Hennes & Mauritz: Full-year & Fourth Quarter Results

Follow up to prior analysis 


  • I covered part of my short exposure below SEK 240 as the risk-reward profile has changed with the stock selling off.
  • The Swedish investment community has a lot of trust in the H&M stock. The stock is still a crowded trade and the willingness-to-buy in conjunction with any good news seems overoptimistic to me.
  • H&M’s Q4 report was pretty much inline with my estimates, and even though Mr. Market seems positively surprised with the report, I still see the same structural problems in place.
  • I still see no margin of safety in buying H&M over SEK 240, and therefore advise investors to stay away.

As the full year report was very much in line with my forecasted numbers (Net Sales, Margins, CFO, etc.), I will only comment on what’s new. I still see the current consensus estimates as too optimistic, looking for sustained double-digit growth, some margin recovery, improving net cash position and growing dividend. As the risk-reward profile has changed with the lower valuation, I would however recommend to be more careful with shorting. I will reiniate a larger short position if H&M closes in at SEK 300 again, assuming the fundamentals have not changed. Following are a few catalyst that could be problematic for shorters.

Risk to shorting H&M

  • Stronger top-line momentum leading to faster margin progression than expected.
  • Series of particularly strong fashion seasons (with H&M making more “bets”than key peer ITX given its more conventional business model).
  • Material positive economic surprise in continental Europe (where H&M is particularly exposed).
  • Lower-than-expected opex thanks to tighter discretionary cost control.
  • Significant beneficial exchange rate movements, such as a strengthening of the EUR versus the USD or CNY.

Dividend Sustainability

H&M is needed to produce significant cash flow and dividend growth for several years to justify a +SEK 300 valuation. The Board of Directors proposes a dividend of SEK 9.75 (9.75) per share for the 2016 FY. The Board proposes that the dividend is to be paid in two instalments during the year – in May and in November. This means H&M will have two consecutive years without dividend growth. But the underlying problem might be larger than this, as maintaining the dividend at current levels might be unsustainable in the long term.

*The diagram shows H&M’s dividend sustainability. Cash available to satisfy finance providers (CASFP) is calculated by; Adjusted CFO – Net CapEx – Taxation – Cash generated/invested in Net Working Assets. Notice that I adjusted H&M’s original Net interest by including off-balance sheet activities .  

CASFP measures how much money is left from operations to pay dividends and interest on loans. As we can see, H&M’s CASFP is not enough to pay both dividend and interest for the FY. As a result, H&M has been forced to increase their on balance sheet debt for the first time since at least 2005 (I have no further data). The remaining SEK -5,569 M (CASFP – dividend – interest) was covered with on balance sheet debt (SEK 2,068 M) and cash on hand. H&M has SEK 9,446 M cash on hand, facilitating it for them to cover next year dividend if the problem prolongs. The current 134% payout ratio is however not sustainable in the long run. The only way for H&M to see a rebound in dividend growth is for a margin recovery, which would result in a rebound in CFO. Sales growth is not simply enough by its own. If CFO growth is absent for an extended period, deleveraging will be the only solution, which can easily make the stock fall an additional 30%.

Abandoning the expansion target

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.” – quote from my previous analysis.

The management team seems to be following my analysis (which they obviously should) as the company now is abandoning its previous expansion targets to increase the number of stores by 10-15 percent. Instead, the new target is to increase total sales by 10-15 percent, measured in local currencies. The abandonment of the expansion target tells my that the management now have admitted to themselves that the expansion has become unsustainable. This strengthens my thesis that the glory growth days of the past are gone. In total, 430 new stores are planned to be opened this year, which is an 9.9 % increase from the previous one.

Conclusion

My conclusion is still unchanged. I believe the company will continue to chase growth at the expense of margins. As the decreasing margin starts compounding against the top line growth and net interest starts eating into dividend growth, H&M will slowly start to suffer. I don’t think H&M is a zero growth story, but I do believe the glory growth days of the past are gone. My current DCF-based valuation is ~SEK220 on the following factors: medium-term growth of 5.0%, terminal growth of 2.5%, tax rate of 24% and WACC of 9%

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.


I will update this post when the full annual report is published as a lot of data regarding off-balance sheet activities for 2016 are missing from the stand alone quarters.

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