Burberry: Mixed Results but Long Term Outlook is Positive

There was mixed news in Burberry's first-half results, but the Burberry brand is a source of superior economic returns and is hard for competitors to imitate

Philip Gorham 18 October, 2016 | 3:07PM

Luxury retailer Burberry Group (BRBY) reported a revenue decline of 4% in the first half of the year, although the continued weakness in sterling is boosting growth. Wholesale and licencing sales declines drove the revenue contraction, but a significant improvement in comparable retail sales is encouraging. We are reiterating our £15.50 fair value estimate for the shares, and we believe the sell-off on today's news offers a modest amount of upside to the share price.

Positive performance in the U.K. and China is a sign of brand resilience

There was mixed news in Burberry's first-half results. On the one hand, the wholesale business, which represents about one fourth of the total business, was weak, and the decline of 14% was below our expectation of a decline of around 10%. On the other hand, comparable store sales rebounded materially from down 3% in the first quarter to up 2% in the second, leaving first-half comps unchanged over the year-ago period.

Encouragingly, management cited strength in Asia, excluding Hong Kong and Macau, as being a positive contributor to growth. While the United Kingdom delivered "significant outperformance" in the first half, we doubt that this level of performance will be maintained in the medium term, particularly if the terms of the U.K.'s exit from the European Union prevents access to the European single market. In general, however, a pickup in fashion items bodes well for the strength of the brand and for our confidence in Burberry's wide moat rating.

Despite some economic uncertainty in the United States and Japan, we regard the positive performance in the U.K. and China as being a sign of brand resilience. Our own valuation contemplates long-run growth just below mid-single digits, which we see as achievable. Store closures will offset openings this year, but net of renovations should see a low-single-digit increase, while the weak pound should eventually lead to modest price increases and better translation rates, particularly in the second half of the year, both of which should lift comparable-store sales.

Investment Thesis

With its recognisable fashion elements, such as its iconic tartan, and a history of innovations, including patenting the trench coat and creating the fabric gabardine, the Burberry brand is a source of superior economic returns and is hard for competitors to imitate. The company exhibits high gross margins of around 70% and operating margins in the high-teen to low-20% range, and we believe Burberry is again on the forefront of innovation.

The company is smaller than many of its global peers, but has been offering distinctive marketing and developing differentiated customer experiences as it grows, and will continue to take control of international distribution, as well as expanding its product lines. In our view, its status as the largest publicly traded British luxury fashion house also sets the company apart, especially internationally, where the company garners more attention than smaller British brands. We believe its brand, designs, and recognizable fashion elements occupy a unique space in customers' minds, giving it a defensible niche in luxury and earning it a wide economic moat.

We look favourably on the company's growth and profit-improvement strategies related to leveraging the core brand, elevating Burberry's image and average prices, focusing on new markets, leveraging company-operated retail locations for growth, and investing in operations. We believe selling, general, and administrative costs are one place investors could see additional operating leverage over the long run, where size and scale will make it harder for smaller luxury houses to compete.

Regarding its retail strategy, we view Burberry's current build-out and the increase in grand-space flagship stores in gateway cities as a positive, and also call out the company's efforts in digital engagement, which appear to be complementary. Flagship and large-format stores are in major cities and tourist destinations, and we see the ability to secure unique spaces in the world's top cities as a competitive advantage for luxury companies such as Burberry. Despite additional investment, retail brand control is yielding dividends.

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Securities Mentioned in Article
Security NamePriceChange (%)Morningstar
Rating
Burberry Group PLC2,002.00 GBX3.62
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Philip Gorham