Disappointing Financial Highlights
Slight Improvement in Sales: Group turnover amounted to $33.8 billion (2010: HKD $33.7 billion). The group turnover grew because of an increase in retail turnover growth of 6.2%, which compensated the decline in wholesale turnover decline of 6.0%.
Disappointing Net Income: Net profit of the group fell to HKD 79 million (2010: HK$4,226 million). Earnings per share dropped from 3.35 per share to 0.06 per share. The decline in net income is due to the provisional cost of store closures and divestment of operations in North America, which has amounted to $1268 million and $1161 million respectively.
Key Business Strategy Highlights
- Esprit plans to spend HKD 18 billion dollars into implementing a critical restructuring of its company over the next 4 years
- The restructuring will consist of 1) building brand awareness, 2) improving product offering, 3) Exiting unprofitable markets and Expanding into profitable ones, and 4) Improving efficiency in its supply chain
- Esprit is divesting its unprofitable businesses in the North American, Spanish, Danish & Swedish markets and focusing its expansion in China in addition to German speaking countries such as Benelux and France
- A majority of the restructuring spending (HKD 6.8 billion) will consist of building back up its brand value.
- The full transformation process will take until FY 14/15 to complete.
You can read full discussions of its business strategy in these links:
Overreaction from retail investors
In a matter of several days, the stock price of Esprit has dropped by more than 50%. The reason for this drop is due to the following reasons.
Disappointing Net Income: With net income dropping from HK$4,228 million to 79 million, most investors would be scared of such drop.
However, let’s not forget that a majority of the loss was due to the one-time restructuring cost and impairment charges, which means that Esprit’s rise in cost is temporary and made of mostly non-cash items. Adding back these restructuring cost/impairment charges, the company’s operating profit and net profit would have been $HKD 3121m and HKD 2352m respectively.
Although this is still a drop from the previous operating income ($ 3,121m) and net income ($ 2532m), the drop may not be as significant as how most retail investors portrayed it to be, causing an overall overreaction from the market.
Stopped paying dividends: For the first time in many years, Esprit didn’t pay dividends at the end of its fiscal year, which is of course added bad news for retail investors out there.
However, if we take a deeper look at Esprit’s financials, the reason why they stopped paying dividend is mainly because they paid too much before. In fact, Esprit actually paid more dividend when in comparison to last fiscal years. For the FY10/11, Esprit actually paid out $2,079 million of dividends (FY 09/10 $1,483HKD); as a result, once again the retail investors might be overreacting to the new dividend policy.
Analyst Downgrade: The biggest factor to the price drop is mainly contributed to the downgrade by analysts in the financial community. Many analysts are uncertain of Esprit’s future and their success at building its brand. They believe that the ongoing weak European macro factors might further affect the profitability of Esprit.
Here is couple of analyst’s coverage you could read:
Overall, I understand why the analysts would downgrade Esprit’s value. With the uncertainty of Esprit’s transformation and the ongoing risk from the Euro-zone, the downgrade is understandable.
However after analyzing Esprit’s recent changes, I am still bullish in the company’s future.
Clues of Esprit’s future success?
In order for Esprit to be successful in the future, Esprit has to be able to do two things 1) Expand Successfully in China 2) Rebuild its brand to compete with brands such as Gap, H&M, Abercrombie and Fitch, and Zara.
Expanding Successfully in China
Overall, the expansion in China is in line with Esprit’s direction. The reason why China is an ideal place for Esprit to pursue is the fact that “The return on investment is so much higher in China on every euro or Hong Kong dollar that we invest than in New York” said Van Der Vis (CEO of Esprit). Based on the recent turnover report, Esprit is continuing to see positive performance in China. YoY sales growth in China has been 4.4%. In addition, there is an upward trend in the sales growth of comp stores. China contributes 8% to the group’s turnover, and it is placed second in terms of sales by countries.
Rebuilding its brand
The most important factor that will put Esprit back in the map is the rebuilding of its brand.
The only conviction that I have that Esprit’s brand will improve is the fact that Esprit was able to find Gisele Bundchen as their new face of the company.
As of now, Gisele Bundchen is the highest paid model in the world. With such a high status on the line, I don’t think Gisele Bundchen would be willing to accept Esprit’s endorsement unless she thinks Esprit will be successful in elevating its brand. Otherwise, it would make her status go down for future endorsements.
Gisele Bundchen has probably done her own research before picking Esprit. I am guessing she sees that with her help, Esprit might be able to improve its brand in the future.
Discount rate: I maintain it at 10% based on high free cash flow predictability and easy to understand business model.
Discount Cash Flow (Valuation: $35-$24 Median: 30)
I used 0% growth rate for owner’s earnings and free cash flow; this is a conservative assumption that factors in short term drop in profitability and high capital expenditure in the next 4 years.
Earning Power Value (Valuation: $44-33 Median: 42)
I used 5 years normalized FCF, owner’s earning, & normalized Adjusted Income and apply it to current sales of $HKD 33, 767 million and added a marketing value of 2.5 billion in the valuation.
Graham Valuation (Valuation: $36-11 Median: 14)
Growth Rate Assumptions: Free Cash Flow per share (0%), Earnings per share (0%), & Owner’s Earnings per share (0%).
Adjusted per share: Earnings (2.24), FCF (4.07), and Owner’s Earnings (1.65)
Industry Apparel Multiples Valuation ($56-2.45 Median: 5.36)
I used industry multiples based on 179 apparel companies in China.
Price Multiples used: P/E, P/BV, P/Sales, Trailing P/E, & Net Income/Market Cap
Historical Multiples Valuation ($21-3.19 Median: 17.50)
Price Multiples used: P/E, P/NAV, P/Cash Position, P/OCF, P/Owner’s earnings, and P/Free Cash Flow
Based on my valuations, the company should be valued somewhere between $14-38 with a price target of $17.50 within 12 months – this valuation is based on Esprit undergoing a no growth scenario.
If Esprit’s were to be successful in building its brand within the next two years, their valuation should be somewhere closer to the EPV of $44-33 or a median of $38.
Although I have set my price target lower than my previous, I still believe there is still a bargain opportunity for this company. When Esprit starts improving earnings and giving out dividends, the market would realize the mispricing with Esprit.
Revenue is expected to decline between 3% to 5%, and operating margin is set to be 1%-2%. This stock might encounter a lot of obstacles along the way, but the future looks good. At its current price, this company is extremely undervalued and might become a potential buyout target.