Investment Strategy: Earning Power Undervaluation
Valuation: Next 12 months target : 17.50, 24 months target $42-$50 (Median:$46)
Esprit Holdings Ltd is engaged in wholesale and retail distribution along with the licensing of quality fashion and lifestyle product under its own internationally known brand name, Esprit.
Esprit currently has 12 product divisions, each with their own team to cater to their respected market. Esprit’s product line includes apparel, footwear, accessories, jewellery and house-wares, all under the Esprit label.
A majority of their revenues is generated from Europe, which accounts for 79.2% of the group’s turnover, while other countries in the Asia Pacific and North America generate about 17.1% and 3.7% (based on 2010/2011 Interim Report).
Esprit belongs in the consumer cyclical industry; as a result, the demand for their product is dependent on the economic climate. Right now, the macroeconomic condition in Europe has greatly affected the demand for Esprit’s product. Based on the most recent report, Esprit’s total turnover in Europe has decreased from $15,706 million to $14,014 million (mainly contributed by the decline in wholesale turnover).
Improving 2Q Results: “-Turnover up 1.6% year-on-year in local currency, with significant improvements in 2Q -Retail turnover up 8.7% year-on-year in local currency -Strong growth in second quarter for wholesale business -Efforts in differentiating product divisions bearing fruits -Gross profit margin increased 0.9% point to 55.6% -Effective tax rate down 2.5% points to 19.1% -Strong cash position of HK$7.3 billion -China business starting to accelerate in line with 5-year plan §-Point-of-sale increased by 7.6% to 1,002 -Total number of cities increased from 169 to 183 -China EBIT margin up 5.0% points to 19.7% -Asia Pacific share in Group turnover increased from 12% to 17%”- Esprit Website
Deteriorating Wholesale 3Q Results: Total turnover has gone up by 0.7%, but wholesale showed signs of weakness with a 7.1% declined- Esprit Website
Long Term Business Strategy
Increasing Global Brand Awareness – Esprit’s main strategy is to invest heavily into building their company brand name. Doing so will allow Esprit to add greater intangible value to its products and maintain a strong competitive advantage over its competitors – giving Esprit better pricing power in its products.
Brand Building Strategy
- Upgrading store visuals in their stores and shop windows to create an inspirational shopping environment.
- Established flagship stores in popular cities such as New York, Hong Kong, and Frankfurt.
- Convert multi-label retailers to franchise stores carrying only Esprit products.
- Reduced the number of styles offered and differentiate between different divisions.
Increasing Presence in China – In 2010, Esprit bought out the remaining 51% equity interest from the former China Joint Venture. This acquisition has made China the new growth engine for the Esprit group.
Current 5 year expansion plan is as follows:
- Double current China turnover by expanding from base of 169 to over 400 cities
- Increase the number of POS from 931 to 1.7— and increase selling space in China by at least 70%
- Using low cost e-commerce channels in China to introduce lower priced lines in the tier 3-4 cities for further upside and market share growth
- Expanding the wholesale from 163 to over 400 cities, focusing on tier 3-5 cities with the existing franchise model
- Increasing POS and selling by over 65% in the new five years
Financial Statement Analysis
High Quality of Earnings – operational cash flow/net income has range between 124%-159%. Free cash flow has been growing on 5 years median of 6%, while owners’ earning has been growing at 7% (5 years median).
Strong Financial Strength – Debt to equity ratio is 16.78, and interest paid vs. FCF is 0.23%.
Strong Competitive Advantage – I compared selected financial ratios and common size categories that measure profitability, efficiency, and solvency for 4 different companies (HKEX Stock code: 1880, 1913, 2020, 3998) with Esprit. Based on my competitive analysis, Esprit is currently enjoying a durable competitive advantage over its competitors.
Rewards Shareholders: Esprit recently announced an increase in the regular dividend payout ratio from 40% to 60% going forward – this is a testament to their commitment to sharing their success with their shareholders.
High Capital Allocation efficiency: The management has done a great job in terms of their capital allocation strategy. The five year average return on invested capital has been at about 34%, which is higher than the industry average of 29%. The 10 years net income vs. 10 years capital expenditure is equal to 26%, which is significantly lower than 50% – a benchmark used by Warren Buffett.
Consistency with targets: Comparing the targets set in 2009 with the recorded results in 2010, the management team was able to fulfill many of their stated objectives.
Great Long Term Business Strategy: Current strategy is emphasized on expanding into new markets and building brand awareness. Management is also willing to accept short term decrease in earnings in order for better long term profitability - Passed most of the Fisher, Warren Buffett, and Peter Lynch Test of a good business
CEO Compensation: CEO compensation increased from $137,123 (2009) to $190,696 (2010) (HK$’000), while net profit has decreased from 4,745 million to 4,226 million respectively. Although the compensation did not move in line with performance, the management was able to meet most of the company’s targets for 2009 in 2010; as a result, I believe the compensation is still considered reasonable based on management’s ability to achieve targets.
Overall, Esprit possesses a high quality management that is in line with benefits of the shareholders.
Valuation (Methods: DCF, EPV, Graham, & Multiples)
Discount Rate: Esprit possesses an easy to predict business model, a high durable competitive advantage, as well as a stable free cash flow history. Thus, I set the discount 1% lower than my average benchmark return for the S&P 500 of 11%, placing it at 10%.
FCF Growth: 5 years median growth rate for Free Cash Flow and Owner’s Earning is 7% and 6% respectively. I used the historical growth rate as the basis for my valuation. I believe that with Esprit’s strategy to expand into China, the historical growth rate should not be hard to meet. As for terminal growth rate, I simply chose 1% for conservative reasons.
Initial FCF/Owner’s Earnings: I used the 5 year median historical free cash flow and owner’s earnings, which are $5,195,000 and $3,601,000 (HKD) to factor out temporary economic downturn.
Graham’s EPS/FCFPS: I used the 5 year median EPS/FCFPS as the basis for the Graham’s Valuation, which is 4.04 and 3.93.
Graham’s Valuation Growth: I used the 5 year median Free Cash Flow and Earnings per Share growth rate, which is 6% and 3% respectively.
Earnings Power Valuation: Marketing Expense vs. Sales for the last five years was around 30% and I apply it to the 2010 Turnover.
Multiples Valuation: I used Esprit’s Historical multiples and Industry multiples: (HKE Stock code: 1880, 1913, 2020, 3998)
Based on my valuation, Esprit should be valued somewhere in the range of $42 – $50. This gives a margin of safety of 51%-59% based on August 29, 2011’s price of $20.60. Putting a median to that price range will give a price target of $46.
Temporary Slow down in Wholesale – wholesale business continues to be impacted by cautious consumer sentiment and spending in their core Europe market. However, based on the last financial year annual report, the company has stated that the wholesale order book has improved for the period between January 2011 and May 2011, which shows a low single digit decline.
Furthermore, based on the company’s new direction to expand into new markets, we believe the turnover decline in the wholesale market can be compensated by the increased market exposure in the China and North America markets. As a result, we believe the recent wholesale turnover decline will only be temporary and will not impact Esprit in the long term.
Based on our report, we have found that Esprit Group Holdings possesses a high quality management team as well as a high competitive advantage against its peers. Both factors would allow Esprit to overcome the recent decline in profitability and move into a better direction in the future. In addition, with the new current expansion plan to China in place, Esprit possesses a new engine for growth in the next 5 years.
From our valuation, we concluded that Esprit is a buy with a price target of $42-$50 dollars per share, which gives a margin of safety of 51%-59% based on August 29, 2011’s price of $20.60.