak of 20 % in 2007. The increasing competition from other fast fashion retailers and store growth that is penetrated in the high value locations have led to and is contributing to an ongoing significant margin erosion. Most of these comparable are sourcing the same materials from the same factories going after the same customer base, all with great ambitions to grow very rapidly. It should be emphasized that If H&M continue to see a decreasing margin at the same historical rate into the future, the company’s growth prospects will completely disappear.


“We are growing in existing markets as well as in new countries. The expansion is long term, with a focus on quality and sustainability. The growth target is to increase the number of stores by 10–15 percent per year with continued high profitability” – H&M’s webpage, expansion strategy tab. 

The diagram to the right is showcasing H&M’s impressive store growth and is proudly displayed in H&M’s annual report. Every quarter brings some news of massive expansion — or at least another campaign starring David Beckham. H&M’s robust store growth, which have served the company very well in the past, are, however developing into the company’s biggest weakness. In fact, as margins are falling, H&M’s growth has become completely dependent on the expansion in its number of stores. An over-reliance on store expansion has made the company’s target to yearly increase its number of stores by 10-15 % a bare minimum for the company to keep up with its historical cash flow growth.

Off-Balance-Sheet Financing

H&M is displaying an extremely conservative balance sheet in their reporting, trying their best to convince investors that their growth is sustainable and that there is still room for leverage expansion. The group’s balance sheet for 2015 shows Total Liabilities around 28 BSEK and Total Equity around 58 BSEK. Yearly CFO is around 30B, indicating that H&M could cancel all their outstanding debt with only one-years’ worth of cash flows.

From a corporate finance point of view H&M’s current capital structure makes no sense at all. By increasing the company’s debt proportion, the return on equity would increase in a linear fashion. And because interest paid on debt is tax deductible, issuing bonds effectively would also reduce the company’s tax liability. The reason the balance sheet makes no sense is because the balance sheet does not represent the true picture of the company. As a result, the conclusions investors draw using information from H&M’s current balance sheet end up far from being accurate.
The truth is that the majority of H&M’s debt is hidden off-balance sheet. This fact is however completely overlooked by the Swedish investment community. Even the most established banks are clueless regarding H&M’s true leverage (Or they are aware, but choose to look the other way to steer prices). Quoting Carnegie bank and Handelsbanken, two leading financial advisor and asset manager with a focus on the Nordic region.

Carnegie has thus continued a buy recommendation for H&M’s share, to capture the company’s strong global position, remaining potential in increased store expansion, strong sales- and profit growth, solid balance sheets and good dividend opportunities. Carnegie price target for the shares is set at 375 crowns.

Handelsbanken assesses that this will change now and see great potential in the share. In addition to continued strong retail growth (close to 100 new stores in Q2), the online investment and new concepts, Handelsbanken likes H&M’s debt-free balance sheet and stable dividend yield.

Presumably our readers realize that, while taking into account H&M’s massive store expansion, it’s not reasonable to assume that H&M has close to none long term & interest bearing debt. H&M leases all of their stores, and by reporting all their leases as operating leases, H&M can stack debt off-balance sheet.

There are two ways of accounting for a lease, either as an operating lease, or as a capital lease. When leases first evolved, managers quickly advocated treating them as operating leases.  Operating leases essentially are rentals. The argument continues that accounting for these operating leases involves a simple recognition of rental expense and the payment of the cash or recognition of a payable. Capital leases are those leases that in substance are really purchases of the property. The lease contract serves merely as a legal mechanism by which the transaction is effected.

To simplify, all investors really need to know is that capital leases consolidate on the balance sheet while operating leases do not. Managers do not like to show lease liabilities, especially when they become huge. Managers therefor expend much time and effort in an attempt to keep these liabilities off the balance sheet.

While the operating lease method appears acceptable when one rents something for a short period of time, such as a day, a week, or even a month, it stretches credulity to make this argument when the rental period extends for a substantial time. In H&M’s case, we can clearly see that the management team has the ability to stretch the lease period as long as they want.

“Most of the agreements contain options to extend the term.” Annual report 2015, page 98

Even though H&M’s rental period extends for a substantial time, the company reports the leases as operating leases and not as capital leases. These lease-assets are of major economic importance for H&M but management chose to entirely omit them in the balance sheet. To clarify, leasing in itself is not the problem. The problems lie in treating the leases as operating leases when they obviously should be booked as capital leases. The best solution for stakeholders to protect themselves from these kind of shenanigans is to carry out adjustment to put these liabilities back on the balance sheet where they belong


*OFF-BS stand for off balance sheet and ON-BS stands for on balance sheet. BC stands for best case and WC stands for worst case. BC uses the present value of the company’s future lease commitments and WC uses rent expense times 8.

Adjusting for operating leases indicates that at least 70BSEK is kept of balance sheet, which is probably being too conservative, and at most 164BSEK is kept of balance sheet, which is probably being too harsh. The adjustment range is indeed big, as it’s a big difference between 70BSEK & 164BSEK. The reason the estimates are very rough is because off H&M’s lack of disclosure.

“It is better to be approximately right than precisely wrong.” John Maynard Keynes 

Managers are obviously trying to hide the debt from stakeholders which makes it hopelessly to adjust with great precision.  These adjustments may not be exact, but they are still crucial for analytic work. Digging deeper in H&M’s annual report we can find information regarding future implementation of IFRS 16.

 “IFRS 16, leases will be adopted by EU beginning on January 2019.” page 91, 2015 annual report    

In 2005, the US Securities and Exchange Commission (SEC) expressed concerns about the lack of transparency of information about lease obligations, reiterating concerns already expressed by investors and others. One of the prime reasons for the implementation of IFRS 16 reads like this

Under the old IAS 17 entities were able to classify a significant number of liabilities as operating leases and as a result keep both the asset and the liability off balance sheet

This means that by 2019 H&M will be forced by IFRS standards to put these liabilities up onto the balance sheet. How this will affect the stock price I can’t answer for, but it surely will be interesting to see how much liabilities are actually off balance sheet by then.

Companies are regularly required to make statements regarding how future accounting changes will affect their business. Hidden in the footnotes a very political answer can be found.

The group has not evaluated the standard, but expects it to result in recognition of material assets and liabilities associated with the group’s leases for premises.


*Total Debt is calculated by; On balance sheet activities + average of Worst-case off-BS & Best-case off BS. Total Debt / OCM is equivalent to a Total Debt / EBITDA metric.

By adjusting for operating leases, H&M all of a sudden went from having a very conservative capital structure to a more aggressive capital structure. Diagram 4 shows that H&M’s Total Debt to OCM ratio is closing in at dangerous levels. Ratios higher than 4 or 5 typically set off alarm bells because this indicates that a company is less likely to be able to handle its debt burden. As debt expansion in H&M is required for continued growth, this ratio is expected to grow higher in the future.




*Diagram 5 shows accumulated percentage growth for Total Debt & OCM. The percentage growth is calculated using an arithmetic average.

Comparing Total Debt and OCM growth, we can clearly see that debt is growing faster than OCM. If the divergence between Total Debt and OCM continues, H&M’s store expansion will not be sustainable in the long run. As growth in Sales and growth in Off Balance Sheet Debt are highly correlated (around 0.77), H&M has nowhere to go. A future deleveraging would result in catastrophic result for the shareholders who bought in at 300SEK+.




*The diagram to the right shows H&M’s expected store growth on a net basis. The diagram assumes a 12.5 % yearly growth rate in stores.

To put H&M’s growth target, to increase its number of stores by 10–15 % per year, into perspective, H&M would by 2025 need to own as many stores as Walmart does today. To assume that H&M will grow into the same size as the world’s largest retailer is not a reasonable assumption in my opinion. Today, almost three new stores are opened per day. Every time you eat breakfast, lunch or dinner a new store is opened. And still H&M is expecting to increase their pace into the future.

 2016 – Sell off

The stock market attaches great weight to the indicated trend of earnings. The trend might prove deceptive and valuations based on trend obey no arithmetical rules and therefore may be too easily exaggerated. As H&M was trading around 360SEK+ in late 2015, the stock was set up for a major correction. As the attitude of Wall Street changed the stock sold off in similar fashion to 2008. Each consecutive quarter in 2016 has been worse compared to 2015. H&M pinpoints the exact problem with pricing in too much growth. Even if the difference between the fundamentals in 2015 and 2016 appear rather small, the priced in expectations transforms such a small difference to a disaster.


*Diagram 6 shows H&M’s dividend sustainibility. Cash available to satisfy finance providers (CASFP) is calculated by; OCM – Net CapEx – Taxation – Cash generated/invested in Net Working Assets.

CASFP measures how much money is left from operations to pay dividends and interest on loans. As diagram 6 shows, the spread between CASFP and the dividend has been shrinking close to zero, indicating that not only future dividend growth is threatened, but also that maintaining the dividend at current levels might be unsustainable in the long term. I want to emphasize that the dividend, and most important, the dividend growth, is key factors that will contribute to the total return for long term investors. If H&M doesn’t turn around its cash flow growth, H&M’s future CASFP will not be enough to support the expected dividend growth while still maintaining a somewhat healthy balance sheet. If the CASFP doesn’t hold up, the unsustainable dividend will work like a slow growing cancer, forcing H&M to use even more leverage debt to support the dividend growth, or a more reasonable assumption, lowering their future dividend.

H&M’s explanation for their bad quarters in early 2015 & 2016 follows as

Below expecting profits are mostly explained by the strong US dollar effect on purchasing costs.

The statement that the strong dollar is hurting H&M is probably reasonable, but I still find it a bit questionable. On page 92 in H&M’s 2015 annual report you can find.

Most of the group’s sales are made in euros, and the group’s most significantpurchase currencies are the US dollar and the euro.Fluctuation in the US dollar/euro exchange rate is the single largest transaction exposure within the group.To hedge the flows of goods in foreign currencies and thereby reducethe effects of future exchange rate fluctuations,100 percent of the group’s purchases of goods and the bulk of correspondingforecast inflows from the sales companies are hedged under forward contracts on an ongoing basis.”

I interpret this paragraph like that H&M has hedged the dollar euro exposure. My first though was that either H&M is using the dollar argument as an excuse for the bad result or H&M hedges by fixing the purchase price at the time of purchase (uses a very short hedging period). How much the stronger dollar has contributed to the below expected results for H&M I will leave up to the reader to calculate by them self, as I don’t have great confidence regarding this subject.


What investors can learn from H&M is that competition, regulation, the law of diminishing returns, etc., are a powerful enemy to unlimited expansion. Hence, instead of taking the maintenance of a favorable trend for granted – as the stock market likes to do – the analyst must approach the matter with caution, seeking to determine the causes of the superior showing and to weigh the specific elements of strength in the company’s position against the general obstacles in the way of continued growth.

I believe the margin-dilutive factors can be found in increased competition (leading to pricing pressure), inflationary pressures on cost of products, or less-than-optimal same-store sales performance. Given the uninterrupted focus on store expansion, I believe the company will continue to chase growth at the expense of margins. As the decreasing margin starts compounding against the topline growth and net interest starts eating into dividend growth, H&M will slowly start to suffer. Management seems to be focused on absolute growth and not on profitability measures like ROCE or ROIC. It is demented to open up to 10-15 percent new stores of your store count while your ROCE is consistently declining. I don’t think H&M is a zero growth story, but I do believe the glory growth days of the past are gone.

I see no margin of safety in buying H&M over 240SEK+, and I will classify H&M as speculation if bought above these levels.

7 thoughts on “Hennes & Mauritz: Where Did My Operating Margin Go?

  1. thanks for an interesting read. Worth highlighting is that rent leases bring an offsetting benefit (access to store space) which is currently not reflected in assets.

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