Alexandros Michailidis
It’s been over a decade since I’ve written about Fast Retailing (OTCPK:FRCOY) (OTCPK:FRCOF) for Seeking Alpha, but that long stretch of time has been good for this Japanese “fast fashion” retailer. While revenue growth has been a little weaker than I’d projected back then (around 6.6% annualized versus my 8.1% modeled estimate), the company has become more profitable than I’d expected. That’s been a perfectly fine trade, as the local shares are up close to 400% and the ADRs are up almost 200%, comfortably outperforming global peers/comps like Gap (GPS), H & M Hennes & Mauritz AB (OTCPK:HNNMY), and Inditex (OTCPK:IDEXY), though the ADRs have lagged Abercrombie & Fitch (ANF) some over that time.
I continue to like the growth outlook for Fast Retailing, particularly the company’s strong position in mainland China and opportunities to grow throughout Asia, while growth in North America remains an option management could also explore. The downside is valuation. While I acknowledge that a weak Chinese economy may be hiding the true earnings potential of Fast Retailing in the near term, using a P/E in line with the norm between when ex-Japanese growth really started to accelerate and when the pandemic hit still only suggests a modest amount of upside from here.
I don’t like to abandon good stories, particularly good growth stories, just because of valuation, but I also don’t believe in just ignoring valuation. To that end, a pullback in the share price would make this name quite a bit more interesting.
Healthy Earnings Despite Challenges In China
All told there’s really not a lot for me to pick at with the fiscal third quarter earnings that Fast Retailing reported a couple of weeks ago. Not only did Fast Retailing exceed expectations, but management also raised guidance, and this all coming despite a challenging operating environment in China – a key driver of the business.
Revenue rose more than 13% year over year as reported in the last quarter and close to 8% in constant currency. To the extent that Hennes & Mauritz and Inditex are fair comps (and the differing geographic mixes do certainly complicate things), Fast Retailing outperformed the 3% local currency growth at H&M, while underperforming the 11% constant currency growth at Inditex.
Sales for Uniqlo Japan rose 10%, with 9% same-store growth driven overwhelmingly by ticket (up 8.9%) over traffic (up 0.2%); e-commerce sales growth was also strong at 12%. Uniqlo International sales rose about 19% as reported and closer to 7% in constant currency terms. Growth was robust in North America (up around 28% in local currency) and the EU (up around 42% in local currency), while results from Greater China were weaker (down around 4% in local currency), with sales in mainland China “down sharply” in local currency.
Gross margin improved almost three points (to 56.5%), with improvement in both Uniqlo Japan (up 410bp to 54.5%) and Uniqlo International (up 210bp to 58.1%). Operating income rose 31%, with operating margin up 250bp to 18.5%, and Fast Retailing beat Street expectations by about 15%. While growth in the international business was held back by challenges in China, the Uniqlo Japan business grew profits by 57%, with margin up more than six points to 21.2%.
Although Japan’s retail sales have been perking up of late, Fast Retailing still comfortably outperformed the market by a good margin, as well as rivals like Shimamura (where comparable quarter revenue rose about 5%), and the same is true of the business in North America and Europe. While benchmarking the results in China are more challenging, it seems that Fast Retailing is still outperforming peers based outside of the country.
Meaningful Growth Runways In Multiple Markets
A key positive to the Fast Retailing story in my opinion is that the company still enjoys healthy growth runways in multiple markets that can continue to drive profitable growth.
Growth opportunities are likely most restrained in Japan, where demographics just aren’t in the company’s favor. Still, it has established itself as the leading player in Japan’s apparel market, and further share gains are still possible from its low double-digit percentage today.
In North America, Fast Retailing is about one-quarter the size of American Eagle (AEO), and while the company seems more interested in an online-forward expansion strategy here, I don’t think that’s a bad strategy as shoppers continue to gravitate away from in-store shopping in favor of digital. Likewise with the company’s opportunities in Europe.
China is a different story, and the company continues to look to add close to 100 stores a year, though while pursuing a “scrap and build” strategy where the company looks to close under-performing locations and open new stores in more promising locations. Given the sheer scale of China’s retail market, I don’t think 922-plus stores comes close to saturating the Chinese market, and I think this can be a healthy growth market for years to come.
I also see some potential growth in Fast Retailing moving to embrace more sustainable practices in its business. It’s a stretch to say that mass-market consumers avoid clothing companies on the basis of their sourcing practices, but Fast Retailing is nevertheless moving to separate itself from a lot of the past sins of the “fast fashion” trend, including making more durable clothing and looking to source more of its yarns from recycled materials (a 50% target is in place for 2030) and from countries with better labor practices.
The Outlook
Given growth opportunities like the e-commerce channels in Japan, North America, and the EU, as well as growth opportunities throughout Asia in physical locations and e-commerce, I believe Fast Retailing can continue to generate healthy revenue growth, and I’m looking for around 7% long-term growth from the company.
I do also see additional scale/leverage opportunities, as well as opportunities to generate more profitable sales through e-commerce channels (and improve profitability through more efficient distribution and logistics). That should be able to drive at least a half-point of operating margin improvement over the next few years, and likewise improving EBITDA margins. With that, I think free cash flow margins can move toward the mid-teens, driving high single-digit FCF growth.
The bad news is that none of my assumptions really support a robust fair value estimate. Neither discounted cash flow nor margin-driven EV/EBITDA suggest that Fast Retailing is cheap. A P/E approach is somewhat more favorable, but even this requires some stretching. If I use a forward P/E based upon the average between when Fast Retailing really started accelerating the overseas business (in China especially) and the start of COVID, that 35x P/E only gets me to a fair value a little bit above today’s price on the basis of my FY’25 EPS estimate (JPY 1,204/share).
The Bottom Line
Even though I think Fast Retailing will continue to outgrow its peers, a 35x P/E still strikes me as steep. I’m fine with owning quality growth names even when the valuation is less than ideal, but this is a name I’d prefer to reconsider on a pullback rather than pay up for today, even though I do expect sales in China to rebound, and I still expect years of profitable growth ahead.
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