ASOMY ASOS Plc (PK)

By Stephen Wilmot 

How to justify sky-high earnings multiples for online fashion retailers? The old question has acquired a new urgency as business for traditional clothing shops, most dramatically U.S. department stores, has rapidly deteriorated.

The good news for investors looking to shift money into the growing part of the market is that those eye-watering valuations aren't as irrational as they seem.

Shares in Asos and Zalando, the European leaders in online fashion, trade for 63 and 51 times forward earnings respectively, according to FactSet. It can be hard to reconcile such multiples with those of bricks-and-mortar retailers such as Macy's at 11 times.

The most obvious justification for these differences is in growth rates. Asos and Zalando are both enjoying top-line growth of roughly 25% a year, whereas Macy's is losing sales. But there's an even more crucial consideration: To manage and maintain their growth, Asos and Zalando need to invest continuously in management systems, logistics and advertising. That means they make far lower operating margins than traditional retailers.

A theoretical illustration: An investment in an online retailer at 60 times next year's earnings would work out at 29 times earnings after five years of 20% annual sales growth, assuming a constant 3.5% earnings margin. That still sounds expensive. But assume it then focuses on profitability, not growth, prompting a doubling of the margin to 7%--the arguably conservative "terminal" level used by analysts at RBC in their models--the multiple would fall by half to a fairly normal-sounding 14.5 times.

This calculus explains why margins are just as closely scrutinized as growth rates. Zalando's shares have jumped 30% since management in mid-July forecast a margin of between 4% and 5.5% this year--up from its previous guidance of 3% to 4.5%. Analysts are particularly excited that the Berlin-based retailer made a second-quarter margin of 13.9% in Germany, Austria and Switzerland, its most mature markets. This is abnormally high, but the four-quarter average of 9.4% is the kind of margin online retailers could make if they didn't relentlessly recycle profit from established markets to expand in areas.

The core uncertainty is that nobody knows what margin a mature online retailer makes. The largest player, Amazon--which owns Zappos, the company that inspired Zalando-- is still growing furiously. At 3.3%, its operating margin for the last 12 months is even lower than those of Asos or Zalando, which paradoxically helps explain why its earnings multiple, at 86 times, is higher. The other reason is that Amazon is the market-leader in a winner-takes-all world.

Online-retail valuations aren't mad, but their dependence on shifting mature-margin expectations makes them highly susceptible to minor forecast tweaks. The resulting volatility is then exaggerated by momentum traders.

This makes for a rocky ride for investors, but it also presents an opportunity to build a long-term stake at a discount. The best time to buy Asos or Zalando is when the market is worried about profitability--as it regularly is. Zalando shares traded for 42 times forward earnings before July's bullish update. Don't be put off by comparisons with old-fashioned chains: For an online retailer, that is cheap.

Write to Stephen Wilmot at stephen.wilmot@wsj.com

(END) Dow Jones Newswires

September 06, 2016 08:09 ET (12:09 GMT)

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