H&M: Stuck Between a Rock and a Hard Place?

All amounts in SEK. 

The story of H&M goes back to 1947 when Erling Persson – father to Stefan Persson (Chariman of the Board) and grandfather of current CEO Karl-Johan Persson – opened the first store. Since then, H&M has grown and expanded its business internationally. At the end of its latest full fiscal year in 2015 it operated a total of 3,924 stores in 61 different markets around the globe with total sales of 181 billion (fiscal year 2015). As of 31 August 2016 the group had 4,135 of which 176 were franchise stores.

The Persson family is the dominant major shareholder and controls 69.7% of voting rights and 37.7% of total shares outstanding (see table below). H&M is more of a publicly listed family company. This could be one of the reasons explaining H&M’s poor quality when it comes to financial reporting and the disclosures presented in the annual report.

This text focuses on H&M’s annual report for fiscal year 2015 (1 December 2014 to 30 November 2015).

hm_majorshareholder
Source: H&M Annual Report 2015

Expansion has been nothing but extraordinary with each year offering new store openings and growing total revenues. Focusing on revenues, H&M has delivered some pretty solid growth. But, the further down the profit and loss statement we go, the worse it gets. Profitability has not kept up with the growth in sales, putting pressure on profit margins.

During the last nine years, that is 2007 to 2015, H&M grew its revenues at a compounded annual growth rate (CAGR) of 8.7%, from 78,346 million in 2007 to 181,861 million in 2015. Gross profit and operating income during the same period grew at a CAGR of 8.0% and 3.9%, respectively. The lower CAGR in gross profit and operating income put pressure on profit margins, with gross profit margin going from 61.1% in 2007 to 57.0% in 2015, and operating margin from 23.5% to 14.9%.

The last decade has offered a solid mix of challenges for H&M; a financial crisis, currency movements, weather and fashion trends as well as growing competition from e-commerce and online retailers. The problem is not in the revenue growth itself, it is that profitability has significantly declined.

For most businesses growth comes at a cost. To maintain and grow its store count – from 1,522 in 2007 to 3,924 stores in 2015 – H&M spent a total of 56 billion in tangible capital expenditures. Then we also know most businesses have costs for growth SG&A and increasing working capital needs that comes with a certain amount of growth. H&M also spent an increasing amount of cash on its online sales business, either expensed directly through the income statement or capitalized on the balance sheet. Other operating expenses have increased from 8.9% of sales in 2007 to 10.8% in 2015. Intangible capital expenditures amounted to 5 billion, of which 4 billion was spent in 2012-2015.

The high level of investments together with declining profitability have resulted in a lower amount of cash, with cash and cash equivalents steadily declining from 20.9 billion in 2007 to 13.0 billion in 2015 (8.7 billion per Q3 2016). H&M is no longer able to found its yearly dividend from free cash flow, and the dividend has been maintained at about the same level in the latest five year period thanks to cash in the bank from prior years. Of course this could be solved to some extent by H&M if they decided to stop or reduce its growth capital expenditures (and other growth expenditures) or manage to increase profit margins and cash flows. The unpleasant part in this equation is that lowering capital expenditures would most likely result in a lower future growth rate (fewer store openings each year, even if compensated in the best case to some extent by rising online sales), or no future growth at all and in a worst case scenario with declining future total revenues.

hm_10y_financials
Source: Morningstar

Average return on equity (excluding cash and cash equivalents) has averaged 88% in 2007-2015, from a high of 134% in 2007 to a low of 52% in 2015. Returns are still great, but it’s also obvious that what we’ve got here is a negative trend in the underlying profitability. The main question for investors today is what H&M’s future profitability will look like? With the retail industry, and especially the fast-fashion sector being one of heavy competition it’s not entirely obvious what the future has to offer. Historically, H&M has made its long-term shareholders very wealthy. The question going forward isn’t about whether H&M has been great or not in the past – we all know it has. The question is what future performance H&M will be able to offer? And the last 5, 7 and 10 year periods may all have made a reasonable answer to this make-or-break question a little gloomier. But, it may still be as great as its always been, or? Since we don’t know in which areas H&M deploys all its growth expenditures and the mix between the “old H&M” and the new growth initiatives and brand building that has been ongoing for some time.

As always, we know what’s been but not what will be. H&M is currently trading at 234 per share, a level first reached in 2010. In the middle of 2013 the market changed its view of H&M and the share price went from 230, reaching an all-time high of 368.50 in 2015. Since then the share price is down about 36%.

It’s been almost a decade of declining profit margins and profitability. With a great annual report at hand we would be able to search for potential answers and understand in a good enough way what goes into this negative trend in profitability. But I’m afraid we don’t have one, since H&M seems to be following more of a “non-disclosure” policy than the other way around– sad but true, at least for outside passive investors. Let’s take a look at a few different areas in the 2015 annual report to see what’s missing.

hm_shareprice
Source: Avanza.se

Quality of Financial Reporting

Reading H&M’s annual report for fiscal year 2015 provides some great insights into the business. Although there are a few things that an outside passive investor would probably very much like to know, about which H&M says nil.

When reading an annual report and thinking about a specific business, ask yourself; What financial and non-financial metrics would I want if I was the one running the business? A few things you probably would like to know about are:

  • Sales per region, per country, at the store level, as well as sales per square meter – for each major brand in the portfolio.
  • The profitability of the business – that is, profit margins and invested capital turnover, together making up the return on invested capital – and any changes occurring and the reasons explaining any significant changes in underlying trends – again for each major brand in the portfolio.
  • Tangible and intangible capital expenditures – both maintenance and growth – split between the major brands in the portfolio.
  • Revenue growth – probably on a quarterly basis, but at least year-over-year – per region, per country, and at the store level – and again you’d want to know this for each major brand.

Does management tell you the business facts that they themselves would want to know if their positions were reversed? Let’s find out, but as a primer – you might become a little concerned about the state of things if you keep on reading.

Same Store Sales Growth. H&M no longer discloses monthly same store sales data. That’s fine with me if we talk about monthly data, but I would very much like to know what same store sales, at least year-over-year, look like. Especially in a case like H&M were growth in new stores could mask the performance in the current and old store count. Too bad, H&M does not provide this data to outside investors. Of course the relative value of this metric declines as online sales makes up a greater part of total sales. But, since H&M does not break out its online sales, should outside passive minority investors interpret this as a fact that online sales makes up a non-material part of total sales? Because if online sales made up a material and significant part of total sales, shouldn’t this information be disclosed in the annual report?

Same store sales growth is a relevant metric as long as there are physical retail stores making up a material portion of total revenues. And with the current strategy of maintaining a high growth rate and expanding the total number of retail stores, it seems unreasonable to expect this to change for some time. Thus, same store sales data is a metric of interest to investors and should therefore be disclosed, at least on a yearly basis in the annual report.

Total square meters. What are the total square meters of all of H&M’s retail stores? Management knows, you don’t since this is a non-financial metric that is not disclosed. A highly relevant metric, one could argue, for a retailer to make it possible to track revenue, profit, and invested capital per square meter for its physical retail stores. This metric should also be disclosed (at least in the annual report).

Operating Segments. Below is note 3 Segment Reporting from the 2015 annual report. There is only one issue with this note; the way it is structured and presented. It doesn’t provide anything of real value to someone trying to understand, analyze and assess the underlying business fundamentals. Maybe that’s what management want? To make it as hard as possible for others to get a glimpse of how different regions are performing. I don’t know. All I know is that this disclosure from H&M about their operating segments is of no value to me when evaluating and valuing H&M as a going concern. Right now a great part of the total operating profit belongs to Group Functions which makes it a little less useful when it comes to analyzing and assessing the development for each operating segment.

One has to assume that this segment information is in line with the requirements in IFRS 8, but one also has to assume that management does not want to provide any real value to readers. If they had wanted to do so they would have designed it in a different way.

H&M should provide information about the different geographical segments (at a proper level), different brands and their sales and profit margins and invested capital. Regarding online sales, this should also be separated and reported on a stand-alone basis. More about this below.

segmentreporting
Source: H&M Annual Report 2015

Share of Online Sales. How much of total revenues is generated from H&M’s online business? No one knows, except for management. You could look around and try to make an educated guess, and that might be good enough, but a disclosure about revenue from online sales is nowhere to be found in the annual report.

One could elaborate on the question regarding at what level of online sales in relation to total sales that would require H&M to disclose this key metric. If H&M’s online business accounts for as much as 10-12% of the total 2015 sales revenue, that is around 21 billion to 25 billion (Source: Bernstein via just-style), one could argue that this is material information to investors, and therefore should be disclosed in the annual report.

It will be interesting to follow how this develops and whether we’ll see any online sales figures in the upcoming annual report for fiscal year 2016.

Profitability of Online Sales. As much as we want to know how much sales the online business generates, we also would like to know any profitability of such sales. But, there’s no information about this in the annual report. I guess we could all agree on the importance of online sales for fashion retailers from now on. The question is what profitability looks like in this area? An educated guess is that it might not be the high-margin, high-profitability business that we’ve gotten used to in the past where most of the sales was generated via H&M’s physical retail stores.

E-commerce is no cash cow for fast-fashion retailers, whose thin profit margins from high volume sales are slashed by free shipping and returns. As the retail market as a whole is moving online, however, H&M—which was late to the game—is finally making the necessary investments to compete. “The penetration rate of online sales for apparel is just going to increase over the next five years, so if you don’t have an e-commerce website, your customers are likely to go elsewhere,” said Grant. (Source: Forbes)

Sales and profitability of different store brands. H&M discloses total revenues (hey, that’s great – ain’t it?), revenue per country and also revenue per region (in their segment reporting). What’s missing is a breakdown of revenue between the different brands, and also the split in revenue between physical retail stores and online sales. Further, no information is provided about operating income and invested capital for each brand.

hm_brands
Source: H&M 2015 Annual Report

CEO comments. The CEO comments is a great chance for a CEO to talk directly to all the shareholders and outside passive minority investors. Many CEO’s are either not good enough to express themselves and their business strategy in writing, or they just don’t want to make an effort great enough to do so in a proper way (at least seen from the perspective of an outside passive investor). CEO comments when it comes to H&M might be good, but I still think it could be improved a lot from here since much of the information provided doesn’t really offer any great insights into the business more than on a consolidated level.

Marketing and other operating expenses. H&M does not disclose its marketing expense and not any expenses related to IT. By putting together the different expense categories (rental, payroll etc.) disclosed in H&M’s annual report we can calculate how much of total operating expenses that is made up of other expenses – see table below.

Total operating expenses to sales increased from 76.5% in 2007 to 85.1% in 2015, mostly explained by higher COGS to sales (+2.3 pp), depreciation to sales (+1.1 pp), and other expenses to sales (+3.3 pp). Rental, labor, and amortization was almost unchanged. Other expenses made up 12.7% of total operating expenses in 2015 compared to 11.7% in 2007. It would be interesting to know what makes up these other operating expenses and how they have changed in composition during 2007-2015.

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Calculations by Hurricane Capital. Source data from H&M.

Earnings Call Transcripts. This is not an issue that is specific to H&M, neither to the annual report itself. I bring this up just because I think all listed Swedish companies should be required to provide transcripts of earnings calls in their investor relations section. Fortunately, there are external parts providing transcripts. See here for some H&M earnings call transcripts provided via Seeking Alpha.

Nine-Month Report 2016

A quick look at the most recent nine months shows an increase in net sales of 5.6%, compared to an increase in total store of 12.5%. H&M opened 264 (206) stores and closed 53 (42) stores, i.e. a net increase of 211 (164) new stores. The group had 4,135 (3,675) stores as of 31 August 2016, of which 176 were franchise stores.

Revenue growth slowed significantly in the first nine months in 2016 compared to the same period in the prior year. The negative trend in both gross and operating profit continued to put pressure on margins and profitability. Earnings per share declined in Q3 2016 (-9.3%) as well as for the nine months 2016 (-17.2%).

Inventory increased with 23.9% year-over-year to 31.231 million at the end of Q3 2016. Total capital expenditures amounted to -9.288 million (tangible capital expenditures of -8.087 million and intangible capital expenditures of -1.201 million).

Also, H&M raised 3.724 million in short-term loans in the first nine months 2016. Without this short-term loan H&M’s cash and cash equivalents would have been 4.956 million instead of 8.680 million at the end of Q3 2016, compared to 10.963 million in Q3 2015.

hm_q3_2016
Source: H&M Nine-Month Report 2016

Final words and valuation

To wrap this up, H&M is a good business and I have liked it earlier on and might come to do so again in the future depending on how it all plays out. What I don’t like is to invest in a business I think is a good one – especially when the historical track record has been great (which could have a significant impact on the quality of your own judgement) – just to realize later on that it wasn’t such a good business as I originally thought (and by then running the risk of a permanent loss of capital).

hm_valuation
Calculation by Hurricane Capital. Source data from Börsdata.se.

Currently H&M is trading at a P/E (TTM) of 21.2 and EV/EBIT (TTM) of 16.1, in line with its 10-year average. If H&M is able to maintain or even turn around the negative trend in earnings and keep growing the business, the current share price probably would be considered a great entry point for investors in hindsight, most likely somewhat of a bargain. If this is not the case, that is, profitability will decline even further along with slowing revenue growth, the current share price is at a high level and you should look elsewhere for ways to invest your hard-earned money.

Personally, the last decade and the negative trend in profitability coupled with increased importance of having a presence in the online sales field and the tough competition in the retail business makes H&M a too uncertain investment case for me, at least at the current price level. There are many other great businesses out there with more favorable characteristics and less uncertainty. Let’s go try find some of these instead.

If you want to make your own assessment of the quality of H&M’s financial disclosures, click here to read H&M’s annual report for fiscal year 2015.

Disclosure: I have no position in the stock mentioned, and no plans to initiate any position within the next 24 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. This article is informational and is in my own personal opinion, and should not be considered investment advice. Always do your own due diligence and contact a financial professional before executing any trades or investments.

4 thoughts on “H&M: Stuck Between a Rock and a Hard Place?

  1. Excellent write-up! You touched on things ignored by many. The stock is down another 10% or so in a couple of months. Is there a valuation that you would buy this company?

    I notice that the stock has gone nowhere in 10 years (while its sales/earnings/etc has gone up about 50% and book value about 80%). The market is clearly marking down the stock since growth is decelerating and operating margins have declined significantly (around 20% down to 15% now). P/E ratio is contracting.

    In America, apparel retail is getting killed and the sales number support that (people aren’t spending more on clothes and there are way too many chains)–not sure if same thing is going to happen throughout the world.

    The brand also isn’t as popular–likely hit a peak. I did a quick Google Trends search and “H&M” popularity (based on Google searches) seemed to be going sideways since 2012 (it was growing up to that point) (https://trends.google.ca/trends/explore?date=all&q=%2Fm%2F01d8pr).

    The question is whether the company is worth it at, say, P/E of 17 (right now it’s around 20 so another 10% drop in price assuming earnings don’t drop).

    One really good thing about this company, assuming the Morningstar numbers you quoted are right, is that share count has not gone up and no debt, which is really good!!! Probably because owners manage/own this.

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