Description

Following my latest write-up regarding Salvatore Ferragamo, during the last week I’ve decided to investigate more in detail another Italian renowned luxury business - Brunello Cucinelli (“BC” or “Company”) – whose stock experienced a large appreciation in the last months (below the 3-year and 1-year charts) and highlights extraordinary high multiples. 

Price doubled to more than €50 in a few months and largely exceeded previous peaks below €40.

From an investor standpoint, more than the magnificence of the products and the brand awareness, which I do not question, anyone easily agrees that the most important feature is the ability of the business to generate free cash flow and therefore a return on capital sufficiently attractive in comparison with a reasonable estimate of the cost of capital. This is the key statistic that I wanted to dig deeper into detail. As a result of my analysis, I suggest going short on the stock of Brunello Cucinelli. I prepared the investment thesis having regard to the appropriate economic valuation of the business according to (i) its historic financial evolution and performance (ii) the outcome of a largely positive expansion in the coming years. I will argue that the evolution of the cash flows do not support the current price of the stock. Therefore, according to my analysis, the price appears unsustainable. Put another way, the market value of the asset seems disconnected from fundamentals. Most agree that it is worth keeping exceptional, even if overvalued, businesses in the portfolio because a high return on invested capital and abundant cash generation allows, in the long term, to create more value and compound on it. This is not the case with BC: the brand has characteristics of uniqueness and iconicity. However, competition in the sector is high and requires continuous substantial investments. I therefore think that the return on capital might slightly improve from the current values. 

As I discussed for Salvatore Ferragamo (https://www.valueinvestorsclub.com/idea/Salvatore_Ferragamo_SpA/3632672437), I do not indicate a specific catalyst for the decline in the stock price. I think it will come from the repricing of growth expectations and risk. My thesis is based on valuation. What I have is the publicly available long-term target of the management, which is to reach €1bn in revenue in the next 6-7 years. I used the management goal as the key reference point for the analysis and I have detailed a business case around that, in order to confirm the existence of an adequate margin of safety.

Since most of us are here to present and discuss situations where there is a significant deviation of the price from the estimated intrinsic value, I would appreciate receiving comments, in particular from those who will rate this write-up very low. I welcome feedback and comments challenging the thesis rather than a simple rating. Although international opportunities on peripheral markets such as the Italian one are the exception on VIC and require more investigation for the members, as advised by VIC, it would be valuable receiving a comment in the case of a “well below average” rating. I trust that this will benefit everyone.

The thesis summarizes as follows:

• BC is an alluring Italian apparel business with distinctive features and a brand positioning among the top end of the luxury space. 

• The historic financial performance highlights a remarkable development of the top line with revenue expanding at a 12% CAGR in the last 8 years, up to 2019. Management achieved expansion through wide development of Directly-Operated Stores (DOS). The Gross Profit margin benefited from the shift from wholesale channel to direct retail and advanced from 36/37% to 50%.

So, everything is fine in terms of strategy/growth/vision. The complications come with cash flows and valuation. Assuming the business largely recovers the 2020 decline and grows at 10% in 2022, it trades at 21x 2022 EBITDA; and most importantly 46x EBIT 63x NOPAT 83x Free Cash Flow. It is crucial to focus on the multiple of Free Cash Flow: it would be an “acceptable” figure starting from 2026-27 where it would drop to 35-30x, at the end of a period characterized by a projected 9% CAGR of revenue.

My intrinsic value estimate is in the region of €32, adopting a 7% cost of capital which is conservative (i.e. pretty low in case of short positioning). Any weakness on the realized economics and any partial inability to hit the targets expose the stockholder to an enormous repricing risk. From the standpoint of the short positioned investor, this represents an extremely attractive opportunity from a risk/return perspective with a significant margin of safety (40%).

The Company at a glance

Brunello Cucinelli (https://www.brunellocucinelli.com/it/) engages in the production and sale internationally of clothing, accessories and lifestyle products for men, women and kids. The business is strongly anchored to the distinctive features identifying the brand and positioning it at the top end of the luxury segment. It leverages on the expression of the best Made in Italy. Italy and Europe account for 44% of turnover while North America 32% and China 11%.  

The Company, founded in 1978, listed on the Milan stock exchange in 2012 with a €60m rights issue. Control is largely retained by the founding entrepreneur. 

Financial performance 

The historic financial performance was largely positive while in 2020 revenue declined was limited to 10%: retail sales (operated through DOS) closed down by 20% while wholesale channel finished the year unchanged compared to 2019 thanks to the resilience of the multi-brand segment (nearly 44% of turnover). The significant weight of the department stores distribution channel (i.e Wholesale Multi-Brand) allowed mitigating the disruption induced by the pandemic.

In 2011, the Company leveraged on 23 DOS and 39 TOPS with a large weight of sales through multi-brand stores (67%). Over the last 10 years, the Company progressively shifted the distribution towards the DOS (which increased to 107, accounting for nearly 50% of turnover) as a “natural” development for an iconic luxury house. The move permitted capturing a higher gross margin. At the same time, TPOS remained mostly unchanged. Below the breakdown of revenue development. 

Appended below the economics of the business after having adjusted historic figures to get a pro-forma pictures of invested capital and profitability (2019 is the first year impacted by IFRS16 with the leases presented as “right-of-use” asset in the balance sheet):

Profitability is stable over time (10-11%) while turnover worsened in 2014-16 (a period corresponding with a remarkable expansion of DOS) and stabilized at nearly 85%. ROIC set at 8-9%. 

As far as the cash flow is concerned, see below:

It is crucial to recognize that growth did not come with satisfying cash generation. Actually, Free Cash Flow was irregular and peaked in 2017 thanks to positive movement in working capital. Capex absorbed a large chunk of income and totalled more than €100m in 2019. According to the Company, investments accounted for nearly €50m in any of the last 2 years (mostly tangible assets for commercial transactions in relation to the DOS opening) while the remaining part of Capex pertains to repayment of lease liabilities (which we shall consider a recurring outflow as per the requirements of the business model). 

The projections 

The management affirmed its target to reach €1bn in revenue in the next 7 years. Below, based on the management target and available analysis is a business case envisaging 9% CAGR of revenue and improved EBITDA margin up to 31%.

Assuming that incidence of net Capex on Revenue drops to 11% from the historic 15-16% as effect of improved turnover of revenue (higher sales per DOS and/or increased efficiency in the capital employed), below I append the likely cash flows:

According to the analysis, the business should generate €100m free cash flow starting from 2026 with revenue hitting €1bn. With 2026 FCFE at €1.44 and market price in excess of €51, the stockholder faces a 36x and 30x multiple on, respectively, 2026 and 2027 (exp) Free Cash Flow! 

Do we have to pay today the multiple of the time t+6 or t+7 because the interest rates are zero? Are the company's cash flows risk free? Alternatively, is there something wrong with this market price?

To the reader who arrived here it appears easy to understand my conclusion and the figures speak for themselves: there is a large disconnect between price and intrinsic value.  

An extraordinary brand with strong emotional factors attached as per the attributed top-end design and manufacturing skills of authentic Made-in-Italy. The expansion plan is ambitious but the projections might be conceivable embracing a very positive view. Provided that the target revenue is achievable, the dynamics of expected cash flows indicates that the price is not sustainable. I believe that a remarkable repricing of growth expectations and risk can occur. 

According to the management case and the likely projected cash flows, adopting a 7% cost of capital and TV cash flow at 150, my estimate of intrinsic value is in the region of €32 (ca. 40% below the current market price). That leaves the short positioned investor with an adequate margin of safety. 

The risk for the investor of a wrong thesis is exceptionally low in a context in which the projections are anchored to very positive development and a further rise in expectations is implausible.

Catalyst

The repricing of growth expectations and risk.