Zalando (ZAL.DE): The Starting Point for Fashion
“Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger. If we are delighting customers, eliminating unnecessary costs, and improving our products and services, we gain strength. […]
When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as ‘widening the moat.’ And doing that is essential if we are to have the kind of business, we want a decade or two from now. We always, of course, hope to earn more money in the short term. But when short-term and long-term conflict, widening the moat must take precedence [emphasis added].” – Warren Buffett
“So, what heuristics do investors incorrectly apply to Costco (why might shares be mispriced?). Heuristic one: ‘the company has low margins.’ True, but that’s the point. The firm is deferring profits today in order to extend the life of the franchise. Of course, Wall Street would love profits today but that’s just Wall Street’s obsession with short-term outcomes [emphasis added].” – Nick Sleep
I buy the vast majority of my clothes online. I find it to be a better experience. I can order various items, styles, and sizes, try them on in the comfort of my home, keep what I like, send the rest back, and pay for it later. I can place an order on my phone whenever or wherever, whether at home on a Sunday night or on an early weekday train ride. I’m done wasting Saturday afternoons going from one brick-and-mortar retail store with limited inventory to another, sweating profusely as I’m trying on the tenth pair of pants that don’t fit (years of heavy weightlifting will do that to you—both the sweating and the inability to fit into regular-sized pants). I always leave empty-handed and head home frustrated.
I used to search for clothes on Google and browse different sites. Today, I head straight to Zalando. I almost exclusively use Zalando and think they will dominate the European fashion market for years to come due to their superior core experience. They offer 1) endless choice, 2) seamless convenience, and 3) a tailored digital fashion experience. The company constantly strives to improve this core experience by investing heavily in the customer, sacrificing short-term profits for the ultimate price of becoming the starting point for fashion. Zalando is already the most visited online fashion destination and most downloaded fashion app in Europe, ahead of H&M and Inditex.
Endless Choice
The starting point for fashion needs to have the largest assortment of pieces. With the assortment available on the site, “if you can’t find it on Zalando, it probably doesn’t exist.” With over four thousand brands and one million SKUs in 2021, a 50% increase in items offered by the company compared to 2020, that statement becomes truer every day.
The company’s platform strategy enables this huge and growing assortment. In addition to the standard wholesale model, the company provides brands and retailers with a direct-to-consumer sales channel via their Partner and Connected Retail Program, which connects the inventory of brands and retail partners with over 48 million customers, resulting in endless choice for Zalando customers and significant business opportunities for brand and retail partners. It’s a win-win situation because more partners who provide a larger assortment of items on the platform attract more customers, which increases the business opportunities for partners, drives more partners to the platform, enables an even larger variety, and, thereby, draws even more customers to the platform and so forth. It’s a classic flywheel effect.
The transition to a platform business model is the key lever for long-term value creation since it drives the overall growth and scale on the consumer side and creates high-margin revenue streams on the partner side. Currently, the partner business makes up 30% of GMV (up from 10% in 2018), while wholesale makes up the other 70%. The goal is for the partner business to be 50% of GMV by 2025.
Seamless Convenience
Providing the best shopping experience is key to get customers into shopping for fashion online. One aspect of the seamless convenience that Zalando provides is fast delivery times. Zalando offers same-day or next-day delivery in over 130 cities across Europe.
The company’s best-in-class delivery times are enabled by a €1 billion logistics network, the largest in Europe besides Amazon’s. Compare Zalando’s logistics infrastructure to two online retail competitors from the UK: Boohoo and ASOS. Zalando has 13 fulfillment centers across seven continental European countries with plans to open at least another seven by 2025. Boohoo has four warehouses located in the UK. ASOS has nine fulfillment and returns centers, four of which are in the UK and one in the US. No one can compete with Zalando on delivery times across continental Europe, and its lead over the competition will only increase with the continued expansion of its logistics infrastructure.
Other aspects of Zalando’s seamless convenience include free delivery, free returns, and flexible payment options. By combining all three, the company essentially has recreated the fitting room experience at home. Customers can order a bunch of different items and sizes without laying out a single Euro, receive the items on the same or the next day, try them on at home, return what they don’t like, and pay for what they keep later. Returns are straightforward and stress-free. Every Zalando parcel contains a pre-printed adhesive return label. Customers can put the items that they don’t want back into the parcel, apply the return label, and send it back. Within days, the company will issue a refund to customers, no questions asked. I can attest that the whole experience couldn’t be any more convenient.
Some competitors are starting to charge their customers for returns to deal with these difficult economic times. Fortunately, Zalando has the scale and size to afford not and instead continues to invest in the customer experience, further widening the moat to competition.
The company’s logistics infrastructure is the key enabler of this superior convenience experience. Zalando Fulfillment Solutions (ZFS) is an optional service for brand and retail partners. It allows them to leverage Zalando’s logistics network to increase their customer reach and satisfaction as measured by an increased Net-Promoter-Score while reducing the complexity and cost of cross-border e-commerce in Europe. It’s a way for partners to offer that same seamless convenience. ZFS shares of the Partner Program items were 55% in 2021. The goal is to increase that share to 75% by 2025.
Tailored Fashion Experience
Zalando employs a team of over 2000 software developers and data scientists focused on improving and innovating the customer experience and services for brand and retail partners. The more a customer uses Zalando, the more tailored the experience becomes to them. Customers will get suggestions for complete outfits based on past buys, likes, views, as well as recommendations for sizes. These suggestions drive down returns and help customers to navigate their style options. As someone who spends zero time thinking about fashion and how items match, I find the suggestions useful. Having used many online apparel retailers, I can say that Zalando has the most tailored customer experience. The more tailored the experience, the closer the relationship Zalando builds with its customers.
The company’s attention to data also encourages targeted marketing services to brand partners. For example, Zalando Marketing Services (ZMS) enables partners to leverage Zalando’s customer data and speak to its more than 48 million customers. ZMS includes performance-driven campaign solutions with sponsored listing ads that increase the visibility of products and brand marketing campaigns that engage deeper with customers by telling stories. In addition, partners enjoy access to aggregated consumer insights, allowing them to better understand their customers and the company’s relative positioning and performance. ZMS advertising revenues accounted for roughly 2% of GMV in 2021, a significant increase from 0.7% in 2018. The long-term ambition is to reach 3 to 4% of GMV.
Zalando Plus and Other Propositions
The company has recently made a big push to expand its beauty assortment by entering into a partnership with Sephora, one of the biggest beauty retailers in the world. Customers can shop for fashion and beauty in the same place, which makes the combined offering attractive for customers and fashion and beauty partners on the platform. Again, this is a win-win. Other propositions are Pre-Owned, Designer, and Off-Price (Zalando Lounge).
Everything is tied together by the membership program Zalando Plus. For €15 per year, customers can enjoy faster delivery times, early access to hot releases, preferred notification on discount promotions, and more. While Zalando Plus was limited to only German customers until last year, the company already has over 1.5 million members. Despite the challenging trading environment this year, Plus subscriptions have grown 164% in H1 2022 year-over-year. There’s latent pricing power in the subscription fee as the company continues to expand the benefits of Plus membership.
Management
In the fall of 2008, in the midst of the global financial crisis, two university friends, Robert Gentz and David Schneider, started selling shoes on the internet from their shared apartment turned office and warehouse in Berlin. In the early days, they would use their private cell phone numbers as customer hotlines and carry packages to the post office themselves. They set new standards in online retail in Europe by offering free delivery and a 100-day right to return, recognizing early that it pays to invest in delighting your customers. Robert and David are still young guys at 39 and 40 years of age and are still leading the company as Co-CEOs to this day. They own around 5% of the company.
“Unfashionable”
The company’s stock price is caught in a perfect storm of post-COVID-19 normalization, inflation, rising interest rates, derating of growth darlings, and weakening consumer sentiment, particularly in Europe. A recent financial times article discussed how the share price dipped below the 2014 IPO price of €21.50 after eight years of trading. The article showed the company’s historic share price graph and captioned it “Unfashionable,” which prompted me to take a deeper look at Zalando as an investor after using their product as a consumer for a while.
Today, Zalando trades at around €20.00 per share, down 80% from its 2021 high of €102.95 per share and slightly down from the 2014 IPO price. While investors who bought the IPO have lost money to date, the company exceeded all expectations fundamentally. Since the IPO eight years ago, Zalando has grown:
- GMV by 5.3x – from ~€2.700 billion to €14.348 billion (26.95% CAGR)
- Sales by 4.7x – from €2.214 billion to €10.354 billion (24.65% CAGR)
- EBIT by 6.8x – from €62.1 million to €424.7 million (31.61% CAGR)
- Active customers by 3.3x – from 14.7 million to 48.5 million
- GMV per active customer by 1.6x – from €183.7 to €295.8 (7.04% CAGR)
- Total warehouse space by 5.1x – from 278,000 m2 across three sites in one country to 1,407,500 m2 across 13 sites in 7 countries
During the same time, valuation has compressed from 2.5x LTM sales in 2014, with a peak of 3.4x in 2021, to 0.5x today. Although EBIT has increased handsomely since 2014, widening the moat has taken precedence over short-term profits and will continue to do so.
Danish billionaire Anders Holch Povlsen, the largest shareholder of ASOS and the second largest shareholder of Zalando, recently bought approximately €10 million worth of stock at roughly €32 per share.
Valuation
The European fashion market is forecasted to be worth €450 billion in a few years. With €14.348 billion of GMV in 2021, Zalando currently represents a 3.2% market share. The long-term ambition is to capture more than 10% of the European fashion market.
Currently, Zalando is in 25 European countries with a total population of 500 million. Active customers in 2021 were 48.5 million, close to 10% of that total population. However, in the top five mature markets, penetration is over 20%. The least mature markets are much less penetrated but are growing fast. Penetration in top markets is also still growing because of the continued shift from offline to online. Zalando has captured more than its fair share of that shift, outgrowing the European online fashion market by 2-3x since the IPO.
Online penetration for fashion in Europe currently sits at approximately 30%. Where that number will ultimately settle is anybody’s guess. As someone who buys more than 80% of their clothes online, I believe we still have a long runway of online growth ahead.
If Zalando can reach 20% population penetration across all markets by 2026, that equals 100 million active customers or double the current amount. Assuming GMV per customer grows at a more modest 5% per year (compared to 7% since 2014) to €360 in 2026, total GMV will be €36 billion (20% CAGR), representing roughly 8% of the €450 billion European fashion market.
GMV of €36 billion should translate to €24 billion in sales. Assuming they can at least get back to 2021 EBIT margins of around 4%, that’s €1 billion of EBIT against an enterprise value of €5.2 billion at today’s share price. Although 2021 was an extraordinary year in some ways, I expect profitability to increase meaningfully with scale and the continued transition to the platform model. The company guides to 10-13% EBIT margins in the long run, which translates to €2.4 billion EBIT (around 1/2 of current EV) on my 2026 sales expectation.
But let’s not take the double-digit EBIT margins for granted. Instead, let’s think about how we might get there. First, we know that the company has always been more profitable in mature markets. For example, the last time the company reported DACH (Germany, Austria, Switzerland – mature markets) EBIT in 2015, margins were 6.4% at a much lower scale. As the other markets mature, we will see an overall lift in profitability.
Second, the partner business is inherently higher margin than the wholesale business. The company projects 20 to 25% margins on the partner business compared to 6 to 8% on the wholesale side, underlying the consolidated margin guidance of 10 to 13%. It makes sense that collecting commissions on sales from brand and retail partners is an inherently higher margin business than buying and selling merchandise yourself. Eventually, that business will exceed the wholesale business in share of GMV. The goal is to be at 50/50 by 2025.
Growth in partner business will also drive growth in the additional value-added services of Zalando Fulfillment Solutions (ZFS) and Zalando Marketing Services (ZMS). ZFS pricing follows a cost-plus approach and is, therefore, a low-margin business on its own. Still, it’s an important enabler of the partner program, improves customer experience, and drives superior wholesale order economics for brand partners.
Now ZMS is where things get interesting. Marketing is a relatively high-margin business. Currently ad revenue is 2% of GMV, up from 1.5% in 2020 and 0.7% in 2019. As the share of partner business grows, ZMS revenue will increase. Amazon’s ad revenue as a percentage of retail GMV is around 7%. If Zalando can achieve half that by 2026—I believe it will grow significantly higher in the long term—they will do around €1.26 billion in ad revenue. At a 40% operating margin, in line with other ad businesses, that’s approximately €500 million EBIT for ZMS alone (roughly 1/10 of current EV).
Let’s turn to Zalando Plus. Despite the difficult trading environment this year, Plus subscriptions have grown 164% in H1 to 1.5 million subscribers. The program is only available in a couple of markets right now. The ambition is to double the number of Zalando Plus markets by the end of 2023. It’s not hard to imagine that 10% of active customers become Plus members eventually (more than 70% of the US population is subscribed to Amazon Prime). The subscription price is low compared to the benefits offered at just €15 per year. I can easily see the price being raised to €30, which would still be very cheap. A 10% conversion at 100 million customers in 2026 gets us to 10 million Plus members for a total subscription income of €300 million. The higher fulfillment costs associated with Plus members outweigh the subscription income now, but Plus members spend three times as much as non-Plus members. Zalando’s data shows that it’s not just correlation (i.e., customers who spend more already are likely to be subscribed to Zalando Plus) but causation (i.e., customers spend more after becoming Plus members) because they want to generate as much value from the membership as possible and it offers an even better customer experience.
On the cost side, marketing investments should decrease in relation to sales over time as the starting point for fashion vision unfolds and the share of existing customers increases, reducing the need for costly new customer acquisition or existing customer retention measures. Admin expenses will decrease with overhead efficiencies and economies of scale. Capital intensity will decrease once the logistics network has reached critical mass.
Forecasting is hard. The only thing I’m certain about is that my forecasted figures will be wrong. However, I do feel confident about the competitive position of the business and its eventual status as the starting point for fashion in Europe. If I have that right, the numbers should follow, and my figures should at least be directionally correct. Great businesses usually surprise to the upside.
Pre-Mortem
The company has undoubtedly benefited from riding the secular tailwind of rising e-commerce penetration over the last decade. The European online fashion market has grown 10 to 15% yearly since 2014. If the shift from offline to online ends here and online penetration settles at 30%, a significant portion of the company’s growth driver is lost. However, I find it highly unlikely that online penetration settles here, as I personally almost exclusively buy clothes online. I see no reason why online share cannot eventually exceed offline. To me, online is a superior experience. Ultimately the company itself and its superior customer experience is a large driver of the continued shift to online. The shift will continue as long as the company invests in this experience.
My bigger concern is on the margin side. Widening the moat might never actually end in the face of fierce competition, and the investments in the customer experience will never be scaled down, resulting in mediocre margins and few distributable free cash flows to owners. If you draw a parallel to Amazon, most of Amazon’s profits come from AWS. I wouldn’t want to bet that Zalando will create an equivalent. However, Amazon’s retail business, in aggregate, is a lower gross margin business than Zalando’s. Other online apparel retailers like ASOS and Boohoo have shown 10% EBIT margins in the past. Zalando printed close to 7% EBIT margins in its mature markets in 2014 at a much lower scale. With the platform strategy and the starting point for fashion vision unfolding, Zalando can eventually earn low double-digit EBIT margins. I can also see a world where they don’t, but as Nick Sleep says, maybe that’s the point. Maybe that’s the price you pay for becoming the most dominant player in a market, and even mid-to-high single-digit margins are plenty when you capture a large enough piece of the pie.
Conclusion
Great investments never look obvious at the time. This is one of those rare opportunities to invest in a long-term success story at a depressed valuation.
Despite the 80% drop in share price, the probability of failure is lower than for most growth stocks. It is lower again when one considers that Zalando’s growth plan is self-funded and not relying on capital markets. The company controls its destiny to a greater extent than many other growth businesses. The continued focus on investments in the logistics network and the customer experience will ensure the franchise’s longevity. So, what attracts me to Zalando is the predictability of the outcome. I don’t think the company will fail. On the contrary, I believe they will succeed in becoming the starting point for fashion in Europe. With the immense success they have already seen, they’re well on their way.