Zalando held a Strategy Update call earlier this week, looking back at FY23 and giving new financial mid-term targets. We dialled into the Keynote given by Co-CEOs Robert Gentz and David Schneider. We did not listen to the Q&A and the business unit deep dives. Find investor material (here). These are our subjective views. This isn´t investment advice or research. We don´t cover the stock.

FY23 Review

• FY23 saw lower inventory by 20% yoy, driven by reduced wholesale buying and ZAL returned to negative net working capital (EUR 442mio), a key feature of  all successful retail companies (i.e. Aldi, AMZN, etc)
  
• Demand was (and still is) weak (revenue, GMV, order frequency, active customers all down yoy LSD; AOV +5.5% as offset). ZAL focus was on profit over growth („not chasing it“)
• Cost structure: Gross Profit 38.7%, fulfillment 24.2%, marketing 7.4%, admin 5.2% --> adj. EBIT 1.9%
• Guidance FY24:  GMV, sales growth 0-5%, EBIT EUR 380-450 (+50bp at mid-point), net working capital negative
• Current Trading: consumer confidence still low, but start to spring was ok

Strategy Update

• (Personal impression) Co-CEOs Gentz and Schneider looked like two students doing a homework presentation that was finished in the wee hours the night before. They (esp. Gentz) were nervous, which is surprising as they do this for 15 years. They don´t  seem „natural“ or „at ease“, which reduces the credibility of their messages.
  
  
• The  content of the strategy update was solid. Key messages: consumers like multi-brand, ZAL´s target remains to be the „most important meeting point for consumers and brands“. ZAL is prepared to embrace and benefit from changes (i.e. shopping and entertainment converging, fashion needs to become sustainable, brands need partners). ZAL is changing its reporting structure and going forward splits the business into B2C and B2B. The evolution is from retailer  (2008) to platform (2019) to now „ecosystem for e-commerce“ (2024)
  
  
• In B2C, ZAL aims to de-focus from „transaction“ towards go-to-destination for quality shopping (fashion, lifestyle and inspiration / entertainment). ZAL wants to differentiate itsself (i.e. vs Shein, etc) via a „quality approach“. They want to provide a „North Star“ destination where integrity of brands is protected and can thrive („safe home“) against the „noise and stress“ of current social-media driven models (TikTok, Shein, etc). This quality angle is also covering „sustainability“ (ZAL thinks in the mid-term regulators will curtail fast fashion). ZAL intends to widen its TAM beyond fashion (i.e. address customer lifestyle needs: kids, family, sports, etc) based on more client engagement (aka data). Share of wallet and retention are much higher with clients that are addressed more holistically (according to tests done at ZAL). Finally, they aim to attract more eyeballs, engagement via personalized, quality content (also AI and user-generated) to benefit from the convergence of retail and entertainment. Key lever here is recently acquired HighSnobiety. All three levers are destined to improve advertising revenue.
  
  
• In B2B, ZAL aims to become the operating system to enable brands’ e-commerce across Europe on and off Zalando. Europe as a market is still very heterogeneous and fragmented and hence hard to address for smaller, newer brands. Zalando offers an „operating system“ (logistics, software, marketing, service, data analytics, etc) to brands. B2B is currently pushing already EUR 900mio in B2B sales at similar EBIT margin vs B2C. B2B gross margins are lower though, dragging down group gross margins. Going forward, B2B will outgrow B2C.
  
  
• Mid-term (FY28) targets and key margin drivers (see chart below). Scale effects and efficiency gains are supposed to drive margins towards 6-8% (double today´s). Bloomberg consensus sees a 5y EBIT CAGR of 19% p.a. The new company guidance (mid-points) implies a 23.3% p.a. EBIT CAGR (EUR 350mio->1bn). Using a 40% tax rate, WACC=8% and g=2%, the new mid-term targets imply a FV24e of ~EUR40 (see chart below).
  
  
• Long-term opportunity: B2B offers ZAL the opportunity to benefit from transactions outside of ZAL (hence widens the TAM). Fashion e-commerce penetration in Europe is still massively trailing the online-penetration in the US and China. They see a TAM of EUR 450bn (total European fashion market) of which they target >15% (ecosystem B2C and B2B). Margin-wise they see potential for a steady-state EBIT margin of 10-13% (in both segments). Ballpark, this would mean EUR 6-7bn in EBIT (or less than 1x current EV).

Verdict:

• The value proposition portrayed in the Strategy Update makes sense. Importantly, ZAL has returned to negative working capital and a more realistic growth plan (vs targets lifted in pandemic to justify >EUR 100 share prices). The targeted profitability improvements need flawless execution, but would result in significant upside for the stock.
  
  
• We have 3 problems with ZAL:
  
  A) The management team will bring a „new strategic focus“ and change goalposts (i.e. reporting lines) every other year (i.e. ambition to introduce AMZN-like membership fees, sustainability/re-use, Lounge, market place, 3rd party services, etc). More strategic continuity would increase credibility (follow through on goals).
  

  B) As a result of constant strategy adjustments, the financial targets are adjusted too often (or vice versa?), and always around some arbitrary round numbers (i.e. this time 2x profitability, arrive at EUR 1bn EBIT in 5 years, would result at 2x share price, etc). We don´t think the management has a clear understanding of what the real, over-the-cycle return potential of this business is on a >1 year perspective. Fun Fact: the new mid-term targets result in the same FVest. that the company´s original 2025 targets (issued prior to the pandemic) yielded, just 3 years later.

  C) We aknowledge that (especially in the last 4 years) fashion retail is very volatile, but to this date we´re not sure whether e-commerce can really overcome the core problems of fashion retail: limited demand predictability, high barriers to exit (the market is always oversupplied, very few players ever exit the market) and low barriers to entry.
  

• ZAL is offering an attractive value proposition to brands (ultimately their real clients?). The more ZAL can de-focusses from own wholesale (the transaction) and zoom-in on providing audience, services to brands, the less sensitive it will become towards the core problems of fashion retail (see above). „Provide the arms, rather than fight yourself“, should be the way forward for ZAL. Focus on B2B and „becoming on operating system“ is a good idea. The most „building“ will be needed to sustainably attract and retain audience in B2C. ZAL increasingly needs to become an entertainment, content company, which will be difficult and expensive. The differentiation vs Shein, etc via quality will require ZAL to let go clients who are attracted to the ultra-fast-fashion-model (challenge of GMV de-celeration).
  
  
• Given more continuity in strategy (and maybe even less ambition in financial targets; to reduce pressure), shifting the business model from transaction to service paired with constantly negative working capital could be ingredients to turn ZAL from a "growth-obsessed" into a "value-creating" company (what are the across-the-cycle, sustainable capital returns?). ZAL can be a sustainably cash-generating business. Has the current management (who did a great job building Zalando from scratch, growing it) the right mindset and skills for the next phase of ZAL, when successfully balancing growth initiatives (re-investment) and allocating surplus capital (buybacks, dividend, deals) might be more important than aggressively building, chasing growth ?