Expansion at the expense of margins

Business Zalando came into existence in 2008 and over its decade of life, it became the leading European online platform for fashion-related goods and one of the top 10 fastest-growing retailers worldwide. The platform offers an extensive selection of fashion and beauty products to 17 markets in Europe. The company has gained a market share of around 1.1% of the overall European fashion retail market and 8% of the online fashion sector. Its customer base has expanded rapidly to reach 25.1m active customers across Europe in 2018. Zalando is consolidating basics to become a marketplace in the long term. Zalando is building the key assets for a performing online business. Fulfilment capacities are being raised across Europe and automation has been upgraded through AI tools across the entire value chain. This expansion is crucial as it allows for a competitive mix of offers and flexible logistics. However, there are still plenty of issues to be tackled. Returns and margins are foremost. Zalando still has a high rate of returned garments (around 50%), mainly in low established online markets. This adds a substantial risk to the common challenge of excess inventories. The shopping club and physical outlets enable it to dispose of excess stock but at discounted prices and this adds pressure on margins. The latter are already squeezed by high opex and costly e-commerce services. These issues would be eased by AI algorithms being developed by the company to optimise the purchasing process and reduce returns. Efficient logistics are another challenge in both upstream and downstream and this is why distribution will be limited to Europe for the time being. There is no aim to knock on markets’ doors outside Europe. Entry barriers in the online retail are tiny and competition is escalating with pure e-tailers raising their capacities and lifting their offer. Operational processes are being upgraded through advanced technologies which has become a key factor for operational efficiency and competitiveness. Zalando has leapt ahead of European peers on warehousing capacities and market share, but much work still needs to be done on the technological side. Growth perspectives are considerable for Zalando given the expected development of e-commerce penetration in Europe (estimated at 16% in 2018 and expected to reach 25% by 2023). Zalando is well armed to conquer a higher market share of the European online retail market. However, the path is not straightforward and is full of challenges. Recommendation and upside We are initiating coverage of the German Zalando (a market cap of €6.5bn and a free float of 58.7%) with a REDUCE recommendation and a target price of €26.8 per share, leading to a poor upside potential of 1.7%. Our upside is driven by: 1/ a top-line expansion at a double-digit rate in the long term thanks to the fast development of e-commerce; 2/ growing investments in assets supporting a competitive offer; 3/ a slow margin improvement due to the costly online offer. We are sceptical about the company’s earnings development compared to the huge capital employed invested. The online customer is increasingly demanding costly and sophisticated services which put retailers in a dilemma with competitiveness/profitability. Strategy Zalando is moving forward in expanding its business and building up the basics for a performing online offer. The strategy is focused on investing on warehousing and technology to move to an infrastructure provider in the long term. However, pressures on margins are intensifying and room for margin expansion is thin in the mid term.