High cost of doing business – downgrade to Underperform
■ Reasons for caution. With distribution and warehouse costs +90bp higher in the period 1H results have shown again how hard it is to achieve leverage in fulfilment costs at ASOS given the global distribution model and the need to keep investing in additional warehouse capacity and delivery proposition. Many of the drivers behind the momentum in the business over the past 12 months (US duty savings, free-returns, next-day delivery in EU and select international markets, A-List, FX etc.) also are now annualizing and growth rates will start to ease even as fulfilment and sourcing costs, capex and depreciation remain elevated.
■ Valuation premium to European peers is at all-time highs. Particularly the c40% premium to Zalando looks stretched in our view given the widening margin profiles of the businesses over the next two years (consensus expects ASOS to see c50bp EBIT margin improvement to 4.7% vs. c100bp for Zalando to 7%) and the strong drop-through of EBITDA to cash at Zalando.
■ We are increasing sales but cutting margin forecasts. For FY17 we raise our revenue forecast by 2.4% and cut operating margin by 10bp to 4.1% reflecting the strong topline growth in 1H and revised guidance (c30-35% sales growth) as well as higher costs in fulfillment and sourcing, and one-off transition costs leaving FY PBT forecast largely unchanged at £79.6m. For FY18 and FY19, we increase top-line forecasts by 6.7% and 10.1% respectively but assume a slower path to margin improvement than before.
■ Target price revised up from 5100p to 5300p. Our new 12m target price is based on peer multiples (1.7x EV/Sales, 22x EV/EBITDA) and DCF (8% WACC and 7.5% terminal margin). With c10% downside to the current share price, which we think more than discounts the current momentum in the business and benefits from sterling weakness, and limited visibility around LT margins, we downgrade our rating to Underperform.