Our current investment thesis is:
- While we were completely wrong about ASOS as a long-term investment, we do see value as a short-term opportunistic play. Sentiment is at a low and its valuation is depressed. We believe with reasonable execution, focused on cutting costs and ensuring alignment to trends, the company should experience an upswing once economic growth returns.
- From our review of what went wrong, we do not believe the company has the credentials to be a long-term hold. There are far too many risks and a lack of differentiation. A potential partnership with Frasers Group (OTCPK:SDIPF) and/or Bestseller could change this, however.
ASOS (OTCPK:ASOMF) (OTCPK:ASOMY) is a wholly online fashion and cosmetic retailer based in the UK. Its target demographic is “20-something” year-olds, offering them over 100k products across its 13 ASOS brands and over 900 third-party brands.
We last covered ASOS in March 2022, rating the stock a buy. Since then, its share price last lost over 80% of its value, having already declined ~75% from its all-time high.
We were very wrong, clearly. Not only did ASOS spectacularly decline, but so did many of its other peers. Our thesis was based on ASOS continuing to expand in the US, alongside incremental market share growth in Europe following the acquisition of the Arcadia brands.
Whilst these factors are still playing out, ASOS was negatively impacted by a combination of a change in market conditions alongside poor operational capabilities being exposed by the downturn.
We will seek to analyze how things went so wrong so quickly and lessons we can learn from it, before turning our analysis to recent trading.
Presented above are ASOS’s financial results.
It is important to contextualize ASOS’s broader financial trajectory as part of our analysis of its current predicament. ASOS’s revenue growth has been impressive despite the 3-year stagnation, with a CAGR of +17%. The business rapidly gained market share, and whilst its revenue is only down (10)% in FY23, many in its industry have fared far worse, implying its current position is somewhat insulated.
ASOS’s recent decline is a reflection of a combination of factors that impacted the company over a short period of time. Some of these factors were clearly within its control, while others can be chalked up to cyclicality.
One of ASOS’s fundamental selling points is its broad suite of products, giving consumers of differing tastes and interests options. For this reason, the company holds substantial inventory. This said, there were likely early warning signs here that the company’s approach was not scalable without compounding risk.
As an online retailer, the expectation would be for a high inventory turnover, given stock does not need to be actively held in stores, as well as for online sales. Despite this, ASOS has persistently operated with a low inventory turnover (~3x), which has now declined to 2.3x. For context, the large online and brick-and-mortar fast-fashion giant Inditex (OTCPK:IDEXY) had an inventory turnover of ~4.4x during the last decade, while the online-only boohoo (OTCPK:BHHOF) has averaged ~5.5x.
For this reason, as it scaled, the level of cash tied in inventory relative to revenue has grown, contributing to increased sensitivity to short-term changes in demand… which is exactly what occurred.
Many suggested at the time that inflation was transitory or that after a decade of record-low rates, inflation would rapidly fall with rate hikes. This potentially clouded Management’s expectations for demand. What followed was ~18-24 months of difficulty for consumers, particularly in Europe (exaggerated by the war in Ukraine), contributing to softening retail spending and a cost of living crisis.
As the following illustrates, retail sales volume in the UK has declined almost persistently since Q3-21, while pricing has driven top-line growth. Whilst this has supported many large businesses, those in competitive industries with an inability to materially lift prices have struggled. This is why many of the European fast-fashion houses have equally experienced a decade. While their prices are competitive, consumers are still not happy.
RIP fast-fashion, long live faster fashion
In the last 3 years, we have seen an acceleration in the interest in what we have coined “faster fashion”. The fast-fashion industry began with the simple innovation of speeding up the runway to the high street process but for the masses, driven by the likes of H & M (OTCPK:HNNMY). Following this, the industry experienced a one-in-a-lifetime revolution due to e-commerce, giving birth to firms that could quickly produce goods in the Far East and export them to the West. Welcome ASOS, et al.
The next stage of this is what we are currently in the peak of, and what will likely drive the fashion trends of the next few years. This is even faster fashion (or the TikTok era), with prices declining further and choices broadening. Consumers care even less for mid-tier brands, prioritizing price and design. Examples of faster-fashion brands are Shein and Temu.
Unfortunately for ASOS and its European peers, they lack the capabilities and scale locally in the Far East, as well as the responsiveness to changing trends. With ASOS so heavily tied to retailing third-party brands also, it has lost out here.
Amidst a decline in demand, ASOS has been unable to control its costs. The business has always focused on growth at all costs, as illustrated by its limited margin development despite revenue being 4.6x larger than in FY13.
This lack of operational focus has left ASOS in a weak financial position, with discounting considerably increasing in order to maintain demand.
The issue here is that, while inflation is a near-term issue, the fundamental problems will not be resolved without investment in its supply chain, which it does not have the financial resources to do.
ASOS was run as a lean growth machine. Management likely neglected incremental improvements, contributing to a “cool” business becoming out-of-date. By way of comparison, Zalando’s website is considerably more modern than ASOS’s, with greater functionality and the perception of quality.
20-something year olds are no longer 20-something
Whilst faster fashion is in full swing, many consumers are turning away from the industry in general, particularly as they age and income grows. The 20-something demographic that ASOS targeted has changed, and the company has failed to keep up. This is the same issue that brought down (to mediocrity) the once global icon that was Top Shop.
Many consumers now care more for sustainability and are rejecting fast-fashion for these reasons.
ASOS’s prior leadership, the team that founded and substantially grew the business, departed in recent years as criticism and its recent decline contributed to their ousting.
We believe there was potentially not enough challenge to the company’s strategy, which was far too focused on growth and not enough on building a sustainable business. As we have discussed above, there were clear issues, albeit difficult to see.
So, what are the lessons from ASOS’s decline?
- Which direction is the wind blowing? – We are incredibly passionate about fashion, which is why we consider it (for the most part) a bad investment. Consumer trends change rapidly and whilst it generally moves in cycles, the wait may be too long for some. It is critical to carefully observe when the tides are changing. We are currently watching Abercrombie & Fitch (ANF) with much interest. A much-beloved brand that fell out of favor and is now having a renaissance.
- Are the basics being done correctly? – Whilst growth was the darling that drove ASOS higher and higher, operationally the company was neglecting its duties. Progress cannot be tracked by one metric but the broader interrelationship between factors (growth but no margin improvement in this case should have raised more questions).
- Red flags – Red flags do not always need to be large and clear but are almost always visible if they exist. A low inventory turnover likely meant margin destruction and FCF negativity was certain, yet most (including ourselves) completely missed it.
- Why are customers here? – ASOS’s customers were drawn by two things, choice and price. The issue with both is that they are not high-quality forms of differentiation. Both things can be replicated fairly easily, particularly by loss-making new entrants. Long-term quality differentiation is a requirement for a winner over time.
Every stock has a fair value and so problems can always be “priced in”. However, during the last decade, ASOS traded at a growth company’s valuation (Avg. NTM EBITDA multiple of ~24x) which the lessons above should have dissuaded investors.
Presented above are ASOS’s most recent quarterly results on a half-year basis, as is reporting customs in the UK.
The company appears to have stemmed the bleeding, with FCF and EBITDA turning positive in H2’23. Revenue growth continues to decline, which is expected, as Management delivers margin improvement in the short term through pricing and limiting discounts.
There is a fine-line between liquidating stock for cash in a downturn and protecting margins, which Management appears now to be balancing following several difficult periods.
This said, it is also worth highlighting that the company has benefited from easing inflationary pressures, with reduced shipping costs.
Presented above is Wall Street’s consensus view on the coming years.
Analysts are forecasting mild growth in the coming years, primarily due to a ~8% decline in FY24F. Alongside this, margins are expected to sequentially improve, exceeding its decade-average by FY28F. Based on these forecasts, analysts are essentially expecting a rebirth by ~FY27F.
We do see merit in these forecasts, particularly for the coming 2 years. Whilst the business has been materially damaged, all hope is not lost. Management is actively cutting costs through a transformational exercise, whilst also “right-sizing” inventory. Further, the expectation is for rates to decline in 2024 and into 2025, returning healthy economic growth.
The key execution wise will be operating with a higher inventory turnover and improving its competitive position, which Management can begin wholly focusing on in early 2025. With good execution, we could see the business exceeding its historical levels by c.2028.
ASOS is currently trading at 0.3x LTM revenue and 10x NTM EBITDA. This is a discount to its historical average, which is clearly warranted by the factors discussed in this paper.
To value ASOS’s revenue at less than 1x implies almost no value can be extracted. This is extreme in our view, even given the criticisms identified.
If growth of low-single-digits can be achieved, alongside a similar FCF margin to that expected in the forward period (~2%), the company would currently yield ~16% on its valuation at a reasonably compounding rate.
As crazy as it sounds given the last few years, this does imply value.
Additionally, the King of British Retail Mike Ashley has taken a substantial stake in the company (as well as boohoo), as has Bestseller A/S (Danish retail group). This creates the optionality for a strategic partnership, activism, a takeover, or anything in between.
Key risks with our thesis
The risk to our thesis is that the issues we highlighted do not get rectified. Ideally, Management would seek to close off issues prior to a return to growth, at which point it can focus on marketing and returning to its prior trajectory.
We were very wrong about ASOS but that does not mean what has happened to its share price subsequently is appropriate. Share issues, leadership changes, investor economic fears, and many other sentiment-driving factors have contributed to a share price slump.
If ASOS can return to even reasonable growth and low-single-digit EBITDA profitability, which is completely within the realms of possibility, the company appears undervalued. The key for the long term is fixing the issues we have identified.
For investors today, this stock could represent an opportunistic play on short-term financial improvement at an NTM FCF yield of 16%.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.