Why I Won't Be Buying Shares in Asos

Asos is a company I really struggle to judge, and the market clearly does too. Since 2010, the Asos share price has crashed over 50% in three separate instances, each time rallying by more than 300%. I can’t imagine what this rollercoaster has been like to ride for long term holders, but if they have managed to hold on, they will likely be quite happy with the result to date. Asos continues to grow into its UK, European and US markets and has recently acquired Topshop and other assets salvaged from the break up of Phillip Green’s empire. Whether Topshop can be integrated into Asos effectively or just gets wound down, I still think it is a smart move, as Topshop in the hands of a competitive owner or private equity would have diverted sales away from Asos’ business.

I own both JD Sports and Boohoo in my personal portfolio, and I like the fashion market, especially for the more digitally engaged operators. However, I don’t own a position in Asos for these four reasons.

1. Growth / Profit mix

My first issue with Asos is that it doesn’t seem to be growing that fast. I say ‘that’ in a light-hearted fashion, as a four year average of 23.6% is very good growth, and much faster than the wider market. However, looking at UK peers JD and Boohoo, Asos hasn’t quite performed in line in growth terms. Some of JD’s growth is arguably attributable to their recent acquisitions of retailers to increase their global footprint. However, Asos’ growth hasn’t been solely organic either.

I can understand buying a slower growth business if profits are more significant, in essence, you trade off some growth to receive a more cash generative business. However, Asos’ operating margins are pretty woeful. An average of 3.5% in the last 4 years is not good and is under half the level of Boohoo and JD, peers that are growing much faster than Asos. You may argue Asos is at an early stage in its growth story, however, Boohoo is not only smaller, but also younger in its growth story than Asos, and yet manages double the operating margins.

Even as investors in growth companies, profits still matter, and operating margins are a strong precursor to how likely the business will be able to reinvest capital for future growth.

2. Competitive Pressure

The second factor that influences my preference for other companies would be the competitive pressure that Asos faces. The online fashion marketplace is fierce. Well capitalised global peers in the online-only retail space such as Zalando in Europe, Fashion Nova and Revolve in the US and Boohoo in the UK fight for market share with more traditional retailers such as Debenhams and Selfridges in their local markets. They also fight a resilient core of low to mid-tier brick and mortar apparel companies such as Next, Zara and H&M.

Further competitive pressure on the fashion retail marketplace is the increasing threat of key brand suppliers looking to increase their DTC (direct to customer) sales, which have better margins. Pretty much every clothing brand’s conference call I listen to — whether that be Nike, Adidas or a recent call in Levi’s Q1 results — the second hot topic on the agenda after sustainability is increasing DTC sales and reducing wholesale retail (the sale of products to third-party retailers).

In my mind, the switch to online has changed the game in retail. Previously, a strong argument for owning clothing retailers (in a brick and mortar setting) was the comparison effect — shoppers liked to view a brand or product next to other potential product choices to help aid the decision-making process. This worked well in a physical store, as a multi-brand retailer can have many different brands listed next to each other so the shopper can make a comparison. Switching to online, if, for instance, I am evaluating my next purchase of a pair of jeans, I can load five pages from each of my favourite brands and visit their online stores to compare products. Thus, in an economic sense, the cost of comparison is minimal in the online setting vs bricks and mortar. With the shift to online ever increasing, I think the DTC model of key brands is only going to grow from here, thus putting further pressure on multi-brand retailers to compete for the business of key suppliers.

Lastly, further competitive pressure on the online-only retail space is the advent of an entirely new product category that has spun up over the last few years, sustainable retail, such as the online second-hand clothes shops Vinted, Poshmark, Vestiaire Collective and Thrift. With Asos’ core customer base of millennial 20 somethings, a (typically) climate change and sustainability-conscious demographic, I would expect challenges to be seen looking to future growth.

3. Lack of Niche

To me, the Asos business model lacks a specific niche. Asos’ sales are spanned across all apparel lines, accessories and footwear, and even though its mission is to be ‘the #1 destination for fashion-loving 20-somethings worldwide’ I am not sure Asos’ is discernable to any specific age category or customer type. By catering to a broader market, it increases the scope and scale of Asos’ business. However, Asos’ product lines are far more general than both JD and Boohoo. JD caters to a cash-rich, resilient, ‘sneakerhead’ market, where teens see JD and other retail sites such as ‘Size?’ and ‘Footpatrol’ as the place to go for the coolest footwear. Boohoo appeals strongly to the younger teen market, with a niche for Instagram style influencer wear. To me, Asos has a much more general basket of customers, which can lead to less loyalty, as they are easier to influence to spend money elsewhere.

4. Low own-brand sales

This lack of niche isn’t helped by a low input of its own brand revenues. Asos makes roughly 28% of revenues from its own Asos brands vs the vast majority of its own supply for Boohoo. Now we all know the risks that are present in owning your product supply chain, especially if you have poor governance in place, however, by relying on branded retail products for +70% of revenues, you begin to see why profit margins are of lower quality at Asos. By commanding own-brand sales, retailers benefit from higher margins and better relationships with customers. By tailoring products faster to new trends, own-brand retailers like Boohoo can outpace competitors who are waiting for their wholesale supply chain to pick up on the trend.

Asos has made improvements here in recent years, and the purchase of Topshop was likely to improve Asos’ footing in this department.

JD does rely on key brands Nike and Adidas to a large extent. However, JD is a value-add retailer — its sought after urban locations (such as the new flagship store in Times Square, New York) are locations where Nike and Adidas would want to show off their latest collections to a high volume audience. It is this value add process that gets JD sports named specifically by Nike as a preferred retailer in conference calls, and it is why I am less concerned about JD's reliance on big brands.

An in-depth look at the financials can help explain some of the aforementioned points. Whilst growth has been pretty punchy over the years, the two missteps in 2015 and 2019 show that a low growth year every once in a while can be expected and is partly the reason behind such a volatile share price. Gross margins are solid at around 50% but the key quality metric of operating margin remains low at <5%. Asos has been fairly leveraged in recent years, with a debt to equity ratio above 1.5 for the majority of the last 5 years — however, with good top-line growth, leverage is probably worth having. The recent Topshop acquisition has added significantly more assets to the balance sheet, thus reducing Asos' return on capital employed (ROCE) from a previously impressive 20% down to 13%. This likely means the acquisition hasn’t been immediately accretive to profits, however, in the long run, I would expect the purchase to pay off.

In summary, there are lots of reasons to like Asos — the growth story looks set to continue and returns have been magnificent for long term holders. However, there are a few specific reasons I prefer Asos’ peers for exposure to the fashion market as mentioned above. There could be more volatility in future, and I will be revisiting the Asos story if signs of margin improvement or a significant share price decline ensue.

The Twenties Trader does not own shares in Asos.

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