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Business Breakdowns – episode 196

Introduction

Matt
This is Matt Reustle, and today we are covering the world of fast fashion and breaking down Inditex. If you don’t know the name Inditex, you certainly know Zara, the core business inside Inditex. My guest, Alistair Wittet, recently launched Aecus Partners, an equity boutique specializing in European and global equities, and he has followed Inditex for decades.

He gets into how this company pivoted their business over the years from the initial store expansion, the e-commerce evolution, and what has allowed Inditex to succeed where other fast fashion peers have really struggled over the years. Now, personally, I love hearing about a business that is powered by its supply chain and how this vertical integration has been core to Inditex’s DNA from day one stands out.

We also get into decentralized decision-making at the store level, and Alistair was kind enough to do some channel checking at the store prior to our recording. There are so many interesting themes here: success in no-growth industries, the power of thoughtful vertical integration, decentralized decision-making, corporate pivots. Alistair captures it all.

And if you want more on the founder and thoughtful pioneer of this business, my friend and colleague David Senra just dropped an episode number 372 on Amancio Ortega, the genius behind the Inditex group. So make sure to check out the Founders podcast. We will have a link in the show notes.

What is Fast Fashion?

Matt
All right, Alistair, I am excited to get into the world of fast fashion with Inditex today. And to start us off, I think that Inditex is a name that’s probably familiar to people in the investing space, but not necessarily the world broadly.

Their brands, and one brand in particular, is familiar to the world broadly. So maybe you could just start us off with the simple overview of what Inditex is, how it operates, and some of the key things just to lead off the conversation.

Alistair
Thank you very much for having me. So Inditex is the world’s largest clothing retailer. It’s best known for its flagship brand, Zara, which accounts for plus or minus 70% of sales. But it has a number of other brands that we’ll all know well, brands like Bershka, Massimo Dutti, Stradivarius, and the likes.

So the world’s largest clothing retailer, close to 40 billion euros of sales. It’s valued at over 150 billion euros by market cap. It operates pretty much everywhere in the world. It’s in 214 countries. And it is one of the few success stories in an industry which is littered with failures. So clothing retail is a business which is difficult.

Most companies fail. And Inditex is one of the few that has survived, and not just survived, but thrived over the years. And that’s something that we can dig into over the course of this episode.

Matt
Absolutely. And I think and associate that success with, with this theme of fast fashion, which is differentiated them and a few other brands, but really Inditex and their success with it. So maybe you can get into what that actually means, what fast fashion is and how Inditex embodies it.

Alistair
So fast fashion as an industry has grown over the years. It started in the late 1900s, and Zara is the epitome of that. And I want to maybe start with just an anecdote to illustrate that.

If you go back to when the Barbie film came out, it was in the summer, I think, of last year, and it became a huge hit and everyone wanted to or increasingly wants to wear Barbie-style clothing. Pink became very fashionable. And if you went onto the websites of most of the major retailers, whether it’s the Gap, whether it’s H&M or other retailers, they had no clothes that were representing that new fashion, which was pink and Barbie style.

And there’s a good reason why they didn’t. It’s because they had ordered all of their clothes six to nine months previously and they had no idea that this phenomenon would arrive. If you went on to Zara.com, there was a whole section dedicated, even as you went onto the website straight away, to Barbie, to clothes that represented the film, to colors that could be associated with Barbie.

You know, we’re going to dig into how they did that. But Zara, as a business model, is able to adapt extremely quickly to what is fashionable and adapt its collection to make sure that it is always on point from a fashion perspective.

Matt
We can definitely dive really deep into that. But just to frame it up front, when I think about that ability for speed in terms of getting that out to release, I would assume it has something to do with the supply chain, logistics, operations, really the infrastructure inside the business that has allowed them to do that.

Are there any key things that you can point to that they do differently versus what I would consider the traditional retail operators, and I’m going to use the US Examples like a J.Crew or a Gap?

Alistair
Absolutely. The business model at Zara or at Inditex is completely different to other retailers. And it’s partly. And we’ll come back to it maybe later. Why is this such a great business, and what are some of the lessons in fashion?

Fashion brands come in and out of fashion. The most durable business is one which is based not on the fashionability of the brand, but on the ability of the business model to ensure that they’re constantly bringing the right fashion to the customer. And so what is it that’s unique about Inditex?

Maybe the best way to illustrate it is to illustrate how it works in other retailers and what the more normal approach. What tends to happen is that a retailer will design their collection, let’s say, for the summer, they’ll design it in the winter of the year before, and they will be inspired by the fashion shows of that period. They will design a whole set of clothes.

They’ll send it to their manufacturers, typically out in Asia, and they’ll give them six months to prepare all of those clothes in the volumes that they expect to sell it, ship it to all of the stores, and then hope that it will sell. And what tends to happen is that a portion of that collection is on point, a portion of it isn’t, and the portion that isn’t is then discounted at the end of the season. So that’s the typical model.

Now, what does Inditex do, which is very different? Instead of starting from designing the collection and then pushing it to the customer, they start with the customer. So for a large portion of their collection, and we can go into the details in a minute, but for a large portion of their collection, they wait to the last minutes before producing it and before designing it. So they have their store managers and actually, I spoke to one this morning to confirm that this is very much the case.

Their store managers are feeding back to the headquarters what is on fashion, what isn’t, what is selling, what isn’t, how are people dressed when they come into the store? The store manager this morning said to me that we have customers who have come off the street from Faubourg Saint-Honoré, which is where all the Haute Couture brands are. And they will walk into the Champs-Élysées Zara store where I was, and they will start talking to the store managers about the clothes, about what they like, what they don’t like.

And that information is being fed back to the head office in Spain, who will then design the collection and adjust the collection according to the information they’re getting back from the customers. They will then send those designs to their manufacturers who are, in large part, located close to the headquarters, what they call proximity sourcing, whether it be in Spain, Northern Africa, or in Turkey.

And they will turn around those designs extremely quickly, typically within the space of a couple of weeks. They will then be sent back to that headquarters and then sent out to the stores, which means that you can have from design to on the shelf, typically at Inditex, you can have that cut down to the space of a few weeks, whereas for most other retailers it’s measured in months and typically six months.

Inditex’s History and Business Model

Matt
That’s incredible to see the differences there. And it’s neat to hear. I had an appreciation for how fast it moved. I did not have the appreciation for where that was being led and the customer interaction and the store level communication back up to the corporate office. Before we go too much further, I do want to get into the origins of this business.

It has some history and we mentioned when we were talking previous to this, it’s not quite the history of some of the European brands, but certainly extends further than my age. So maybe you can get us back to the early days of Inditex and just some of the key chapters that we can touch on as it’s been built into what it is today.

Alistair
So the origins date back to the 1960s. A person called Amancio Ortega founded the company. He was a manufacturer of dresses in a small town called La Coruña in the northwest of Spain. And now there are different stories that come from different sources, but one of the stories goes that he had an excess of inventory for these dresses. His client cancelled the order, so he didn’t know what to do with it. And so he decided to sell it directly to the consumer.

So he created, if you like, in that sense, a retail function which over time became known as Zara. His actual original name that he wanted was Zorba, after Zorba the Great, which is his favorite book. But there was another Zorba in the village and so he had to rename it using the letters he’d already ordered. So he rearranged the order of the letters and created the name Zara, so that’s the origins.

The first official Zara store was founded in 1975 and it started expanding pretty quickly actually in the 80s and 90s. They started moving across different European countries. The first new market was Portugal in 1985. They even started in the US in 1989. They moved there very early. So that’s the expansion period of the 80s and 90s.

The company then IPO’d, came to the market in 2001. Now this was a major, major event for a very private company to the extent that there were no public photos of Amancio Ortega prior to the IPO. And this was a big topic of debate actually by the bankers who told Inditex, you know, we really need a photo, at least one photo of the founder of this company if there’s to be any credibility in the eyes of investors.

So there was one famous photo that was taken of him, this was then published and became the face, if you like, of the founder of the company. It was IPO’d in 2001, as I said, at a value of 9 billion. It’s now, as I mentioned, worth over 150. So that gives you an idea of the scale of the success.

Matt
Yes, I want to just make sure we capture in the early days was the fast fashion piece core to Zara and Inditex broadly, was that in the DNA from the early days?

Alistair
No, that developed actually slowly over time. What was in the DNA, and I think this is a really important point, was the vertical integration, manufacturing and retailing. And that is something that is really key to understanding the competitive advantage of Inditex is this vertical integration all the way from designing, manufacturing, shipping and retailing those products. And actually it goes even further now as we’ll come to later, to second-hand usage of those clothes.

Matt
And you brought us up to the IPO. I’m sure the 2000s continue to bring some success. I remember first encountering Zara while in Europe sometime in the mid to late 2000s. But then we have two things happening at the same time. And I’m curious how the business responded to the financial crisis and then the E-commerce boom. You have two different things which, you know, in theory the E-commerce boom could have been an opportunity, but it was very much a threat to these types of businesses.

So maybe you can walk us through the environment then and the financial crisis, which we have to remember for any US listeners in Europe was extremely, extremely painful. So how did the business respond and adapt through that period of time?

Alistair
It was a very interesting period. I started working in 2006 and I was covering Inditex at the time. And it was, in theory, a company that was going to be very badly hit by the financial crisis, because on the one hand, it sells discretionary products, fashion, clothing, and on the other hand, heavily exposed to probably the worst market in Europe, which was Spain. 40% of sales at the time were in Spain.

What actually happened is very interesting. And we saw the same, by the way, happen during COVID which is that they came out much stronger from the crisis. So despite having such a huge exposure to a very weak market and selling a discretionary product, their sales were actually flat. In fact, their sales grew during the financial crisis.

So what happened there? Consumers, during difficult times, tend to concentrate their purchases. So rather than shopping in 10 different shops to try and build their wardrobe, they will tend to concentrate around the brands that they know are going to be correct on quality, where the fashion content is going to be right.

They don’t want to take risks. And by going to Zara, they knew they were taking fewer risks because they knew the quality of the products. They knew that the products were fashionable, so they were not making a risk from that perspective.

So they gained market share very strongly during that crisis. And the same happened, as I said, in Covid, where they came out of the COVID crisis much stronger. But again, we can maybe come back to that later. So I thought that was a very interesting period in the history of Inditex, and it was a real test of the strength of the business model. Online was another hugely important event, and it’s a good example of the approach that Inditex takes to disruption. When I first met Inditex in the late 2000s, online was just starting.

And I remember asking the CEO very clearly, what is your online strategy? What do you expect to do? And he said, we don’t want to be online. And we don’t want to be online because we don’t think we can display our clothes properly. So we will remain a bricks and mortar retailer. That was their view at the time.

So they were a bit late to the online theme. But once they realized this was here to stay, once they realized it was going to be very important, they moved very, very quickly. And they did two things in particular.

The first was that they adjusted their store estate. So they realized that actually now a store was no longer somewhere where you just pile clothes high, go in and buy them. It’s somewhere where we’re going to display the clothes and where consumers may walk into the store, get inspired, and then go home and buy it online, on their phone or on their PCs. So now the store has a different role.

So they adjusted their store estate. They started reducing the secondary locations. So locations, for example, next to a train station, rather than a customer walking into the store before jumping on the train, they would go straight to the train and surf on their phone. So that store no longer had a place, but the store in the prime locations became much more important.

So they expanded the size of those stores, they refurbed them, and they made them showpieces for the brand rather than places where you necessarily were going to buy them. So that was a major, major change they made. They also invested heavily in technology and in particular in RFID technology, which allowed them to track the inventory perfectly. So despite being a late comer to online, they ended up actually being one of the frontrunners in that revolution.

Matt
And do you have any context today for that split between online versus in-person sales for the business?

Alistair
Yeah, it’s a bit under 30% is sold online and the rest is in store.

Matt
Would you say that compares similarly to other competitors? If you broaden the scope to other retailers with significant brick-and-mortar presence.

Alistair
It’s probably similar to a little bit lower. And that is because they’ve done so much work on making sure that they have great stores. So it’s worth zooming in a little bit here, because online was hugely disruptive for traditional brick-and-mortar retailers. And it was hugely disruptive, I’d say, for a couple of reasons.

The first is that from a supply chain perspective, it was a nightmare to manage. Whereas previously you were making all your clothes in Asia and then shipping them pretty much directly to the stores to then be stacked up there, they now had to ship them to lots of individual addresses. So it created a bit of a mess from a logistics perspective, which they took a bit of time to adapt to.

The second reason that it was challenging is because their store sales started to decrease. And stores are pretty much a fixed cost business. You have fixed rents. Even the staff to a degree, is fixed. It’s variable to some degree, but it’s also fixed to some degree. So when your sales start to decline, it has a really bad impact on margins. Not only that, but your online sales were probably not earning you as much margin either. And that’s because you had to pay for the shipping typically.

So this was really painful for traditional retailers. Margins were really coming under pressure. And Inditex was one of the few companies whose margins actually held up. And part of the reason was because they were very early to adapting their store estate. So their sales densities actually held up really well. In fact, if anything, slightly improved because they were very quick to close down those secondary locations.

They were very quick to adjust their primary locations. So their store-based sales remain very strong. And I think even today that remains one of their key competitive advantages. They have basically great stores and great locations, and so that’s why they’ve managed to do better than most in that space.

Matt
And you referenced the supply chain challenges or the logistical challenges with shifting from 100% brick-and-mortar to having some portion of your business done via e-commerce. And I think particularly in the US, we’ve seen so many historical businesses struggle as they’ve tried to retrofit what are stores and make them into both stores and inventory locations that can also do shipping to end customers.

And you get this mixed, challenging equation. Has Inditex approached that challenge differently? What would you point to in terms of their strategy with e-commerce?

Alistair
Inditex is very different. And to be honest, it’s more luck, I would say, than anything else. This wasn’t designed with online in mind, but Inditex has a central inventory position. So they have all of their inventory, no matter where it’s manufactured, it’s brought to their headquarters in Spain where it is stocked and then shipped out directly to various stores.

Now, the advantage of that is that they are extremely flexible as to where the inventory goes. So again, if I go back to a classic retailer, they may ship in 10 T-shirts, 20 jeans and 30 shirts. And the store just has to deal with it and try and sell it. At Inditex, they have everything centrally stored in Spain.

And then each store individually says, I want three T-shirts of this size, I want four jeans of this color and this size. So they’re very precise about exactly what they need and what they think they can sell. And they can do that because all of the products are stocked in Spain.

Now, why is this important for online? Because online is essentially, rather than selling to 5,000 stores, I’m now selling to however many million individual customers. And because my inventory is all stocked centrally in Spain, I have perfect availability across the whole world to ship those products, rather than having inventory in the case of a classic retailer stored slightly awkwardly

in northern France, when in fact the demand for it is in eastern Germany, I’ve then got to ship it across from northern France to eastern Germany. The fact that Inditex has it all centrally stocked means they can much better meet those demands.

Eking Out Growth in Tough Times

Matt
I want to transition a bit into the economics of all of this. I think you’ve made some reference to margins and I’m very curious how this looks on the cost side of things, but let’s start at the top line with revenue. The durability or the strength of revenue through historical periods is incredibly surprising to me.

To hear that you had flat sales in the financial crisis was not something I expected to hear. So generally, is this a steady GDP-esque type growth rate that the business sees? When you think about the levers, whether it’s volume, price, new stores, how do you think about that equation and what that trend’s like over time?

Alistair
So historically Inditex was a pretty visible copy paste store opening growth algorithm. Let’s say if we go back to the 2000s, they would open something like a mid-teens percentage of space. Their same-store sales would grow on average around 4%. So they were delivering high teens sales growth without much margin leverage. So that was dropping down to the bottom line.

Then if you go through to the 2010-2020 period, this was a period where online started to really have an impact and it impacted primarily on new space where they started reducing quite substantially the pace of new openings. In the 2000s they were opening one store a day that fell over the period of the 2010, 2020 to a stage where actually they were net closing stores.

But constant currency sales growth did slow a little bit over that period, down towards 10 to single-digit territory by the end of that period. So that’s the online story playing out. That’s also, I think, partly a maturity story because despite having relatively low shares in most of their markets, Zara is still a pretty niche brand. It’s a brand for white-collar, relatively well-off urban dwellers.

So it’s really popular in big capital cities like Tokyo, Paris, London, New York, etc. It’s less relevant for the Midwest of the US, for example. So its growth started to slow, I think, also for that reason. That continued through to Covid and indeed the company was starting to reduce its capex plans. It was starting to talk about being a very strong free cash flow generator because they weren’t investing so much.

And then Covid, a bit like the financial crisis, gave them a spurt of growth because these events tend to clean out the market. And if there’s ever a market where there are a large number of zombies, it’s clothing retailing. And so it cleaned out a lot of the underperforming brands. It reinforced the strength of their brand. So they’re now coming out of that with a renewed spurt of growth.

And to answer your question, what should we expect in the years to come? It’s quite hard to say because whereas previously it was quite visible, we knew how many stores they were opening, we knew what the sales would be per store, so we could build quite an accurate growth model. Now it’s much harder because a lot of the growth is still coming from online and it’s much harder to predict what the online growth will be.

But it’s been growing double-digit over the past couple of years. Part of that is recovering from COVID but not only, and I think over the coming years it’s reasonable to expect the company to grow high single-digit with a little bit of new space because they have gone back to opening space. And the rest of that coming from same-store sales and online.

Matt
And the same-store sales I maybe think is the more mature number or steady-state number. And you referenced in the 2000 that 4%, which I would think of as the GDP-ish type range. Is that the framing that you would think about?

Obviously you still have this e-commerce story, but you’re going to get that as the organic year over year and then you’re going to have some additional leverage via added growth from whether it’s same-store, more e-commerce shift, things like that. Is that fair in your mind?

Alistair
Actually, probably not, because clothing retail is not a very attractive industry. So it was a growth industry through the 90s and 2000s and quite simply, people were buying more and more clothes. So we have data, for example from the UK where back in the early 90s the average UK consumer was purchasing 20 items of clothing and footwear per year. And that grew to 50 items in around 2012, 2013. So there was a big growth in the number of clothes and shoes we were buying every year. And since then it’s flatlined.

So the clothing industry is actually in volume terms in mature markets is a no-growth industry. There’s still growth in emerging markets, but if we focus on mature markets, it’s a no-growth industry. And not only that, but there’s not much pricing either. It’s a pretty deflationary industry because there are new competitors coming in, especially with online. And we can talk about one of those big competitors later, Shein. But it is an industry which is also slightly deflationary.

So the industry I would say is a no-growth industry in euros or dollars. And then the ability that Inditex has to deliver 3-4% same-store sales growth is really market share gains. That’s not GDP growth. That’s them managing every year just to attract one more customer or a little bit more of each customer’s wallet. That’s what’s driving that.

What Drives Inditex’s Industry-Leading Margins

Matt
Well, Alistair, I love any time that someone corrects what might be considered overly bullish or overly optimistic comment of mine. And I wouldn’t have even considered that low single-digit growth rate to be in that category. So it only adds to the credibility of what you’re saying to properly adjust those assumptions lower. And we are going to get to some of the competition before we do.

Just on the margin profile of the business, some of the cost dynamics here. It’s such an interesting industry, it can be so challenging. So walk us through what’s happening below the top line.

Whether there’s operating leverage, whether there’s some type of framework that you would think about from a margin perspective. Anything that you can go into there would be great.

Alistair
I think it’s actually quite an interesting topic. So let’s start with the gross margin. Inditex’s gross margin is high 50s around 57, 58%. It peaked at one stage just under 60%. It then started to come down. Actually it started to come down during the online era for quite an interesting reason, which is that online created price transparency.

And actually Inditex Zara doesn’t sell the same clothes at the same price everywhere in the world. In fact, there’s quite big differences. Spain is about 20, 30% cheaper than the rest of Europe. So just FYI, if you want to buy anything from the Inditex group, go to Spain. You’ll get it cheaper then. So if you index 100 for Europe, Spain is probably around 80 and the US and China, but the US in particular in the 2000s tens was indexed maybe 200. It was something like double the price of Europe.

And at some stage that became a bit of an issue because customers were able to go online and they could go onto the Zara.fr website and they would see that that exact same product is selling for half as much in France. And there were actually even class action lawsuits that took place in the US by customers saying they’re being ripped off for the items. So they went through a period where they started harmonizing their prices around the world.

So that created a bit of margin pressure during the late 2010s, but we’re not talking a lot. The gross margin went from 60 down to around 56 and then has since steadily increased. Now just as a reference point, that close to 60% gross margin is industry leading. So most fashion retailers are probably somewhere in the 40s and then the discount fashion retailers like Primark are even probably in the high 30s.

So this is a high gross margin. And of course, I love gross margin because I think it’s the best measure of value add and differentiation. And the fact that it is a high gross margin shows the extent to which this brand is differentiated.

Matt
And if we just zero in on that number a little bit, the 60 versus the 40, that could be coming from cost savings, that could be coming from higher prices. They’re all correlated together. But would you say there’s one thing or the other that are driving that margin? Delta is efficiency. What might it be?

Alistair
It’s a very good question. So this is detail that we don’t have. So a lot of this is going to be my conjecture. On the basis of conversations I’ve had with the company over the past 20 or so years, I think that they probably don’t necessarily source their products any cheaper than anyone else.

In fact, if anything, there’s probably a slight premium because they’re sourcing it from more expensive locations, which are proximity locations, and they’re having to pay a slight premium for the flexibility. Whereas Primark, for example, when it orders a T-shirt, it says to the supplier in China, « I want 100,000 of these T-shirts and you’ve got six months to do it. » That supplier can then create a supply chain or supply line that is dedicated to that T-shirt and gets huge efficiency from producing it at high volume.

In the case of Inditex, because they’re changing their collection so often, they need suppliers to be able to adjust the design or the shape or the cut of their clothing very quickly. So I think they must pay a slight premium for that. So where are they making up for that?

I think one of the important areas where they’re making up for it is in markdown. This is a real issue for clothing retailers. As I said, most major retailers will sell plus or minus 60-70% of their clothing at full price. And then at the end of the year, just because they got the fashion wrong, they’re going to have to discount massively, something like 30% of their clothes. That is painful for the gross margin.

Now, in the case of Inditex, because they are getting it right more often, because they’re waiting last minute, because they are using the customer’s feedback to choose what to design their clothes, they mark down substantially less. I think they mark down probably half what other retailers do. So something like 15% of their collection is marked down at the end of the season. So I think that is a massive saving that they have on their gross margin and I think goes a long way to explaining why they generate such a high gross margin.

Matt
It’s a really interesting distinction when the traditional sale, it might not show up, but it’s just in that percentage that gets marked down. Fascinating insight below the gross margin line. Just in terms of what flows through into whether it’s earnings or free cash flow, is there anything unique you can point to there in terms of the business?

Alistair
So that 58, let’s say percent gross margin becomes something like 18, 19% at the EBIT margin line. And so the 40% or so between the two is essentially, I would say three lines: store rents on the one hand, personnel mostly in-store personnel on the other, and then online fulfillment as the third line. So those are the three big cost buckets.

And what is very interesting about Inditex, and it’s always been a source of great confusion, I would say for the financial community and for me included, is that a bunch of those costs are fixed. In particular, those rents and personnel in store are pretty fixed costs. As I said, personnel is somewhat variable, but not completely so. Despite delivering very strong same-store sales every year, the EBIT margin for Inditex hasn’t really moved much.

So if I go back to the 2000s, it was an EBIT margin of mid to high teens. And I fast forward to today and it’s still high teens. And even year by year it’s pretty flat. Even during the financial crisis it didn’t suffer much. So there’s an unbelievable control they have over their cost lines.

And I think this is by design. I think this is a company that is very careful about managing its margins and it actually opens another very interesting debate, which is about the tension that great companies have between delivering short term and having a long-term vision. And in my experience, the best businesses have a long-term vision. They absolutely must do. And often those long-term visions are supported by some sort of family shareholding or something. That means that this company’s thinking long term.

But the very best businesses are ones that can marry that with a focus on the short term and focus on delivering short term. And some of the feedback I’ve had from Inditex is that they do manage that P&L quite closely. That they do in a given year, for example, will hold off expenses till September, October time to see how the year’s panning out. And if it’s proving to be a very good year, then they’ll go ahead and invest. If it’s proving to be a challenging year, then they’ll hold that cash back to try and support the margin.

So I think that margin has proved to be pretty flat, mainly because they’ve been managing it to be flat. And where they have oxygen to reinvest, they do. And where they feel like the oxygen is running thin, then they hold back and manage to protect the profitability of the business.

A Free Cash Flow Machine

Matt
I am certainly with you on the short-term management of dynamics and I think it’s one of those things which is often pushed back against from investors and management teams. But I think it matters way more than anyone likes to admit. The main question I would have in terms of the margin stability, when you go back to the financial crisis or even the COVID period, did you see the downside of operating leverage where you had major decremental margins in that margin that showed up?

Alistair
So in the COVID crisis, there was clearly a big margin impact. I think the COVID crisis was much more in that sense challenging for Inditex. As I said, sales grew during the financial crisis. Same-store sales were flat, but total sales grew because they continued to open stores.

In the COVID crisis, sales fell just under 30%. So there was clearly operating leverage on that. So the margin dropped from around 18% to around 9%. So there, there was definitely a margin hit. But it straight out of the COVID crisis.

Matt
I think it would seem to align with your description or explanation for why you don’t see that number continuously move higher. So it’s interesting to hear that on the free cash flow side of the business.

And I’m just curious with what they’re doing with fast fashion, the way that you described the cycle and how short it is, it feels like from an inventory turn perspective, from a working capital perspective, there would seem to be advantages to operating the way that they operate versus how a more traditional peer would. Is there anything that you can point to there?

Alistair
It’s a free cash flow machine. It’s a brilliant free cash flow business. Almost all of the profit is converted into free cash flow. The payout ratio, which is probably the best measure of that is just under 90%. So and that’s a very important number because your payout ratio is what you are pretty confident that you’re going to be able to pay out. Cutting a dividend is a no-no in financial markets.

You’ll be crucified if you cut your dividend. So you tend to pitch your payout ratio at a level which means that you are guaranteed to pay your dividend and they’re pitching it at 90%, which is a pretty strong demonstration of how confident they are that they can generate cash flow from that earnings. Now, why is it so strong?

It’s so strong, I think for a couple of reasons. The first is there’s no financial trickery. This is a company where what they tell you on the P&L is what you get in cash. I love these sorts of businesses. They don’t make adjustments.

The model is probably the easiest companies I’ve ever had to model because I’m not having to restate numbers the year before. I’m not having to make adjustments for stock-based compensation or for intangibles or whatever it might be. It’s a very straightforward P&L and they don’t play around with it. So that’s one of the reasons there’s no financial trickery.

The other reason is working capital. And it’s quite interesting because most clothing retailers don’t have this position. They have a strongly negative working capital position. In other words, they receive money from their customers much faster than they have to pay their suppliers or absorbed in holding onto stock. And I want to zoom into one of those lines, which is the inventory line, the stock that they’re holding onto.

This is a real problem for companies where if you have long inventory days, if you’re having to hold onto your inventory for a very long time, it just absorbs cash. And it can be quite a drag to free cash regeneration. In the case of Inditex, they hold typically 80 days plus or minus of stock. So they’re holding, let’s say two, three months of stock.

Now if I compare that to just one other major retailer, H&M, H&M is holding over 100 days of stock. So they’re holding, let’s say, 50% more stock as a percentage of their business than Inditex is. Or at least they’re holding it for 50% longer than Inditex is.

So that means that relative to peers, Inditex is much more cash generative thanks to this low stock level. And why does it have a low stock level? It comes back to everything we talked about before. They’re buying in their stock last minute, they’re making sure their stock is going to the right store and it’s being sold quickly. So that is really feeding through to the financials.

The Threat of Emerging Competitors

Matt
You’ve referenced some of the competition a little bit. You just referenced H&M. You referenced Shein. How have they held up relative to the one existing incumbent competition and to the emerging competition?

Alistair
So they’ve clearly been a winner, I would say compared to the incumbent competition. They surfed the online wave much better than everyone else. They were much better able to adapt their business and incorporate online and that helped their margins, that helped their sales. So online was a real disruptor.

If I look at most of the major retailers, their margins collapsed following the emergence of online and have really struggled to rebound. H&M, for example, was a business generating over 20% EBIT margins in the 2000s. It’s now sitting in the single digits. It even went as low as below 5% at one stage. So versus that traditional competition, I think they’ve clearly come out as a winner.

The online-only competition is a very interesting discussion and maybe that’s one that we can come back to when we talk about some of the risks for this business. But there have been a number of online-only players that have come out. I would say most of those have failed actually in Europe.

So the likes of ASOS, the likes of Boohoo, even Zalando have struggled. And that is quite interesting. Why has online-only struggled? And I think the answer is that most customers, most consumers don’t want to shop online only.

Clothing is something that you want to try on. You want to feel the fabric, you get a better sense for it in the store. And having a store base actually probably is an advantage. There’s a really interesting stat that Inditex quote which is that one-third of all online orders are collected in store and two-thirds of returns are done in store.

And what you can be absolutely sure of is that when the customer comes in to collect their order and even more so when they return their order, they will have a little walk around the store. And the attach rate of an in-store purchase to an online collection or to an online return is extremely high.

So there is a real, I think in that sense, competitive advantage that Inditex has by having a very well-invested store presence versus those online-only competitors. There’s one, I would say notable exception, at least for now, and that is Shein, as you said, and that is a competitor, which I think is worth maybe digging into a little bit later. But that is one that looks like it’s coming out quite strong. But we’ll see how long that lasts because it’s still a relatively young story.

Matt
And if I were to think about the price comparison versus Inditex versus Shein, how drastic of a gap is there in terms of the price advantage that Shein is willing to offer?

Alistair
Yeah, it’s pretty big. So this is data from the UK and this is the average website price of the products on the website. Zara is around £26 and Shein is plus or minus half of that. H&M is around £16 and then Shein is a little bit below that. So Shein is definitely a lot cheaper, but it is also not selling the same stuff. Let’s be very clear about that. The fashion content at Zara is substantially higher than that of Shein. There’s a lot more basic products being sold by Shein, which I think will explain a large part of that price difference.

Matt
I certainly, even with the other fast fashion peers, associate Zara with a different level of fashion. To your point, it’s always faster and visible much sooner. And I wouldn’t even put some of the others into the same category, although I can’t say that I spend much time on Shein to know what they’re offering at this point.

I want to get into the culture here because they’ve navigated things so incredibly well over the years and it feels like there’s been some core people involved in the business. So can you talk a little bit about that, just how strong the culture is there? I think within, particularly apparel brands, it has an overpowering force when you have a culture. So talk a little bit about how that looks here at Inditex.

Alistair
I think it’s a very interesting question. I think culture is actually probably one of the most important competitive advantages great businesses have, but it’s also one of the hardest to measure. There isn’t a Bloomberg function for culture, so it’s something which is quite hard to pick up in the case of Inditex. I think there are a few indicators that tell you that it’s got quite a unique culture. The first is just feedback from people who have worked there. It’s a company which is very open to challenge to new ideas.

It is not closed at all. And you can see that, I think, in the way it reacted to online as just one example. But there’s lots of them where it had a very strong view that it didn’t want to be online. And then within a couple of years, when it saw that the world was changing, it was able to change and very radically. So I think there’s that openness which defines Inditex to a degree.

And I think actually a lot of that comes back to the founder, Amancio Ortega, who, from what I read, I’ve never met the man. Very few people have. He’s open to challenge, he’s a very humble man. And I think that goes back to his origins. He has a very humble upbringing.

On the few occasions that he has talked about it, he talks about his experience as a young boy going to a grocery store with his mother, and his mother being refused the right to purchase the items because she said she would come back and pay them the next day, so in a sense, buy them on credit at her local village store. And the owner said, « No, I’m afraid I can’t accept that. » And he says that stood out for him as quite a humiliating moment in his history. And I think that probably partly contributes to his drive, to his desire to succeed.

But I think that humility also comes across in the organization as well. So I think there’s a culture there which is quite unique. People stick around. And this is something which I love to look for in great businesses, is the life for companies. Companies where people stay there and do their whole career in that one company.

And just ahead of this podcast, I had a quick look at the top management team. These are the nine top managers of Inditex, and they have been on average at the company for 34 years. Just under 34 years on average. So there’s people there who’ve been actually more than 40 years. And the youngest member of that management team has been there for 21 years.

So this is a company where people stay and I think that brings a huge advantage. They all know the business inside out, they know the industry inside out, they know how Inditex operates, they speak the same language, they think in the same way.

I think that is a huge competitive advantage and that is a function, I think partly of this being a family-run business. And I love family businesses. I know it’s somewhat controversial in classic understanding of ESG, but I think the best businesses are ones where there is some form of long-term shareholder and it doesn’t have to be a family, but often it is.

Who gives this long-term vision? Who’s building this business not to line their pocket in the next five to 10 years, but to pass it down to their child. And that is literally what Amancio Ortega has done as his daughter Marta has taken over the chairmanship of the company in the last couple of years. So he’s thinking in generations, not in quarters.

Fashion is Fickle

Matt
There’s something very interesting about the duration and the tenure of that management team. And then this being a business that is in fast fashion, and I wouldn’t even say style fashion, something that can go and be very short-term and quick and cyclical. How do they balance that?

It seems like something like having a daughter who’s very involved in the business and may have been more in touch with the trends and not to be ageist and suggest that these people in their older years wouldn’t be as on the pulse of fashion. But it is surprising to hear. Can you square that?

Alistair
It’s because it’s the business model, and that’s what’s so brilliant about this business. In fashion, you have two types of businesses that are successful. There’s brands and then there’s business models. And I think business models are much more durable because brands can come in and out of fashion. And there’s so many examples of brands that were huge in the past and are now disappeared. And a business model is much more durable.

So there is no super designer who’s coming up who’s forward-looking and has correctly predicted what the next fashion will be. The fashion is being written every day and it’s being written and passed back to the designers by the store managers who are on the ground talking to the customers, seeing what they’re picking up but not buying, seeing what they’re trying on, asking them why did you not purchase it? And then feeding that back.

So they’re constantly ensuring that they’re on point from a fashion point of view. But it’s the business model that allows them to do it. It’s no one person and I think that’s why it’s so durable. And maybe just one point to illustrate that – the last two CEOs of the company, I find this amazing. But the last two CEOs, Pablo Isla, who became CEO in 2005, and Óscar García Maceiras, who became CEO in 2022, these are both lawyers. They’re literally lawyers.

Their background is in law and they have never worked in fashion. So this is about managing the business model and making sure the business model allows them to be on fashion. It’s not about any one great person coming up with the fashion.

Matt
That is amazing. There’s a lot there that we could laugh about and, and just then thinking about this altogether as an investment. Historically I believe the performance has been strong. But how does the market typically value a business in this space?

Just general framework that you would say is most common to use and then just the debate over Inditex. What does that tend to look like in terms of whether that’s a premium to that number or if there’s something else that you would say is often debated?

Alistair
So as you say, the returns as an investor in Inditex have been staggering. So if you’d invested €1,000 back in 2001, that would now be worth over €17,000. For reference, that would be worth at H&M 2000. It would be around the same for Gap. And then in some cases it’d be worth nothing in the case of other companies. So it’s been a huge success.

What’s driven that success from a total return perspective is clearly the growth. It’s delivered very strong earnings growth, but it’s combined that growth with cash generation, which it’s returned to shareholders in dividends or in special dividends. So you get the two, which is quite rare to get growth and cash return. This is a company that’s managed to do that.

So that’s explained the very strong returns historically. If we go forward, what is the big debate on Inditex? It is the same that it has been for the past 20 years, which is we know that fashion is fickle. We know that most fashion companies fail at some stage. So is Inditex going to be able to continue to buck that trend or is it going to finally succumb to it?

And let’s say it doesn’t, how fast will it continue to grow? And that, as I said, is much harder to predict today than I think it was in the past. Because in the past it was based on store openings and that was pretty visible. Now it’s based much more on same-store sales growth and online. And that is much harder to predict from one year to the next.

So I think the growth algorithm is harder. What the company says is that they target to grow their constant currency sales in the region of 6 to 8% between their existing stores and their online business. And then on top of that they look to open something like mid-single digit or low to mid-single digit new stores in gross terms and then a bit less in net terms because they’ll continue to close stores.

So you could probably look at net space growth of in the region of 1 to 2%, same-store and online sales growth of something like 6 to 8%. So you’re probably looking at high single-digit sales growth as a reasonable medium-term growth algorithm. I would assume a flattish margin and then I would assume most of that comes back to you as a shareholder.

So you invert the P/E if you like, and you get that as a cash return. So it’s currently trading on 25 times earnings. So that’s delivering you a little under 4% free cash flow yield.

Matt
Invert the P/E multiple is one of my favorite things. If it works for a business that earnings tend to align with cash flow. So appreciate you sharing that with us. When you mentioned fashion is fickle, that is always going to be a debate. I tend to feel like, just based on what you’re saying here, they have the flexibility to adjust to fashion.

A risk that I would imagine exists is some replication of the model, more competition in what they’re doing, because, as you mentioned, the business model is so differentiated.

So, one, why hasn’t there been a competitor who’s been able to replicate what they’ve done? And two, how much of a risk do you think that is? Whether it’s some of the names that we’ve referenced before or a new entrant in the future?

Alistair
So I think it’s a really, really interesting question. And in the just under 20 years that I’ve been covering the company, it’s a question I keep asking myself. And to be totally honest, I don’t have a perfect answer to it, but I have elements. So why hasn’t it been replicated by an existing retailer, for example?

I think it’s very hard to replicate because it’s a completely different way of operating. You need to change your complete supply chain. You need to then change the way you’re designing clothes, you need to change your store managers, you need to change your supply chain and your distribution capabilities.

So you need to change really everything about how you operate. And that is extremely hard to do once you’re already at scale and it’s been tried. So actually Next is a UK brand and the Next CEO was once asked about it and he said, well, actually, internally they tried to replicate it to a degree. They started to make changes internally to become more able to adjust their collection as the season unfolds. But he said it was too complex and they weren’t able to for organizational reasons.

So I think that’s one element it’s not easy to change once you’re already up and running, then I think it’s quite hard to start because scale probably is quite important. It’s important for your suppliers because you’re asking them to be super flexible, but you also don’t want to pay too much for that flexibility. So you need scale to compensate for that flexibility. You need a good store footprint, because I think starting that online would be very difficult.

So I think it’s probably quite hard for a new entrant to replicate exactly. It’s quite hard for an existing company to do. The closest I think, that we’ve seen to a company replicating this fast fashion aspect is probably Shein, the online retailer. And they do it in a very different way. So where Inditex is polling, if you like customers to say, what do you want? And let’s go and make it for you quickly, Shein is saying, let’s just make everything there is and let’s put it on the website and let’s see what people are buying. It’s called a test-and-repeat model.

And it’s where they will, for example, in the case of Shein, produce, I think, something like, according to sources, 2,000 new products every day that they put on their website. They will manufacture those products in very low volumes and then they’ll see which ones work, and whichever ones work, they will go back to the supplier and say, rather than produce a thousand of those, I now want you to produce 100,000 of those. Because I think this is what’s working.

So it’s a different business model, but it gets to the same endpoint, which is adjusting the collection very rapidly and trying to make sure that they have only what’s on point available to customers and minimizing the markdown on the stuff that’s not on point. So I think that’s the closest that we have to a competitor. I’m not sure yet. It’s still early days.

I’m not sure yet it is exactly the same, though, because if you go onto a Shein website, you don’t know that what you’re looking at is on point or on fashion. You’re taking a risk there. Whereas at Inditex or at Zara, you know when you go into the store that everything there is on fashion, and therefore it’s much easier from a customer perspective to shop at a Zara than it is at Shein.

So I think it is a bit different, but it’s been very successful. Shein is not public. It says it will become public quite soon. It’s been talking about that for a while now, but I think it will come to the market. And the numbers that it’s disclosed is that it’s generating just over $30 billion of sales. That was in 2023. So it’s still a little smaller than Inditex, but not much. And if it continues at the current growth trajectory, it might well overtake Inditex. But I think that’s yet to be seen.

Matt
Unbelievable growth trajectory over there. And I would agree with you, just from one probably non-fashionable man’s perspective, Zara does have a very specific value proposition, which I know and I think about, which is affordable, fast fashion. Not always what I would necessarily wear.

But I know where I could go to get that. That doesn’t really exist elsewhere or at least with that level of speed. But interesting because competition can come in all forms.

So certainly an interesting risk and one to follow. Is there anything else that you would point to as a risk that you think about related to Inditex?

Sustainability and Other Risks

Alistair
Yeah, I think that is potentially, you know, Shein is probably or other competitors, probably one of the biggest risks. I don’t actually think it’s the biggest risk the company considers. I think the biggest risk the company considers is sustainability and ESG. And it’s not just because they talk about it a lot.

The CEO a few years ago became the head of sustainability, so they made it a CEO title. It’s one that now has a separate executive to manage it. But it’s an important part of the LTIP of senior management. It’s 25% of their long-term incentive plan.

So I think they take it very, very seriously. And of course it is the biggest existential risk that any fashion retailer faces, which is is fast fashion consistent with environmental friendliness and social awareness. So they’re taking it very seriously. They have plans, they have targets for 2025, for 2030. In 2030, for example, they want to reduce their CO2 by 50%. They have an ambitious 2040 target to reduce it by 90%.

So they’re taking it very seriously. And you could ask the question, are they right to? Are they not right to? Everyone talks about sustainability. It’s a very popular topic amongst the young. But then when you look at their spending, just the very fact that Shein, for example has been so strong would suggest that they don’t really care in reality, even if they do talk about it. I’m not sure if that’s necessarily true though.

And I think there’s one market that makes me take it quite seriously as well and that’s Germany, where Primark was a very successful brand. So Primark is the lowest price fashion retailer in the market. It’s even cheaper than Shein. And a few years ago they started to run into sales issues in Germany and the main reason was because customers considered it to be unethical to shop at Primark and this was the feedback they were getting from customers.

If you go online and Google « Primark Germany, » you’ll see lots of articles about how unethical it is to shop at Primark and their sales have really suffered. They’ve come down quite a lot over those years. So I wouldn’t totally ignore Sustainability as a threat to the fast fashion industry and to Inditex specifically.

Matt
It’s a really interesting anecdote because this is an audio podcast, but my face was looking with a critical eye as you referenced. I didn’t expect people’s wallets to match, maybe their vocal behavior around sustainability. But very interesting to see the dynamic in Germany. I guess the other side of the spectrum is just from a shareholder perspective.

ESG funds, ESG mandates, all of these things that were certainly, at least in the US, felt much more popular three to four years ago.

Is that a major dynamic that’s still playing out in Europe? Obviously, I imagine their motivations are pure. But how much does that play a role in corporations’ behavior with this?

Alistair
It’s a very good question. It’s more relevant, I would say, in Europe still certainly than the US. But I think people are a little bit fed up of a lot of the greenwashing and a lot of the regulation that’s come in around ESG. So I think it’s probably a less relevant or less popular topic than it was a couple of years ago. But it’s still very relevant. And it’s mainly very relevant because the regulator is insisting on it.

So we’re launching a fund as we speak, and ensuring that we comply to the regulations on our reporting and on the way we select our stocks from an ESG standpoint is something which is taking a lot of our time but is also a real constraint that the regulator is putting on us. So I think from an investor standpoint it is real and that is having an impact, I think, on the way companies react.

Now I think some companies are greenwashing, some companies are just putting numbers out there and talking a good talk, but are not really acting. From everything I’ve seen, Inditex are really acting. They really are cleaning up their supply chain or have done actually—that’s an old story now. They now have a very clean supply chain and they are investing heavily in the sustainability of their products.

They even launched a pre-owned website. If you go onto Zara.com, the first thing you’ll see is some nice videos and some nice clothes. And if you scroll down a little bit, you’ll straightaway go on to their pre-owned section. So this is something that I think they are really walking the walk and I think they know they have to because at some stage this could be a real existential threat to them.

Matt
Does the quality bar of the clothing meet the requirements? I can understand from the carbon emissions side of things that you can offset, but you’re dealing with fashion, which again is a little bit short cycle in nature.

And I certainly don’t think about any of the clothing I buy from Zara to be something I’ll pass down to my son. So the quality dynamics, would you say, feels like it would be a very large jump or leap before they could meet sustainability factors there.

Alistair
I think this is where it’s an existential problem, is that by definition they’re doing fashion. So if you’re passing down your clothes to your son, it probably isn’t that fashionable, with all due respect.

Matt
Everything comes back over time.

Alistair
True, true. So this is a little bit. The issue they have is that they are selling clothes which are going to remain in fashion for a short period of time, but they want it to be sustainable. So the way they’re going to have to do it is by essentially decarbonizing the supply chain.

So by using recyclable materials, they and others have been investing in using organic fibers to make clothes. So it could be, I think H&M invested in a company that are using pineapple skins to try and use the fibers to make clothes. So trying to find new sources of fiber to make clothes is one of them.

And then the other is at the other side making sure that these clothes can have as long a life as possible and are not thrown into a pit at the end, but are either recycled so the materials can be broken apart. Because just by the way, this is one of the big issues with fashion is that your clothes typically have a number of different fibers in them and trying to break those apart into their constituent parts and then reuse them is almost impossible.

So trying to find a way of enabling us to recycle the clothes and the materials is going to be one of the major steps. And then the other one is, as I said, just trying to make sure that these clothes are worn for as long as possible. And that’s where their pre-owned website comes in.

You Can Succeed in a « No-Growth » Industry

Matt
Trying to reverse chemistry is a challenging feature. Well, I appreciate all of the discussion around that. It is a very interesting business to talk about that theme and I appreciate you bringing the anecdotes and the thoughtfulness around it.

As we close these conversations out, we always try to pull out some lessons that you could take from this business and maybe apply elsewhere. What would be the main lessons that stand out to you from Inditex?

Alistair
I would say there’s a few. The first is that you can succeed in a no-growth industry. The way I painted the industry to you, you probably would have said, well, I don’t really want any exposure to that and you can still succeed. This isn’t an attractive industry anymore, I don’t think, but it’s an attractive company so you can succeed in no-growth industries. I think that’s one.

The other is the importance of the business model, especially in this industry. I think business models are much more predictable than brands or products or genius designers. And so I think that this is a business model competitive advantage. And I like that about this company.

The importance of the long-term mindset, everything it does is with a long-term vision in mind. And I think that is reflected in the life for employees. It’s reflected in the importance of the family shielding and the family presence. And I think that is an important competitive advantage which applies not just to this business or this industry but across all industries.

And I think the third is that point I made earlier about managing that tension between delivering short term and having a long-term vision. And this is one of those companies that I think really does a very good job of managing the tension between the two. And that is also something which I think can apply to many other businesses in different industries.

Matt
As you recounted them, those were themes that stood out to me as well. So I think they’re great lessons and very interesting, particularly the no-growth and then the idea of a business model versus a brand.

Two things that are going to stick with me for the rest of the day and probably longer as I think through them. So Alistair, this has been a fascinating discussion, exceeded my expectations. Thank you very much for joining us.

Alistair
Well, thank you Matt. Thank you very much.