Morningstar - Q2 2021 - 22

Dispatches

he may get the blame. For Slater, perhaps the ideal
scenario would be that Anderson has a mediocre
final year in office.
Holly Black is editorial manager, EMEA, at Morningstar.

Still Dressed for Success
GREATER EUROPE

European Union

Mass-market apparel is a tough, highly fragmented
industry, where the biggest firms claim only
low-single-digit market share and moats
remain elusive because of low pricing power and
high fashion risks. Historically, players like
Inditex ITX:ES, the parent company of Zara, and
Hennes & Mauritz HM B:SW, better known as
H&M, managed to navigate these challenges
through feedback-loop-driven design and small
batches of supplies at attractive prices. That
enabled them to gain market share in the apparel
segment not only against midprice companies
but even luxury ones.
In the age of digitalization, and amid growing
concerns over sustainability, investors are
increasingly questioning this business model.
However, we believe no-moat H&M and
especially narrow-moat Inditex remain well
positioned to tackle the industry's new challenges.
Inditex benefits from an economic moat because
of its intangible assets. Its brand awareness
helps it operate at a structurally lower cost than
peers, bypassing 3% to 9% of revenue in its
marketing budget, and it has cost advantages as
a result of its scale and fast supply chain. H&M
benefits from the same advantages but to a lesser
extent, which prevents us from assigning it
a moat rating. (It has a higher marketing budget, a
slower supply chain as a result of less proximity
sourcing, and operational missteps in recent years
that have eroded economic profits.)
H&M and Inditex both benefit from brand
awareness. Although that's not conducive to

22

Morningstar Q2 2021

pricing power, it helps lower marketing
costs and cements their cost advantage against
peers. Inditex's marketing costs are minimal
compared with peers. H&M spends more
in total on marketing than peers but less as a
percentage of its sales revenue than anyone
other than Inditex.
Big brands benefit from scale advantages owing
to suppliers that offer discounts and allocated
capacities and make dedicated investments for big
partners. These advantages should strengthen
as suppliers consolidate. The speed of supply
chains is another cost advantage stemming from
vertical integration, organizational efficiencies, and
proximity sourcing. Inditex's proximity sourcing
remains expensive compared with Asian sourcing
and is not widely replicated in the European
market. Vertical integration requires high brand
awareness to generate traffic, while organizational
changes such as online/offline integration
and centralized merchandising functions can be
replicated, but Inditex remains ahead of the
competition on the implementation curve.
Competing online apparel platforms such as
Zalando ZLNDY and Asos ASC:UK offer consumers
expanded choices, but Inditex and H&M
products remain attractively priced, and both also
have sizable online businesses. Consumer
intelligence garnered online can be more

advantageous to vertically integrated companies
like Inditex and H&M. Their online businesses
are not dilutive to their margins, and Inditex's
online margins are further helped by store/online
integration, which reduces delivery costs
by around 40%, according to our estimates.
Flexibility and well-managed store real estate can
help the firms transition to a higher share of
online sales without profitability drag. We believe
Western European online apparel sales could
increase to 45% by 2029 from 19% currently, driven
by a generational shift, increased brand
investments, and a so-called flywheel effect, where
more brick-and-mortar store closures make
the online channel more appealing to consumers
and forces more stores to close. We believe
Inditex's online business could grow to 46% of
revenue by 2029 from 14% in 2019, and H&M's
online business could grow to 48% by 2029 from
16% of revenue in 2019.
Consumers are increasingly concerned about
sustainability issues, which could hurt fast-fashion
franchises. However, people aren't reducing
the amount of clothing they buy, they don't always
act on their intentions to purchase more
sustainable clothing, and they're not willing to pay
more for sustainable clothing. Inditex and H&M
have Negligible and Low ESG Risk Ratings,
respectively, from Sustainalytics. They are well

Brand Advantage Inditex and H&M spend less of their revenue on marketing
than do peers.
Marketing Budget

Marketing Budget as % Revenue

EUR 1,000M

10.0

750

7.5

500

5.0

250

2.5
0

0
Inditex Abercrombie
& Fitch

Asos

Source: Morningstar, company data. Data as of 12/31/2020.

Boohoo

PVH

Zalando

Gap

VF

Hennes
& Mauritz
Morningstar - Q2 2021

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