Kill Your Darlings: H&M

“Kill your darlings, kill your darlings, even when it breaks your egocentric little scribbler’s heart, kill your darlings.” —Stephen King

“In writing, you must kill your darlings.” —William Faulkner

Kill Your Darlings: In Investing as Well as in Writing

In chapter 20 of the Intelligent Investor Benjamin Graham distills the secret of sound investment into three words; Margin of Safety (MOS). Graham writes adds that “All experienced investors recognize that the margin of safety concept is essential to the choice of sound bonds and preferred stocks.” If the margin of safety is such a critical principle and concept at the time you consider buying into a business, let us state another three words, of equal importance in your ongoing investment process; Kill Your Darlings (KYD). You probably already know where this is heading, right?

Substitute the word writing with investing in the above quote from William Faulkner, and you’ll get one of the most important things when it comes to investing. To continuously challenge your own assumptions and the quality of them, and always do your utmost to try to replace your current ideas with new ones.

If you fail and the business you own fail, you lose money. Conversely, if you succeed and the business fails, you saved a few pennies, pennies that could be invested elsewhere. I’m not saying that it’s easy. I would obey to the words of Charlie Munger; “It’s not supposed to be easy. Anyone who finds it easy it stupid.” Speaking for me myself, I often feel that investment is just too hard. But hey, maybe that makes me “not stupid,” for what it’s worth.

H&M: A Shining Star, But For How Long

One of the stocks I own right now and have had in my stock portfolio since the beginning of 2008 is H & M Hennes & Mauritz AB (H&M). I first bought the stock when it was trading at a market price of SEK 168 (split-adjusted), just to watch it go all down to SEK 126 per share on November 14, 2008. Since then it has appreciated in value and is currently trading around SEK 266 per share, down from about SEK 300 at the beginning of 2016, a change of approximately -12 %.

I have been thinking, as I often do, about the inherent quality of H&M’s business. Retailing is a tough place to be, and even though it is very easy to look back at the fantastic run that H&M has had over the decades (and might keep up even going forward), H&M has seen declining gross and operating margins over the last few years. Some of this due to the ongoing investment program that hopefully will bear fruit in the coming years and decades if it all turn out as, at least H&M itself, expects.

H&M opened its first store in Västerås, Sweden in 1947. At that time under the name Hennes, selling women’s clothing. Today the H&M Group offers fashion for everyone under the brands of H&M, COS, Monki, Weekday, Cheap Monday and & Other Stories, as well as fashion for the home at H&M Home. It is engaged in the design, manufacture and marketing of clothing items and related accessories. The Company’s product range comprises clothing, including underwear and sportswear, for men, women, children and teenagers, as well as cosmetic products, accessories, footwear and home textiles. The Company offers its products in a number of branded stores spread across over 40 markets. Additionally, the Company offers online and catalogue sales in Sweden, Norway, Denmark, Finland, the Netherlands, Germany, Austria and the United Kingdom. In August 2013, it launched an online store in the United States. In April 2014, H & M Hennes & Mauritz AB opened its first store in Australia. (Source: H&MReuters)


Bear, Bull… or Just Business As Usual?

No one knows what the future has to offer, we only know what has been. This is especially pertinent in the area of investing. With all the noise out there, it could be hard to just sit on the ass and not run away and buy or sell stocks just because you’ve hear someone say something about any of the businesses you might own for the moment.

Below, a five year summary of H&M financials taken from the most recent full-year report for the year ending on November 30, 2015. As you can see from it top-line growth in revenues has been pretty good. The roll-out of new stores is moving on as it has done for a long time by now. The main question is just for how long H&M is going to be able to grow at such rates. H&M still has its own guidance regarding growth intact (even though it has been some discussions about changing it), and the expect to grow stores with 10-15 % per annum.


Looking further down the income statement, it is obvious that operating profit has lagged revenue growth. Some of it due to the impact of the ongoing investment program that H&M has disclosed—about SEK 600 million in 2016 (the same as in 2015). Also, the ongoing investments in IT infrastructure can be seen in the balance sheet as capitalized intangibles assets (will be depreciated over 10 years according to management). Even though a big part of the decline in operating earnings could be explained by the decline in gross profit, it will be interesting to follow how this plays out in the coming year. What could one expect the long-term normalized gross profit and operating margins to be?


The question of profitability is a highly relevant one. What is a reasonable long-term normalized return on invested capital that could be expected to come from this massive roll-out of stores? Return on invested capital (both including and excluding lease obligations) has been falling in the last couple of years. Will this decline level of in the coming years, or not? Is it reasonable to expect any increase in operating margins, that would favorably impact returns on invested capital?

The roll-out story, so far, has clearly moved on at quite a high speed. The question is for how long it will continue, and also what levels of profitability and returns that will be generated.

Click here for a H&M company fact sheet from Morningstar.

Where Are We Going?

Depending on who you ask about the intrinsic value of any business, you will most likely get a whole set of different answers. Nothing wrong with that, since this is perfectly normal when when talking about the subject of valuing a business.

Last week Morgan Stanley released their updated analysis of H & M. To say the least, they don’t have any high hopes for H & M currently, and they cut the value per share to SEK 160 from SEK 240.

Morgan Stanley’s new price target is by far the lowest among the analysts who follow H&M. From the SME Direkt latest compilation from 11 March, the minimum target price of SEK 235. The highest was SEK 380, with an average of SEK 292. (Source: VA)

According to Morgan Stanley, operating profit per square meter has fallen by half since 2007, when it stood at 10,900 crowns compared to their estimate of nearly 5,200 per square meter last year. “During this period, H & M’s profit continued to increase thanks to the new stores the company opened, but the momentum is not sustainable,” according to Morgan Stanley’s analyst report. Further Morgan Stanley states that H&M is approaching the “mathematical breakpoint”. The decline each year since 2007 is on average 720 per square meter, and if that trend, parallel to the trend of how much new retail space supplied annually, stands up, profits will start to decline this year and have fallen by 40 percent in 2020. (Source: VA)

The H&M saga continues. The question is, at what speed, margins and profitability?

“The investor’s chief problem – and even his worst enemy – is likely to be himself.” —Benjamin Graham

Additional Reading

Disclosure: I have a position in HM-B stock mentioned. I am not receiving compensation for it. I have no business relationship with the company. This article is informational and is in my own personal opinion. Always do your own due diligence and contact a financial professional before executing any trades or investments.


H&M’s ROIC incl. Value of Leased Assets

Operating leases – an off-balance sheet item

Operating leases play an important part for most retailers since they lease their stores in which business is being done. The option would be to own all the necessary real estate.

Due to the current accounting rules (in the case of H&M International Financial Reporting Standards – IFRS) the value of leased assets are treated as an off-balance sheet item. Rental costs are recognized in the income statement as an expense linearly over the term of the leasing agreement.

To get a better understanding of the returns generated by a business, an investor needs to make some adjustments to see the underlying return on invested capital including the value of leased assets.

From this I thought I would write a few words about Hennes & Mauritz (STO:HM-B), the Swedish retailer, and their operating leases, and how to think about lease accounting as of today and what to do about this when calculating the well-known financial metric returns on invested capital, often referred to as ROIC.

H&M’s return as reported in annual reports

In the annual reports H&M has reported the following numbers regarding their Return on Equity and Return on Capital Employed:


The ratios in the table above are calculated by H&M as follows:

  • Return on shareholders’ equity: Profit for the year divided by shareholders’ equity.
  • Return on capital employed: Profit after financial items plus interest expense divided by shareholders’ equity plus interest-bearing liabilities.

From the table above, the returns achieved by H&M in the last decade have been pretty good. But as a retailer H&M accounts for operating leases as an off-balance sheet item. If operating leases where accounted for as an asset (and a liability) ROIC would be affected due to the effects on operating profit and invested capital. Return on equity would not change, it would still show the same return, including operating leases as an asset or not.

In the accounting principles section in the notes to the financial statements H&M describes how leasing is accounted as follows.

“Leasing agreements in which a substantial portion of the risks and benefits of ownership are retained by the lessor are classified as operational leases. Financial leases exist when the financial risks and benefits associated with the ownership of an object are essentially transferred from the lessor to the lessee, regardless of whether the legal ownership lies with the lessor or the lessee. Assets held under financial leases are reported as fixed assets and future payment commitments are reported as liabilities in the balance sheet. As of the closing date the Group had no financial leases. Minimal leasing agreements relating to operational leases are recognised in the income statement as an expense and distributed linearly over the term of the agreement. The Group’s main leases are rental agreements for premises. Variable (sales-based) rents are recognised in the same period as the corresponding sales.” H&M Annual Report 2013 

In note 12 Buildings, Land and Equipment H&M reports their rental costs for the 2013 financial year that amounted to SEK 15,044 million, compared to SEK 14,056 million in 2012. 

Note 8 Depreciation states that depreciation has been calculated at 12 percent of the acquisition cost of leasehold rights. H&M has some leasehold rights accounted for as financial leases, which are on-balance sheet. These are depreciated over 8.3 years (1/0.12). Below I will use this length of useful life as a best guess for the asset life of operating leases when calculating the value of leased assets from these.

Thinking about operating leases

So, what is the most proper way to treat leases when trying to figure out the underlying returns of a business and to be able to compare returns on invested capital among different retailers?

In the book Valuation – Measuring and Managing the Value of Companies the authors discuss their view of operating leases and how to treat them in a financial analysis.

“When a company borrows money to purchase an asset, the asset and debt are recorded on the company’s balance sheet, and interest is deducted from operating profit to determine net income. If, instead, the company leases that same asset from another organization (the lessor) and the lease meets certain criteria, the company (or lessee) records only the periodic rental expense associated with the lease. Therefore, a company that chooses to lease its assets will have artificially low operating profits (because rental expenses include an implicit interest expense) and artificially high capital productivity (because the assets do not appear on the lessee’s balance sheet). Although these two effects counteract one another, the net effect is an artificial boost in ROIC, because the reduction in operating profit by rental expense is typically smaller than the reduction in invested capital caused by omitting assets. The result is especially dramatic for profitable companies that lease a substantial portion of their fixed assets, as is typical of retailers and airlines.” – Valuation – Measuring and Managing the Value of Companies, 5th edition

To calculate the value of operating leases the following formula from the book Valuation (see reference above) was used:

Asset Value = Rental Expense / (Cost of Debt + (1 / Asset Life))

  • The numbers for rental expense was taken directly from disclosure in the notes in H&M’s annual reports.
  • Cost of Debt was assumed to be 4%.
  • Asset life was assumed to be 8.3 years from the disclosure in the notes about depreciation of 12% for capitalized leases.

I have made some assumptions about cost of debt and asset life that hopefully are reasonable. As Keynes once said “It is better to be approximately right than precisely wrong.” 

See table below for different calculations.


Comparing return on invested capital including the value of leased assets shows a materially lower return compared to the calculation of return on capital employed without these leases. See comparison in the table below.


The diagram below shows the adjusted operating margin, return on invested capital incl. value of leased assets, and the invested capital turnover during the last decade.


So, returns on invested capital including operating leases differ materially from the same calculation without including them. To be able to see the underlying returns a business is able to generate and also to be able to compare different companies, it’s very important not to forget to think about how to treat operating leases in a proper way.