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Thursday, 4 September 2014

Zalando: Superstar or massive Black Hole?!

This month, one of the world’s largest online fashion and shoewear retailers, Zalando, will enter the Frankfurt stock exchange. It promises to be one of the largest IPO’s of 2014 and one to which many private, risk-loving investors have anticipated. 

Yet, in spite of the mindboggling growth of Zalando – in sales figures as well as in territorial coverage – in the just over six years of its existence and the very ambitious plans of its executive management, most signals are still turned to red. As more often, it is the business and earnings model of Zalando, which raises most question marks…

People could justifiably call it “the mother of all online store IPO’s”; the IPO of massive fashion and shoewear retailer Zalando at the Frankfurt stock exchange. The data of this German-based, internationally owned company come seemingly from heaven: a turnover growth from nought to over €1.8 billion and a territorial growth from 1 to 15 countries in just over six years

Countries where Zalando have opened an online store
Picture courtesy of: Zalando
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Quarterly turnover of  Zalando from 2012Q1 until 2014Q2
Picture courtesy of:
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Annual turnover of  Zalando from 2008 until 2013
Picture courtesy of:
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These growth data are mouthwatering to risk-loving, private investors, as the similarities with f.i. Amazon are undeniable and Zalando seems well under way to become the number one fashion retailer in Europe and (perhaps even) the world. Experts already estimate the value of Zalando to be somewhere north of €4 billion euro.

The following snippets come from the Financial Times:

Zalando, the German online retailer, has confirmed plans for an initial public offering later this year, in what will be one of the biggest tech floats in Europe in years.

The Berlin-based start up said it would sell as much as 11% of its total share capital through a listing of new equity in Frankfurt in the second half of the year. Kinnevik, the Swedish investment firm with a 36% holding in the retailer, and four other core investors will all maintain the size of their stakes.

Zalando launched in 2008 and has rapidly expanded to become the largest online fashion retailer in Europe, with a presence in 15 countries and 13.7m active customers.

An IPO has been tipped for months, as Zalando seeks to become profitable and further expand its operations. Kinnevik has previously valued Zalando at €3.9bn, with the listing expected to draw a valuation as high as €5bn.

That is likely to make it the largest tech IPO in Germany since SMA Solar Technology in 2008 and the fifth largest since the turn of the century, figures from Dealogic show. It will also likely put it in the top 10 European tech IPOs in the past three years.

While still unprofitable on an annual basis, the company effectively broke even in the first half of the year, an achievement it hailed on Wednesday as “an important milestone”.

Rubin Ritter, management board member at Zalando, said: “Listing our shares on the stock market is the logical next step in Zalando's evolution as it, in combination with raising additional capital, provides us with more flexibility to pursue our long-term growth ambitions, independent of market conditions and economic cycles.”

Zalando this week confirmed figures showing it was profitable in the traditionally weak second quarter for the first time in its six-year history, with revenues for the first half of the year of more than €1bn, a rise of nearly 30% on the same time last year. The retailer still expects to make a small operating loss for 2014 as a whole, after an operating profit margin of -6.5% last year.

However, in this case – as almost always – there is a very strong ‘but’ in case of this intended IPO. The red and bold text in the Financial Times story points out very clear, where the problems lie for Zalando and many, many other online stores and tech start ups.

Brand awareness, revenue growth and territorial expansion always come before sustainable (!) profits and unfortunately more often than not, these profits actually never show up at all.

As you could read as well in the red and bold text, Zalando stated proudly that in 2014Q2, the company became profitable for the first time in its brief, six-year history.

Nevertheless, seeing is believing, as the company is probably talking about its EBIT(DA), which is one of the infamous, disguising substitutes of company CEO’s and management consultants for real profits. For this and various other reasons, I would advice you to hold your horses yet. Like any online fashion shop, Zalando faces a number of fierce drawbacks, which are almost impossibly to solve:

  • The relatively small margins on fashion and shoes, especially when the brands are not top of the line and / or being sold exclusively, due to the fierce competition in the fashion and shoewear market. While being the largest competitor always brings substantial economies of scale, the margins are and will remain nevertheless small in this extremely competitive business; 
  • The costs of conquering new territories and new markets, while maintaining a leading position at the existing markets, will always require gargantuous marketing, expansion and investment budgets. Budgets which are almost impossible to earn back from the small margins on clothes and shoes, if these don’t wear brand names like Hermés or Louis Vuitton. And especially for an online fashion store, when it comes to brand marketing, the creed is: “‘Out of sight means out of business”.
  • The enormous logistical and ICT investments and shipping expenses for shipping the goods ‘in order and in time every time’. Some online store chains are already experimenting with shipping ordered goods on the same day. The ICT and logistical challenges of such short shipping times are mindboggling and so are the ICT investments, in order to stay ahead of the competition.
  • Ordering and shipping is for free… for the customer of Zalando. For Zalando itself, it is not, of course.
  • Webpage of Zalando promising toll-free ordering,
    free shipping and free returning of goods
    Picture courtesy of: Zalando
    Click to enlarge
  • Returning one’s goods is also for free at Zalando. Too many customers (ab)use this privilege, by ordering fashion and shoes in more than once size and returning the clothes and shoes that don’t fit. The shipping and logistical costs of returned goods and the ICT expenses for processing these goods are a true pain in the neck for online stores, with the size of Zalando. 

Although Zalando could keep a blacklist regarding customers, who return too much goods or return goods too often, there must always be a possibility for customers to return their ordered goods for free.

Fashion and shoes sometimes simply don’t fit and must then be returned. Of course, customers don’t want to pay for that, as they would also not pay for returning goods in a brick-and-mortar shop.

These circumstances cause that the profitability of Zalando will probably never be so high as it can be for Amazon (in theory), due to the ever elevated numbers of returned goods and the accompanying unfavourable cost structure of it.

In May 2014, when the news of Zalando’s  IPO leaked to the press, the German business magazine Die Welt printed a number of articles with respect to this IPO. The tone of voice of these articles about Zalando was not very positive.

Also in 2014, the new candidate for the stock exchanges, Zalando, will grow fast, but nevertheless it again won’t make any profits. The only goal at the time: conquering new markets.

The online store is treated as a red hot candidate for an IPO, but it still misses a profitable business concept. Also in 2014, Zalando will not grow out of the red figures.

The online trader, which is massively investing in expansion, will ‘probably not fully reach’  a positive EBIT in 2014, according to executive Rubin Ritter. Although the EBIT margin has improved in 2014Q1, it will remain ‘negative’ for the remainder of this year.

However, the core business in Germany, Austria and Switzerland would be profitable and the losses would only be to blame upon the rapid expansion, according to executive Ritter. In these three core markets, the revenues rose with 27% to €284 million.

Another article in Die Welt was even more negative, as it missed the small ‘silver lining’ of the aforementioned article:

Europe’s largest online store for fashion and shoewear goes to the stock exchange, in spite of still deep red figures. Independent management consultant Patrick Palombo of Palombo Consulting in Duesseldorf explains, what the goals of Zalando are with this step.

Palombo: This step could be forseen. Since the participation of various companies in Zalando, the management has aimed towards this step. Zalando increased the virtual stock value, by creating a strong brand. [In continental Europe - EL] Zalando is almost as renowned as Coca Cola. However, this is the only ‘tangible’ value of the company.

The company has yet to proof that it is on the right track, from a business point of view. Zalando used a stockpile of money to build up its brand value and it did so with especially image advertising. The company spent hardly any money on product advertising.

This is always an indication that brand value is more important for a certain brand than making profits or even reaching something like break even point. This brand value creates palpable business value, which could be capitalized through a merger / takeover or an IPO. Zalando could have been sold to f.i. Amazon or it could go to the stock exchange, which it obviously does right now.

Handelsblatt [original publisher of this article – EL]: The company is still writing red figures. Was there no company in the market to take over Zalando and – as a consequence – is Zalando now forced to deploy an IPO?

Palombo: Potential buyers always check the revenues of the company first. They look at the current economic potential of the company. The question is: can this company make a profit soon when we take it over?! However, Zalando did not aim at this goal – of being able to make profits soon – on purpose and instead increased its brand value. The brand is all they have at the moment. We can only guess when this company will ever get out of the red figures. The company should now prove how much potential is really in it.

For Zalando it is the last chance, to capitalize its brand value. It has indeed a lot of brand value, which could be capitalized by its founders and early investors. Nevertheless, one wonders: where is the meat in the company. Where are the Unique Selling Points?! I neither see them in their service nor in their product range. Nothing about Zalando is truly unique…?!

This must-read article (for English readers unfortunately in German) is from May, 2014, but I agree with everything that Patrick Palombo stated and I truly wonder whether much has changed about Zalando since then.

Nevertheless, I would not be surprised when the IPO of Zalando – probably in September 2014– will be a massive success and the company will indeed be ‘worth’  €4 to €5 billion at the stock exchanges.

However, the inquiring reader should wonder: is Zalando a new superstar or is it the contrary: a black hole, which absorbs all invested money, while everybody wonders where it went?!

We already had too many IPO’s, which were simply there to help the founders and early investors cashing back their initial investments. In this bubblicious times, it is definitely something to keep at your retina, before you invest in online stores, such as Zalando.

Like Palombo stated, Zalando is all about brand and almost not about business value. 

The still missing realistic business model and the red figures in the annual data, as well as the massive drawbacks of online fashion stores, make Zalando a shaky investment, in my humble opinion.

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