Description

Boohoo Group PLC

Price p/s: £1.15 | Mkt cap: £1,455m | EV: £1,411m | 10 yr revenue CAGR: 53% | EV / FY21 EBIT: 11.4x

Background to the proposed investment

Boohoo Group PLC (“boohoo”) is an online-only fashion retailer based in the UK and listed on the London AIM exchange. The group was founded in 2006 in Manchester with the lower-priced boohoo brand targeted at 16 to 24 year old trend- and price-conscious women. Today, boohoo makes £1.9bn of revenue, largely from the UK and US markets, selling clothes across most price-points to men and women aged 16 to 50+. Boohoo’s growth has been achieved through the continuous addition of new brands (13 in total today), mostly through acquisition and integration into their unique ecosystem where speed-to-market is everything!

The company has achieved fantastic growth since inception with a compound revenue growth of more than 50% p.a. over the last 5.5 and 10.5 years (year-end in February, growth rates taken to LTM in August 2021). Profit before tax (PBT) has also grown strongly by 34.9% p.a. and 80%+ p.a. over 5.5 and 10.5 years respectively, despite the current year’s lower profitability (to be explained below).

Until recently the market has attached a very high multiple to boohoo, reflecting its tremendous ongoing potential in the growing online fashion market. This changed with a decline in the boohoo share price of c.70% over the last year, resulting in what I see as a good investment opportunity today. The two obvious reasons for the share price decline are allegations of factory worker exploitation in 2020 and more recently missing its guidance (fairly substantially) due to COVID-related costs and delays. The business currently trades at a very reasonable 11.4x EV / FY21 EBIT which is well below the historical valuation levels that average about 3 times this current multiple.

This investment thesis can be summarized as growth-at-a-reasonable-price (GARP). I believe that this is a quality company able to continue re-investing future cashflows at a healthy clip, with a clear competitive advantage that will allow it to gain market share in a growing market. The recent troubles (one partly of their own making and one due to COVID) are temporary and will disappear in time allowing the market to re-rate the share while boohoo continues to grow earnings strongly. An investment in boohoo today can conceivably grow by 2.5x – 6.0x over the next five years. Such an investment would not be on the low-end of the risk spectrum, considering the fiercely competitive market and typical risks of a fashion-retailer, but boohoo has some unique attributes that reduce these risks and should allow it to thrive.

Much mention will be made below of another e-commerce apparel retailer, ASOS. In many ways it is similar to boohoo in terms of its online-only apparel offering and revenue growth over the last decade (27.7% p.a.). I’ve found it very useful to contrast and compare the two companies. For those of you who have read the investment letters of Nick Sleep, the name ASOS may ring a bell. Sleep moved a significant portion of his Amazon position into the UK e-tailer. I actually started my investigation into ASOS before coming across boohoo, but ultimately favoured the sexier younger brother to ASOS. Both are worthy of consideration in my view and I may do a write-up on ASOS as well which trades at an EV / FY21 EBIT (Adj) of 16.9x.

Executive summary

This write-up is fairly lengthy. Some may want to assess whether the opportunity is worth their time so I’ll summarise the key points of the write-up here.

Boohoo has demonstrated an ability to acquire new brands and integrate them into its portfolio. There is somewhat of a coiled-spring here since the company has just acquired 6 new brands (including Debenhams with 19m customers) which are not yet reflected in the earnings. The value offering is clear to see from boohoo’s ability to rapidly attract and then retain new customers. Historical revenue growth has outstripped almost every other major fashion retailer over the last five years, but its market share (c.5% in UK, < 1% in US & Europe) is still small in online fashion which itself is less than 20% (but growing) of the total fashion market. Boohoo’s return on capital employed averages 25% over five years and this is driven by its test and repeat model, which lies at the core of the company’s competitive advantage. It has some of the lowest inventory levels in the market and is able to rapidly adapt to changing fashion trends, reducing its fashion risk. Boohoo’s founders are still directly involved and jointly own about 20% of the business.

The share price has plummeted by 70% over the last year, partly due to allegations of allowing factory worker exploitation and a recent earnings miss. My view is that management did not willfully exploit factory workers and are doing everything in their power to change their supply chain. The earnings miss was due to COVID costs / delays related to low current airline capacity which I expect to correct over time.

Overall the current pricing offers significant margins of safety for a company that is poised to continue growing market share rapidly in a market which itself is growing. A 5x investment return over 5 years is not inconceivable as revenue growth continues, margins normalize and the noise from the supplier scandal dies down.

The financial history and operations of boohoo – a multi-brand UK-based e-commerce fashion retailer

Boohoo’s offices are based in Manchester (England) and it distributes most of its merchandise from Sheffield and Burnley (England). Most of the merchandise is sourced from suppliers in Leicester (England), Asia and Europe, split about 40/40/20. The merchandise is then sold via multiple brand websites direct to customers in the UK (54% in FY21), US (25%), Europe (14%) and the rest of the world (7%). The original focus of boohoo was trend-conscious, price-sensitive 16 to 24 year females, but their multi-brand strategy has expanded significantly over the years to cover a full spectrum of styles, ages, price points and menswear:

Boohoo owns all their brands (at least until Debenhams was acquired which sells external beauty and other brands alongside their own). This differs from other e-commerce apparel retailers like Next and ASOS who sell other brands. It allows boohoo to keep prices low while achieving a higher gross margin, but typically comes with elevated fashion risk.

Delivery is typically charged for, except for boohoo.com shoppers in the UK with the Premier membership where next day delivery is free (costs £9.99 p.a. – think Amazon Prime). Delivery times vary by location and time selected, but are longer and more expensive internationally since everything is shipped from the UK.

At boohoo, speed is everything. This applies to delivery where customers are simply not willing to wait for orders – they want to order a dress in the week and go out wearing it on the weekend. This is ultra-fast fashion. 

Strong and improving revenue metrics for boohoo (and a comparison to ASOS)

The main revenue metrics of boohoo have improved consistently over time. I have shown these below, contrasted against the same metrics for ASOS. 

Boohoo has about 18m active customers, a figure that is closing in on (the more established) ASOS which is stronger in Europe and the Rest of the World. Average basket size is lower than ASOS but growing (6.5% p.a. over 5 years vs 2.4% for ASOS). Since the items per basket are very similar for the two companies, the lower average basket size shows that boohoo plays at a lower average price point. This average basket size has ticked up over the years, probably as a result of the addition of higher-priced brands like Karen Millen. Recent acquisitions of mid-priced brands should help this metric to continue growing.

The revenue growth for boohoo over the last five years has been almost twice that of ASOS. This can be seen by considering the three components in the table below. All three metrics show better 5 years CAGRs for boohoo. The consistent growth in active customers for both companies points to a growing online fashion market.

An overview of boohoo’s earnings and cash flows – steady growth with cash reinvested for the future

As mentioned, the revenue and earnings growth history of boohoo is exemplary:

Revenue growth is steep, gross margins are steady and operating costs are controlled resulting in a fairly consistent PBT margin. Considering the track record, one begins to understand why missing earnings guidance over the last six months resulted in a knock to the share price – the market was likely pricing in perfection.

Boohoo generates decent cash, all of which has been reinvested back into the business to build distribution capacity for future growth, invest in software and acquire new brands. Growth has largely been funded with internally generated cash in addition to the small equity raises in 2018 and 2020. The business does not operate with debt, although they have temporarily drawn down £50m on their overdraft facility recently to help fund significant capex investments:

Operating expenditure – a comparison between boohoo and ASOS

The following graphs show the operating expense split for boohoo over the last 9 years (where annual reports were available). I again found it very useful to compare these splits with those of ASOS. 

*Small difference (c.1% - 2%) in total boohoo total opex ratio provided versus total opex in financials – suspect this comes largely

from not including share-based compensation in “Admin / other” since management also adjust the EBITDA shown in their

presentations for this

A few take-outs from these splits:

·      Warehousing and distribution – this cost has gone up over the last year for boohoo as a result of COVID’s impact on delivery costs. This makes sense with the reduced airline capacity. ASOS spends slightly more on warehousing & distribution despite the very significant amount they’ve invested in automation over the last five years. I think this is likely attributable to boohoo’s lower inventory levels as a result of their test and repeat model as well as ASOS’s greater proportion of international sales where delivery is more expensive.

·      Marketing – boohoo spends a considerable amount on marketing and almost twice as much as ASOS. Boohoo is able to do this partly because its gross margins are almost 10% higher than those of ASOS (since it owns its brands). Arguably boohoo also needs to spend more on marketing because many of the brands ASOS sells are better known and marketed elsewhere. 

This marketing spend by boohoo has been core to their growth. The following graph is a fantastic one from boohoo management that shows the revenue from active customers attracted to boohoo each year and how much those customers spend in subsequent years (ie. customer retention):

Each color represents the customers first buying from the group in a year. Each bar represents the total group revenue for that year.

As you can see, the customers that are attracted to boohoo each year are largely retained and continue to contribute strongly to revenue in subsequent years. This is a testament to the quality of the marketing as well as the total value offering. Marketing is a true investment for boohoo. New customers in 2020 (purple segment) did drop-off more significantly in 2021 than for prior years, but this was an anomalous year (due to COVID) from an online shopping perspective – the sheer size (new customers) of the Aug-20 bar in the Aug-20 financial year supports this view. 

Boohoo currently have 54m social media followers (up 58% in the last two years) which is where they spend most of their marketing pounds. This media following grows significantly each year and allows the company to leverage their spend on social media influencers (which they make extensive use of). There is a compounding effect here: more followers = greater bang-for-buck on marketing spend. 

A history of successfully acquiring new brands and integrating them into the boohoo model

Over the years, boohoo have acquired and successfully integrated a number of new brands to expand their offering across styles, ages and price points. The following timeline shows the new brands added to the group over time. With the exception of boohoo and boohooMAN, these were all through acquisitions:

The management team have been successful at integrating new acquisitions into the boohoo platform. The test and repeat model is applied and the brands are given a greater fashion focus. FY21 was a particularly busy year where boohoo took advantage of the pains in the retail market (when COVID struck) and its healthy cash position to acquire six new brands “at low multiples”. Management identified the upcoming opportunities in 2020 when it did an equity raise for £197.7m on 15 May at a price of about £3.15 per share.

The acquisition management are most excited about is Debenhams, which they plan to turn into a “digital department store”. Debenhams has an established presence in the UK, with over 19m customers at the time of acquisition. Granted many of these customers were shoppers at their bricks-and-mortar outlets, but the brand is clearly well established and achieved £400m of online sales. The Debenhams acquisition gives boohoo an entry into the beauty (with 6m customers), sports and homeware markets in addition to the Debenhams fashion brands.

The ability to acquire established brands cheaply, integrate them into the lean, fashion-focused boohoo model and then role them out to their millions of social media followers is very exciting. It remains to be seen how successful these new acquisitions will be, but the growth runway has certainly be laid out and if history is anything to go by, this could be very lucrative.

Return on capital employed – an indicator of a company’s overall quality

It was when I started comparing the return on capital employed (ROCE) between ASOS and boohoo that I first decided to focus on the latter. Boohoo have a stellar track record in this regard. More importantly, I believe they will be able to continue reinvesting their free cash flows and earn a healthy return on those investments.

The ROCE has averaged 25% over the last five financial years. Boohoo has a great track record of investing in new brands and new customers that then translate into earnings for the group. Its test and repeat model also ensures that it doesn’t spend on working capital and allows for more efficiencies in warehousing capacity capex.

The current year has seen the ROCE dip substantially. The reasons for this are largely a temporary fall in earnings as will be explained. 

The recent acquisitions, continued marketing spend, negative working capital cycle and e-commerce tailwinds should combine to ensure that boohoo is able to continue earning healthy returns (20%+) on reinvested capital. 

The test and repeat model – boohoo’s core competitive advantage

The entire boohoo supply chain is focused on speed-to-market and uses their test and repeat model to achieve this. Test and repeat is all about taking small volumes of each style to market (typically initial order sizes of 300 units), testing the success / adoption of these styles using data feedback, and then scaling up the more popular products quickly. Boohoo have average total lead times from conceptualization to client delivery of 4 to 6 weeks (and as little as 2 weeks). Suppliers accept this lower volume because boohoo place orders for thousands of styles at any one time.

This fast-paced, low-volume style commitment and continuous market testing gives boohoo tremendous advantages, not least of which is their low inventory levels. The following graph shows boohoo’s days of outstanding inventory (average inventory / cost of goods sold x days in sales period) relative to the largest major global fashion retailers:

The inventory levels of boohoo are consistently low, even compared to retailers like Zara which is known for its fast fashion. This low inventory has an obvious positive effect on boohoo’s working capital which is negative – sales growth typically results in a positive cash effect. Low inventory also means less investment in warehousing capex. 

In my view, the single biggest advantage of this test and repeat model is how it reduces fashion risk (the risk of getting the fashion styles wrong for a period resulting is lower sales and high mark-downs). This is one of the biggest risks facing a fashion retailer and boohoo’s model mitigates this risk. Without the high risk of mark-downs, it also means that boohoo’s pricing can be more competitive because they do not have to price (much) for lower future margins from discounted inventory. 

Their sales growth is also bolstered because they are more likely to be on-trend and benefit from changing consumer tastes relative to other retailers. Over time this should entrench boohoo’s brands in the minds of customers as always being on-trend and save them from having to look elsewhere. As an online-only business, boohoo can also clearly link a sale to a customer profile (age, gender, region) to ensure that they’re hitting their intended customers or quickly adapt if not. They can also follow them as they age with brands appropriate to their changing tastes. This is an advantage over a typical bricks-and-mortar retailer that doesn’t always know who their customers are (at least not immediately).

In summary, the test a repeat model is incredibly important to boohoo. It is something built into everything they do and is perfectly suited to online fashion. This makes it difficult for other retailers to copy.

The allegations of allowing factory worker exploitation is concerning but is being addressed

In a Sunday Times article published on 5 July 2020, boohoo was linked to abuse of factory workers in Leicester. This abuse took the form of unacceptable working conditions (poor COVID protection) and underpayment (below minimum wage) of workers. The share price of boohoo fell by 40% almost immediately. Media scrutiny continued since then and more recent reports in 2021 alleged that US Customs and Border Protection (“CBP”) were considering a US import ban over forced labour allegations. Boohoo management said they knew nothing of these CBP claims and were confident that they could provide any body with evidence of their legal compliance. The share price has continued to fall to its current level of £1.15 which is 70% below where it was on 3 July 2020. Some of this more recent fall can also be attributed to the earnings miss and lower guidance.

Now just for some context, boohoo is not vertically integrated. It sources its merchandise from independently run clothing manufacturers, 40% of which are based in Leicester (England). So the affected workers (and yes they were poorly treated) don’t actually work for boohoo. I am not saying that boohoo is free of responsibility, just that these worker concerns are a few steps removed from boohoo.

Now having read through numerous media articles, listened to transcripts from boohoo management and read some of Alison Levitt’s 234 page independent review into the matter, I’ve come to two conclusions:

1.     Boohoo did not intentionally profit from this worker treatment, did not knowingly condone this treatment and their actions since the initial publication indicate to me that they are not trying to hide anything. It was a case of out of sight, out of mind. Senior boohoo management had some awareness of the issues from about December 2019 (and perhaps earlier) that things were not right in the supply chain and initiated some steps to rectify this, but were slow to implement any changes. As per the independent report from Alison Levitt dated 24 September 2020:

2.  I cannot expect anything more from boohoo management in terms of their reaction to the situation and their transparency. They immediately conducted an independent review and published the resulting report in full the next day, despite it saying some very unflattering things about boohoo management. The review was conducted independently and paid for in full before the work was delivered. They have since employed an independent retired judge, Sir Brian Leveson, to head up the changes that were recommended which they are making in full. They have dramatically reduced their suppliers in Leicester from 200 and 300 sub-contractors down to 54 suppliers and no sub-contractors ie. those of scale, willing / able to comply and be audited. They published a list of all the suppliers they work with, first in the UK and then internationally. They’ve setup a JV manufacturing hub at the cost of £10m in Leicester to help educate the local industry. And lastly, every presentation and report since then has focused extensively on this issue. They are not hiding away from it

The reasons that boohoo allowed this to happen in the first place can be summarized by two statements in the independent review:

We currently operate in a world where cancel culture dictates much popular opinion. Negative media headlines also get far more clicks than positive headlines. I personally don’t prescribe to this way of behaving – people make mistakes, should be allowed to rectify those mistakes and move forward. Not all behaviour can be deemed acceptable when making an investment, but in this case I don’t think there was intentionality (just negligence, arguably willful) and there has been a genuine willingness to change. Allegations of CBP banning boohoo’s US imports seem a stretch that boohoo don't know anything about and boohoo’s extensive actions to rectify matters in the last year should address any risks in this regard. Not everyone will agree with me and I encourage you to make up your own mind on the matter.

Valuation and forecasts

FY22’s earnings have been negatively affected by COVID

Up until financial year-end February 2021, the boohoo business was performing extremely well. Revenue was up 41% on prior year, PBT had grown 35% to £124m and they had just completed 6 acquisitions at decent multiples (including Debenhams) during FY21 for a total of £235m. Guidance for FY22 was to grow revenue by 25%, achieve EBITDA margins of 100bps lower than for FY21 as they bed down the new acquisitions, and spend £200m - £250m on increasing their distribution capacity and office space.

COVID then started having a negative effect on boohoo’s business:

·       Net sales (after returns) to the international markets started tapering off significantly during Q3. Management put this down to delayed delivery times due to reduced air freight capacity. This makes sense as people switched their clothing from stay-at-home athleisure to more urgently-desired going-out clothes (especially dresses). US delivery times increased from 3-4 days up to 7-8 days which is simply too long for some customers – this is ultra-fast fashion after all. With the switch to far more dresses and away from athleisure, returns (especially in the UK) also increased significantly for boohoo. This was not a case of getting fashion wrong, but rather just selling far more of a category that historically experiences higher returns. The difference between gross (28%) and net (10%) sales growth for the 3 months to November 2021 was an exceptionally high 18%.

·       Overall for the nine months to 30 November 2021, net sales only grew by 16% thanks largely to a strong performance in the UK. Revenue guidance for FY22 was reduced from 25% to “12% - 14%” as a result. I also suspect that the FY21 base year was exceptionally high, helped by bricks-and-mortar store closures, which somewhat compounded the poor year-on-year comparisons:

·      The second effect on earnings was from increased distribution costs. Boohoo makes extensive use of airfreight, especially for international deliveries. Inbound airfreight costs are expected to increase by £20m and outbound (delivery) costs by £45m for FY22 as per the December trading update.

Forward multiples require normalisation to cater for once-off COVID costs

Management are accelerating plans for a US distribution centre which was previously set to open in 2023. I also expect airfreight to eventually normalise somewhat and allow operating distribution expenses to follow suit. Boohoo have a long, steady history of controlling operating expenses as shown above. FY22 will see the opex ratio jump by 2% - 3%, reducing EBITDA margins by the same amount which is an anomaly from a historical perspective. My view is that this should be normalised for when considering the forward multiples. Acquisition costs for the current year are high due to the 6 recent acquisitions, and not likely to recur:

*Management shows adjusted EBITDA and EBIT where they remove share-based payments – I don’t agree with this approach and have left these costs in the figures above

For context, LTM EV / EBIT multiples for boohoo are shown below for the last five years (average of 45.1x):

For a company that has grown revenue by 50% p.a. historically and considering that management believe strongly (both based on medium-term guidance and current distribution capex) that revenue will continue to grow by 25% per year, these multiples are far from demanding. Current multiples are more in line with those of Inditex (Zara) and Next PLC, neither of which have grown their revenues over the last five years. The historical earnings multiple for boohoo is also at its 5-year low and at less than a third of the average multiple over the last five years.

Discounted cash flow valuation based on three scenarios

I’ve considered three DCF scenarios and compared the value with the current enterprise value:

* GP margins have been very consistent historically, averaging 54.1% over the last five years

** Historical opex ratios have been lower, averaging 45.8% over the last four years. No allowance has been made for the positive cost effects of the £120m automation capex in Sheffield.

*** The tax rate has been modelled at 25% from year 2 onwards in line with the 1 April 2023 increase in UK corporate tax from the current 19% level

·     Downside case – revenue growth never returns from current levels, distribution costs stay high for the next two years before the opex ratio comes back to 48% and the exit multiple also doesn’t recover (and is conservative considering the 10% annual growth) at 12.5x.

·      Base case – revenue growth increases to 15% from year 2, distribution costs take 1 year to normalize back to 47% and the EV / EBIT multiple adjusts up to 16.0x which I consider conservative for a business growing its topline at 15% p.a. and below the current ASOS valuation.

·      Management case – growth returns to the 25% annual management target from year 2, distribution costs normalise immediately to 47% and the business is valued for its growth (although nowhere near historical levels) at 20.0x EV / EBIT. I consider the earnings growth possible considering all of the recent acquisitions and the current small market share in a growing online fashion industry.

Management have mentioned that the current capex plan will give them £4.7bn of net sales capacity by 2023. So in addition to the significant capex in the current year (£125m - £175m excluding new office space) I’ve allowed for a further £150m in year 1 capex in the DCF for all scenarios, which seems reasonable. This is in addition to the ongoing maintenance capex of £40m on physical infrastructure and £15m on software each year which is above historical levels. Under the management case I’ve allowed for a further £150m of capex in year 4 to keep pace with the growth in revenue.

No working capital cash flow effects have been modelled which is conservative considering the negative historical working capital cycle.

Using a 9.8% discount rate (the long-term S&P 500 return), there is a 42% margin of safety under the base case and a healthy 72% margin of safety under the management case. If boohoo never again retains its previous earnings growth then the downside case shows that the current price is quite fair. Overall I consider the risk-reward trade-off here to be skewed in the investor’s favour at the current share price.

Conclusion

If you can get your head around the supplier issues, this is a rapidly growing, quality business at a knock-down price. Risks pertaining to COVID and market competition exist, but I think boohoo is well positioned to tackle these and thrive. An investment here would align you with insiders who hold a significant equity share and could conceivably return 5x money over five years.

Catalyst

Time for the supplier issues to be addressed and the media noise to die down.

A normalisation of the extra COVID costs increasing margins back to historical levels.

Recent acquisitions starting to come through in earnings.