Wide-moat rated Prada (01913) announced first half 2015 financial results, and although worries persist in China and Asia, some stabilization leads us to believe sales and profits should not continue to decline. Preliminary sales and revenue figures were disclosed August 7, up 4% in euro but down 6% in constant currency.
Despite the risks, we remain optimistic for the long run
Analysis of the sales details shows some bright spots in areas such as footwear and in the Miu Miu brand, but the largest segments of Leather Goods, Greater China, and the Prada brand are stable but still negative. This suggests to us that some strategic issues such as store locations and brand positioning exist but are also fixable in the long run.
We don’t see any dramatic change in our €41 fair value estimate, with the gyrations in the EUR to HKD exchange rate having settled at nearly the same levels as our previous model that used a 0.1155 HKD per euro assumption.
The stock has fallen further since our last update, and with some expectation that cost controls on selling, general, and administrative expenses can better match spending to revenue, we believe the risk reward is now more favorable but also caution that the turnaround might require patience.
Gross margins have actually improved some, a positive sign in our view, and are now at 72.7% versus 71.8% last year. We point out that the decline in wholesale and shift to retail benefits gross margin and is still ongoing as the retail mix edged up to 82% of sales. SG&A increased nearly €150 million to just over $1.0 billion, with the majority of the increase due to selling and promotion expenses. SG&A expenses deleveraged on the larger store network, with net 11 openings mostly in non-euro currencies.
Earnings before tax (EBIT) deleveraged to 16.1% of sales versus 21.3% of sales in the first half 2014. But cost controls started to make some improvement as the second quarter EBIT margin was just over 20% and compared favorably to the first quarter where EBIT margin dropped to just over 10% of net revenues.
Details on the sales trend for the half and thus second quarter revealed net constant currency retail trends of negative 2% in the second quarter versus negative 4% in the first. There was some pick up in Europe and Japan in the second quarter, with 12% and 13% constant currency growth, respectively. Asia Pacific declined 18%, driven by a 23% drop in Greater China, which was virtually identical in both quarters, with Hong Kong, Macau, and Korea dragging down the region.
We expect some improvement in the back half of the year as issues in both Chinese luxury spending destinations are lapped from prior year weakness. But we also point out that other luxury goods companies such as LVMH and Hermes are seeing less of a decline in China and greater sales demand in Europe.
Tourists traveling to Europe are driving mid- to high-double-digit sales increases for some product categories, and in the case of Hermes, Japan has seen sales growth over 20%. As Prada is seeing a disproportionate level of decline in its Prada brand which had previously been an area of strength, we believe the price differentials in China are a major issue and that the rapid store build out there is impacting the Prada brand more than peers or the Group’s other brands.
We cite the relative strength in footwear segment sales, up 16% constant currency and 28% reported, as an indication that if the company’s designers have what people want at the right price there is still desire for the brands. Despite the worries in China, Miu Miu was reported to have double-digit growth there, but note that it has a different brand positioning and less exposure to Hong Kong and Macau.
Taken together, it may take some time to reposition Prada stores and make both cost and product introduction impacts on the leather goods business. Despite the risks, we remain optimistic for the long run that the brand is strong enough to recover from the current short-term issues.
