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Nov 6, 2013
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Has Zara reached saturation point? Far from it, investors bet

Nov 6, 2013

MADRID, Spain - The world's largest fashion retailer, Inditex, shows no sign of stalling and investors are betting that its Zara "fast fashion" model has plenty of room to expand in emerging markets by appealing to the growing ranks of brand-conscious middle classes.

Zara AW13/14

Amancio Ortega opened the first Zara store in 1975 and pioneered the idea of quickly imitating catwalk trends to create a global giant with more than 6,100 stores in 86 countries, making the publicity-shy Spaniard the world's third-richest man.

Inditex has weathered the global economic downturn better than rivals like H&M as its "fast fashion" model has allowed it to be more responsive to changing consumer demand, while its focus on the latest trends has made it less vulnerable to the rise of discounters like Primark.

Inditex, which owns seven brands other than Zara, including more upmarket label Massimo Dutti, has also expanded faster to emerging markets, with Asian markets recently overtaking Spain as its biggest source of sales for the first time.

That is part of the key to maintaining its extraordinary growth - Inditex now makes 45 percent of its sales in emerging markets, estimate analysts, compared to just 14 percent for H&M.

It has also moved faster to embrace e-commerce, opening Zara online stores in 22 markets compared to nine for H&M, with its model of stocking stores from central warehouses in Spain well suited to filling orders placed on its websites around the world.

"For three to five years, I don't think there's any threat to them maintaining their pace of growth," said Hala Fadel, a fund manager for Comgest, a shareholder in Inditex.


That helps explain why Inditex shares are so highly prized: they trade at 26 times expected 2014 earnings, compared to 23 times for H&M and 13 times for Gap.

While H&M has adopted many of Zara's tricks, it is still less responsive to fashion fads as it sources primarily from factories in Asia to keep prices low, while Inditex uses more suppliers closer to its main European markets.

Quick turnover of stock and centralised distribution allows Inditex to price more expensively in countries like Japan where consumers are prepared to pay more and to send more pared-down items to countries where shoppers are less affluent.

That responsiveness has meant it has had to discount fewer unsold goods through the crisis, helping improve its gross margin from 56 percent in 2008 to over 59 percent in 2012. H&M has seen its margin advantage over Inditex driven by cheaper production costs gradually eroded in the last three years.

Inditex shares dipped earlier this year after the firm posted its weakest quarterly net profit growth in four years, but rallied again after like-for-like sales picked up at the end of the second quarter and the beginning of the third.

Only two of the top 10 Inditex investors have recently sold shares, according to Thomson Reuters data. Of the 34 analysts who cover Inditex, 16 have a "buy" recommendation on the stock, compared to eight with a "sell" rating and 10 on "hold".


One of the few sceptics is Credit Suisse analyst Simon Irwin, who notes that Inditex's 95 new store openings in the first half was the lowest number in eight years, casting doubt on the firm's ability to expand store space 8-10 percent a year.

"It is clearly a brilliant company but the ability to keep growing at double-digits when you are already that large is quite difficult," he said. "They had a significant advantage five years ago as they were early in China but they are all doing the same thing."

Fadel counters that Inditex's size and eight different brands give it negotiating power in Chinese shopping centres that allows it to secure better locations and more stable rents than rivals.

It tends to have 10-15 year leases in China, with an option to leave earlier, compared to an industry average of three, because it tends to be the anchor tenant and invests a significant amount in each store, says Bank of America Merrill Lynch analyst Richard Chamberlain.

China is already Inditex's second-biggest market after Spain, contributing some 7 percent of sales, analysts estimate. By the end of last year, the company had 396 stores there. But it still seems far from saturation point.

"Steady income growth and hunger for style should continue to fuel their expansion," said Neville Moss, head of EMEA retail research at property consultants CBRE, noting store numbers in big cities for top fashion brands are still significantly below the 1 per million population threshold common in mature markets.

Consultants McKinsey predict the global women's apparel market will grow at almost 5 percent by 2025, up from a historical average of just over 3 percent, with emerging markets accounting from over half of sales by then from 37 percent now.

"There is room for 20 companies like Inditex in the world," said Manel Jadraque, chief executive of Spanish fashion rival Desigual, which is also expanding fast in emerging markets.

Inditex said in September it expects to meet space growth targets for the year although it plans new store openings at the lower end of a 440-480 target as it increases average shop size.

Inditex is expected to report store openings picked up in the second half after it completed a refurbishment of some 70 stores worldwide, launching a new design in some of its flagship Zara stores that divides the collections up in cube-like spaces.

However, Inditex faces a tougher challenge to maintain its dominance at home where consumers are unlikely to go back to the boom years of credit-fuelled shopping any time yet with unemployment still at 26 percent even as the economy recovers.

It faces tough competition on price from Primark, which is opening five new stores in Spain in the last quarter, and H&M, which saw sales grow 10 percent in the June to August period.

Inditex, which saw Spanish sales fall 4.4 percent in the first half, is responding by reworking its lowest cost brand Lefties, according to reports in the Spanish press, although the company has declined to comment.

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