Zalando SEs first quarterly report: Straight As

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Figures in this article reflect prices as of market close on 12/5/2014 unless otherwise specified.

Shortly before Zalando went public, I wrote a cautiously optimistic article about Europe's biggest online fashion retailer, putting it on my watch list.

Since then, the company raised over half a billion euros during its initial public offering, and it has recently published its first quarterly report as a public company. The quarterly results reinforce my optimism.

Don't sweat the IPOZalando's listing was a highly anticipated event, and the stock was more than 10 times oversubscribed. The company set the offer price at 21.50 euros, close to the high end of the range. However, the stock lost around 20% of its value in the week following the IPO.

While many commentators considered the IPO a disappointment because of the sharp share-price drop in the first few weeks, long-term investors should pay little attention to these types of short-term dips. First, IPO prices are often overhyped and are followed by short-term price drops. Second, the timing was unfortunate, as the listing coincided with a brief broad market correction: The DAX dropped almost 10% in the first half of October.

If you need any proof, look at the stock price now. After a better-than-expected third quarter, the company enjoyed a nice jump over the past week and was trading 17% above the IPO price.

Strong growthRevenues were up 24% in the third quarter compared to 2013 and reached 1.5 billion euros for the first nine months of the year, representing a 28% increase. The growth is especially robust at 40% outside the core DACH (Germany, Austria, Switzerland) region, which shows that the company's efforts at geographic expansion are paying off.

Behind this growth there are improving customer metrics. In the third quarter:

The number of active customers grew by 15% to 14.1 million.
These customers shop more often at Zalando, as average orders per active customer grew from 2.7 to 2.8.
The size of each order is also increasing, from an average of 61 to 64 euros.

There is also little reason to believe the company's growth will be slowing significantly in the near future. According to a Euromonitor International report:

The total fashion market in Europe is stable at about 420 billion euros.
Of that amount, only 38 billion euros, or 9%, was online in 2013.
The online portion has been growing at an average 19% annually over the past five years.

At the same time, Zalando, the market leader in the online segment, had less than 5% of the online market, based on its reported sales of 1.8 billion euros in 2013.

To summarize: Zalando is the market leader in the fragmented online fashion industry in Europe, which is growing rapidly and still has a lot of room for expansion based on the low penetration rate of online sales. The company should benefit as it gains a larger portion of the online market and as online sales grow to become a larger portion of the total fashion market.

In fact, during the quarterly earnings call, co-CEO Rubin Ritter reaffirmed a yearly revenue growth rate of 20% to 25% in the midterm. In 2014, Zalando expects revenue growth will be at the high end of this range, even after a slow start in the winter season for the overall industry.

Improving profitabilityThe company also showed "extremely strong progress" on the profitability side, even "above [Zalando's] own expectations," to quote Ritter again. In the third quarter, earnings before interest and taxes, or EBIT, was -2.6 million euros, compared with -50.9 million euros a year ago. For the first nine months of the year, the company actually generated, for the first time in its history, a positive EBIT of 1.0 million euros.

This improving profitability is the result of the operating leverage starting to kick in with the increasing sales. All major areas driving profitability showed strong improvements (values are for Q3):

Gross margin increased from 37.5% in 2013 to 40.7%, driven by more flexibility on the buying side. As fashion is a highly seasonal industry and consumer tastes quickly change, the more flexibility Zalando has with its suppliers, the smaller is the risk that it ends up with unwanted products in its inventory that it needs to sell at low margins.
Fulfillment costs were reduced from last year's 23.5% to 22.7% as a result of warehouse efficiencies. In this aspect, both the overall volume growth and the increase in the average order size play an important role.
Marketing costs showed the biggest improvement, with a decrease from 19.4% in 2013 to 11.4%. This was driven by the sales increase: Advertising costs do not have to increase in lock step with sales. Additionally customer acquisition costs (as a percent of total sales) are also dropping, as more and more of the purchases are from existing customers.

Given that the fourth quarter is usually the most profitable, Ritter is very confident that the company will be profitable for the full 12 months of 2014.

On the midterm, increasing revenues will drive further efficiencies and accelerating profits. The DACH region is already clearly profitable, with about 4% EBIT margin, if the trend continues, I believe the rest of Europe can break even as well by 2015.

Focus on capital efficiencyZalando is also putting a lot of focus on improving its cash position. While inventory levels increased in the third quarter by more than 140 million euros in anticipation of the fourth quarter -- which is usually the strongest in terms of sales -- Zalando didn't have to pay for this increase. In fact, as a result of its favorable agreements with its suppliers, the company's payables balance increased by more than 200 million euros in the third quarter. The company also reduced its Q3 capital expenditures from 26 million euros in 2013 to 18 million euros in 2014.

As a result, Zalando generated over 80 million euros in free cash flow in the third quarter and had a cash balance of 467 million euros at the end of the quarter. If you add the 517 million euros generated from the IPO, the company was sitting on almost 1 billion euros of cash on the first day of October -- which was more than half of the company's total assets.

What is the outlook?Zalando hit it out of the ballpark with its first quarterly results as a public company. It reported healthy top-line growth, strongly improving profits and generated an impressive amount of cash. Moreover, as the online fashion industry in Europe is poised for further growth and Zalando is the market leader, I believe the company still has a lot of growth potential ahead of it. This should bring along further efficiencies and lead to strong profit increases in the coming years. Overall, I feel more confident about Zalando than I was before the IPO, and I am seriously considering a small investment in the company.

Miklos Szekely does not own any of the stocks mentioned. Nor does The Motley Fool.

The article Zalando SEs first quarterly report: Straight As originally appeared on Fool.com.

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