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BURBERRY INITIATION REPORT

 

Supporting DCF Model – Valuation and Projections. Please click here ; BURBERRY PROJECTIONS AND FINANCIAL MODEL.XLS

 

H2 Trading Update – Follow-Up 19/4/17

At the time of my initial report, I believed that the market was pricing in a longer term-deflated sterling hence why the stock was rallying and its was looking like my target price of £16.26 would be exceeded. I also felt that the market was underpricing;

  • the positive strategic changes that new management would be bringing in.
  • the impact of the cost savings initiatives on future margins, with current targets being met for the predicted FY2019 £150m savings (following one-off restructuring costs).

Investment Strategy;

I marginally placed a buy on the stock, since the target price £16.26 was only 1% higher than the current stock price and a reasonable analyst may have classed this investment as a ‘hold’.
Owing to the recent rally, however, I would have held the stock and sold at or around 10% above the target price and possibly earned some extra income through selling a call option at around 10% above the target price limiting the upside potential, but affirming my view that the stock will have been far overbought on market sentiment by this point. This is based on momentum gathered that the pound will stay deflated for far longer post the UK’s FY2019 departure from the EU, and the FX benefits would continue to accrue to Burberry’s top line.

I was also concerned with the performance in US wholesale and the Beauty business as represented in H1 update. A reasonable sell price will have been 5% above the target £17.07.

Since my last report following Q3 update, the following events have taken place;

  1. Shares rally as a Belgian billionaire discloses a 3% stake in Burberry, thus raising sentiment
  2. Burberry paid £144m to take back the licence to its fragrance business in 2013. After dramatically reducing its number of pos from 3500 to 35, it decided to throw in the towel on its 4-year long experiment of trying to bring the business back in-house due to declining licensing revenues as a result of stronger competition in the beauty space by big players such as Chanel and Dior and instead, franchise the business out to Coty. Coty is to pay £130m for long-term term global licence and there will be ongoing royalties thereafter

This is fantastic news for Burberry. The Beauty business had been a drag on profits for quite some time now and this strategic change gives some breathing room for Burberry to focus on its core activities and where it excels the most. Not to mention a fixed revenue stream in the not-too-distant future when, in my view, the pound begins to gain some pace against peer key currencies, Burberry will have lost its FX edge (90% of revenues are generated abroad) and it will need to rely on strong organic growth in line with the rest of the industry. The licensing move has come as a safety cushion.

Following this news, I re-modelled and achieved a new target price of around £16.60. I changed my rating to a ‘hold’, because although at this point the stock was rallying at around £17.37, there wasn’t enough reason to justify a sell;

  • H2 revenue trading update was soon to be announced
  • LVMH (a peer with a similar exposure to the Asain market and sector leader) had just posted some strong quarter trading numbers

 

 

19th April 2017

Since the H2 trading update, I have revised my outlook back to around my initial expectations based on the following factors;

  • Revenues and LFLs were roughly in line with my initial expectations and for Q4, I predicted that strength would continue in key areas;
    – UK due to depressed Sterling
    – Mainland China as growth has re-emergedI expected declines in America due to a strong dollar backing away the tourists and in HK due to continuing lower football. Wholesale revenue was down roughly in line with the company’s expectations, although I actually predicted a higher fx gain than what had actually materialized. Beauty and US wholesale were the main culprits, as suspected.
  • What I didn’t expect was that, according to the company, the impact of the Coty deal is not expected to be accretive to FY2018PBT, meaning investors will need to wait until 2019 to see the royalties and benefits of this deal accrue. I believe there to be a netted out effect from the deal with Coty  and the loss in fx gains from a depressed Sterling, as it is in my belief the pound will have stabilised by FY 2019.
  • Based on the H2 numbers, I revise my target price to £16.15 but maintain that Burberry can take market share once from competition once the Beauty business is isolated and performance can be enhanced in other areas, and through more lucrative means eg. Digital. Cost savings programme is also on track.

Once H2 results were out, the stock plummeted 8% because investors were expecting higher revenue growth and improvement in retail LFLs following the 3rd quarter and put a lot of weight on the depressed pound to be able to achieve that. Investors have also been piling into luxury now because the Asain consumer has returned to the market and good numbers have most recently been posted by affluent competitors; LVMH and Kering. Unfortunately for Burberry, Total revenues for the Half slipped by 1% at constant currencies (up at 14%FX). Underperforming results and Theresa May’s calling of a snap parliament election to gain party support (thus strengthening the Sterling) were a compounding problem that led the fall for the day – £15.66 down from £17.01 – 8% down Burberry’s biggest drop in 6 months.

It is likely that the share was oversold on over reactive sentiment and at the current price now of £15.74 (3/5/17), I think the share is a Buy since there is valued to be earnt in the long-term.

Burberry’s Beta to the FTSE100 rose to 1.24 on the day of the H2 trading update (up from 0.95), so making it more volatile than the market, and against the median of its peers (approx. 1.22).

  • Since LVMH posted Q1 numbers that beat analyst expectations (LVMH has reported organic revenue growth of 13 per cent in the first three months of 2017 vs 9% in Q416 and 8% analyst expectations ). Results show that for the sector leader, industry growth is accelerating faster than expected (3-4% CAGR to 2021 as per Bain and co.) and because of Burberry’s similar exposure to the Asain market, I now believe that Burberry will grow either at the same or a faster rate to the market and fall into the realm of ‘outperformer’, similar to its peer. Given that Burberry has high operating leverage (ie. a high fixed cost base that gets absorbed), improvements in top line numbers will result in margin expansion which are needed to grow in this industry, and thus justify the high PEs having to be paid on the stock.
  • As a result of the strategic Coty move, I don’t think the market is pricing in enough the impact of such management changes will have on the future of the company. Marco Gobetti did very well with turning around Celine whilst at LVMH, so there is no reason why he cannot do something special with Burberry, especially since the Brexit vote has given Burberry a bit of a lifeline with a depressed pound – meaning more opportunity to use resources for investment, capitalizing on its position as a digital leader and using its edge to take market share. Growth in this industry will be driven by margin expansion coming from strategic moves and innovation, and I feel if Burberry harnessed and concentrated on its core skills, it could gain that edge. Creativity in design and creativity in delivery will be key drivers going forward.
  • I don’t think the market is pricing in enough the weight of the cost savings initiatives and the margin expansion such initiatives bring. There is also the relief to be gained from the deal struck with Coty, thus ensuring that management are focusing less time on losing area and focusing on where they can outperform. These are the kinds of initiatives that will keep a company stay competitive in this market and retain its market share.

Despite I feel the Sterling will wear off to the downside, to the upside you have a failing part of the business now being eliminated and all the above other factors that will lead to Burberry outperforming its peers and taking market share.

One also needs to consider;

– Chinese and Russian economies are beginning to recover
– Higher oil prices will support Middle Eastern spending – an untapped market for Burberry, thus suggesting growth opportunities
– Expected tax cuts under U.S. President Donald Trump are seen to be encouraging Americans to shop.

My target price has been revised down to £15.96. The current market price is £15.74. The stock is still a long-term buy for the next 12 months.

 

 

Bull points:

  1. Management change should drive better execution / focus on creativity
  2. Best in class in digital which is the way industry is moving. By 2020 luxury e-commerce is expected to reach 10% of all sales whilst Burberry I sitting at 8%. Burberry has some serious potential for outperforming and taking market share
  3. The re-emergence of the Chinese consumer
  4. Luxury is attractive industry long term as there a middle class in emerging countries that have not yet been exploited for opportunities

Bear Points

A strong USD and interest rate hikes keeps tourists away from the world’s largest luxury market and the wholesale business is suffering.

Products like the heritage trenchcoat and scarves will continue to be resilient, whilst diversification products such as handbags and accessories may continue to underperfom against specialists such as LVMH or Gucci

Decline in global transit retail caused by terrorist attacks and measures taken to increase consumption domestically in China

Industry is in a decline and has been since 2011. So tougher to get expanded margins and achieve superior performance

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