boohoo’s (OTC: BHHOF) the issues highlighted by its December 2021 business update are transitory and the company is well positioned for a recovery. Initial investments will peak in FY2 / 2022 and we expect free cash flow generation to resume in the medium term. With stocks trading at a 6.1% free cash flow yield for fiscal 2/2024, we are bullish on stocks.
Founded in 2006, boohoo is a UK online retailer specializing in cheap and fast private label fashion for 16-24 year olds. In an effort to broaden its target market by expanding its brand portfolio, the company acquired the brand and online businesses of UK department store chain Debenhams for Â£ 55million / US $ 75million in January 2021 , followed by the Arcadia Group’s former fashion brands (such as Dorothy Perkins and Burton) for Â£ 25.2million / US $ 34.3million in February 2021. The company also spends high levels of investment over the course. of fiscal year 2/2022 for future investments resulting in negative free cash flow. It had 18.9 million active customers worldwide in H1 FY2 / 2022. Peers include ASOS (OTCPK: ASOMY), The Hutte Group (OTCPK: THGHY) and Zalando (OTC: ZLDSF).
Key financial data
Source: Refinitiv, created by Karreta Advisors
Sales broken down by geography (S1 FY2 / 2022)
Boohoo shares have corrected 63% in the past 6 months. The key negative event was a business update released on December 16, 2021 that lowered the company’s forecast for fiscal year 2/2022. Despite recording 16% year-over-year sales growth for the third quarter of fiscal 2/2022, the key holiday quarter is expected to be weaker due to the following:
- Significantly higher return rates.
- Continued disruption of its international deliveries.
In this article, we want to evaluate the following:
- The difficulties currently encountered by the company are temporary or terminal.
- The prospects for recovering free cash flow in the future.
We will each take their turn.
Undesirable but not terminal factors
The trade statement released in December 2021 was a negative surprise, but our conclusion is that the issues affecting boohoo are transient in nature and the business can recover. However, the rate at which these factors begin to ease will depend on how the economy develops in the short to medium term.
Return rates (products ordered and then returned) would be 12.5% ââhigher than last year and 7% higher than pre-pandemic levels, lowering net sales recognition and slowing the profile growth. This appears to be due to the fashion’s return to more âfittedâ clothing (like dresses), resulting in orders of multiple sizes compared to the casual homewear that had been popular during the pandemic. We expect return rates to normalize as the currently increased demand for âfittedâ clothing (boosted by an expected Christmas holiday season) recedes to historic levels.
boohoo is not the only one experiencing disruptions on its distribution network. Retailers in general depend very heavily on the holiday season, and if execution is slow or problematic, the consumer will not buy (and even if they do, rising transportation costs are currently eroding margins). If inflationary pressures are assumed to persist, delivery costs could continue to rise. However, we believe that air cargo capacity will experience a gradual increase in supply, allowing better pricing and timely delivery, which will help boost user demand and sales volume. A plan to establish a distribution center in the United States in 2023 will also mean that it will no longer need relatively expensive processing directly from the United Kingdom.
Free cash flow will recover
Management would like to stress that FY2 / 2022 is an investment period for future growth, following the M&A episode of FY2 / 2021. Investments have seen a marked increase since FY 2/2021 but estimates indicate it will peak in FY 2/2022 as this is a one-time purchase of Â£ 72million of ‘a new London office in fashionable Soho.
Trend of investments and “cash out” of acquisitions
As a result, the consensus believes that fiscal 2/2023 will see a return to positive free cash flow. Fiscal 2/2024 should see a return to more appropriate levels as trading conditions fully return.
Free cash flow trend and outlook
Source: Company, Refinitiv
The bullish view is that as the business environment returns to pre-pandemic levels, the company is strongly positioned to recover after taking the following actions over the past two years:
- estimated to have doubled its market share in the UK through organic growth and acquisitions of new brands.
- increased the number of websites and apps from 44 to 81.
- increased the total number of rows more than 3 times to 286k.
- the number of active customers increased by 46%.
- invest in technology and infrastructure involving data analysis and warehouse automation.
boohoo has always been a generator of free cash flow, essentially managing to finance its M&A activity through internally generated funds. The company issued Â£ 200million / US $ 271million in fiscal year 2/2021 to fund M&A opportunities.
Cumulative free cash flow and allocation (FY2 / 2017-FY2 / 2021)
The balance sheet remains well capitalized with a debt ratio of 0.04x. Liquidity is also sufficient with a quick ratio of 1.2x.
With uncertain conditions persisting as the company closes at the start of fiscal 2/2023, the near-term earnings outlook is not very attractive. However, in the medium term, we expect a resumption of free cash flow generation. In FY 2/2024, consensus estimates point to a free cash flow return of 6.1%, which we think is very attractive.
The company is targeting normalized sales growth rates of 25% year-over-year after the pandemic. It may be too difficult at first, but we believe that medium-term growth will be sustainable through adolescence.
The downside risk arises from the market’s loss of confidence in management. Concerns have been raised about negative working practices by its suppliers, highlighting poor social and governance controls in July 2020, which has been negative for public relations. Confidence took another hit with the December 2021 business update.
The company faces increasing competition from foreign players such as Zalando and Chinese fast fashion brand Shein. He may also face challenges revamping old brands such as Burton and Dorothy Perkins, which were losing popularity before being acquired at a clearance sale.
The upside risk arises from a market reassessment. A gradual recovery to pre-pandemic trading conditions will help normalize return rates, product mix and reduce increases in transportation costs. Continued geographic expansion will translate into sustainable growth.
A period of stable performance will help the company’s perception to improve in the market, although it may trade at a discount for a while.
boohoo has been successful in investing and growing its business during the pandemic, and is well positioned to capitalize on post-pandemic consumer demand. The current difficulties in the face of high return rates and delivery issues are transitory, and we believe the fundamentals will improve, especially in terms of free cash flow generation in FY2 / 2024. While management has lost some credibility over the past 18 months, we believe the downside risk is limited, and with the stocks traded on a 6.1% free cash flow yield for FY2 / 2024, we are bullish on stocks.