Evaluating Zalando
Hey! Everything you read here is just me sharing my thoughts and research. This isn't financial advice. Stay smart out there!
This doc's a living thing - it evolves as the company evolves. Make sure to check when it was last updated!
Marketplaces are powerful because they create network effects that compound value with each new participant.
I was chilling with my buddy the other day when he said that this company has been absolutely killing it lately; he buys all his clothes from there. The moment I heard this -boom💡- my investor brain kicked in right away. The friend was talking about Zalando, the leading European fashion marketplace. I know Zalando well as a customer but never thought about it as an investor. Immediately, two things made it worth it for me to dig deeper into it:
- It is an $8B European company, I love companies below $10B and international companies. This means they probably can fly a bit under the radar.
- It is in the fashion industry, which I have actively become focused on. I am of the opinion that being focused on a couple of industries would let me figure out opportunities better.
Business Model
Zalando has 2 business models: the B2C & the B2B. The B2C is where most of the money is made. Also, it is the simpler business model to understand. It is basically a fashion marketplace for brands to put their items for an annual fee and a commission on each sale. Another way the company generates money in the B2C segment is through direct-to-consumer sales, where Zalando manages its own inventory. The B2B model, which is more of a side hustle, offers businesses marketing & logistics solutions. The B2B EBIT in Q2 2024 was 12% of the B2C EBIT. So it is safe to put our focus on the B2C business, and the B2B business should be the wild card that could offer a nice surprise in the future.
Evaluating Zalando
How can we evaluate Zalando's B2C model, you ask? Well, the company gives us 4 key metrics we can use to track what their customers are up to. These metrics are:
1. Active customers
The number of people who've bought something in the last 12 months. Worth noting that the total addressable market (TAM) is about 250 million. Zalando has been stuck at around 50 million active customers. But hey, this customer base is still massive! Just compare it to Amazon, which has about 310 million active customers worldwide.
2. Number of orders per customer
This shows us how busy each customer is on the platform - great way to see if customers keep coming back for more.
3. Gross Merchandise Volume (GMV)
This is basically all the money spent on the platform by shoppers. It's a neat way to wrap up everything customer-related into one number. It tells us about the number of customers, how active they are, and how well we're keeping them around.
4. Average Basket Size
According to Zalando, this is the total sales (after cancellations, returns, and including VAT) divided by the number of orders in the last 12 months. I think it's perfect for tracking upselling and cross-selling success. Quick explanation: upselling is when you get someone to buy the fancier version of something, while cross-selling is when you get them to add related items to their cart.
I will start by charting Zalandos' average customer behavior over the past 3 years. This is basically avg basket size and avg order per customer.
This chart is super interesting - looks like there's an inverse relationship between orders per customer and basket size. It's tough to say exactly what's causing this, and I think the changes in these two metrics over the last two years aren't actually related. The bigger basket size? That's probably more about inflation than people buying more stuff. Clothing inflation in Europe hit about 4%, which I bet contributed to that 10% year-over-year jump in basket size. Now, the drop in orders per customer is trickier to figure out. Are people buying less? Getting more environmentally conscious about their shopping habits? Maybe we're just seeing the post-pandemic online shopping craze cool down? Honestly, I'm not sure, but I'll definitely keep watching this trend.
Customer count peaked in Q1 '23. Yes, the pandemic was over and some users who used to shop online started shopping in stores again. I think this shift is temporary and we should see fewer people choosing stores over online shopping, because right after the pandemic recovery, people were eager to get back to in-store shopping. Now that the novelty of store shopping has worn off, I think we'll see online shopping rise again.
The most interesting takeaway from the GMV graph is that the last 3 quarters had much higher GMV than any equivalent quarters in the past 3 years. This reinforces our earlier theory: people were eager to shop in stores after the pandemic, but now they're gradually shifting back to online shopping.
Economic moat
I was checking some online forums to get a better feel for how people view the company. I was surprised to see a lot of people saying this company has no moat. That's an absolutely stupid take. The company has very strong network effects and brand recognition.
Network effect
With more than 50 million active customers, Zalando's partners have a huge incentive to list their products on the platform. With more brands on the platform, customers have more options to choose from. This creates a virtuous cycle that makes the platform more valuable to both customers and partners.
Partners face high switching costs. They need to go through contracts, set up inventory, develop marketing strategies, and spend time learning the platform. All this effort makes it tough for them to switch to another platform.
Brand Recognition
Like any brand, it's hard to put a number on brand value. For fashion brands, I think social media presence is a good indicator. For Zalando specifically, website traffic and app downloads are also good metrics. Even if some users don't purchase anything, they're still valuable to the brand if they regularly check out the website and app. Here are the numbers for Zalando (all these numbers are as November 2024):
- 2.1 million followers on Instagram
- 235k reviews on app store with an average rating of 4.7
- 50+ million downloads on Google Play Store with an average rating of 4.5
- Monthly visits for Zalando.de (their biggest market) is around 22 million visits
All of these numbers indicate a great brand. The brand value is an intangible asset that we should put into calculations when we evaluate the company's assets and liabilities. We can estimate value for the brand recognition and then add it to the equity value. To estimate the brand value, I will start with mobile app downloads as these are, in my opinion, the most valuable metric. Cost of acquiring a user is around $2.5 to download the app. If we multiplied it by 100 million downloads, we would get €250 million. We can add the value of the brand by estimating the Instagram followers and the web traffic for €150 million. This would give us a total of €400 million.
Balance sheet
| Assets | Liabilities | ||
|---|---|---|---|
| Non-current Assets | Non-current Liabilities | ||
| Intangible assets* | €400.6M | Provisions | €89.8M |
| Property, plant and equipment | €1,212.6M | Lease liabilities | €728.9M |
| Right-of-use assets | €765.4M | Convertible bonds | €467.1M |
| Financial assets | €77.4M | Other financial liabilities | €4.6M |
| Non-financial assets | €4.8M | Other non-financial liabilities | €0.1M |
| Deferred tax assets | €6.4M | Deferred tax liabilities | €44.0M |
| Total Non-current Assets | €2,467.2M | Total Non-current Liabilities | €1,334.5M |
| Current Assets | Current Liabilities | ||
| Inventories | €1,893.5M | Provisions | €21.5M |
| Trade and other receivables | €934.4M | Lease liabilities | €149.1M |
| Other financial assets | €92.9M | Convertible bonds | €391.6M |
| Other non-financial assets | €265.4M | Trade payables and similar liabilities | €3,074.3M |
| Cash and cash equivalents | €2,389.4M | Other liabilities and provisions | €566.0M |
| Total Current Assets | €5,575.7M | Total Current Liabilities | €4,202.7M |
| Total Assets | €8,042.8M | Total Liabilities | €5,537.2M |
* I removed the goodwill(€200m) from the intangible assets because I don't think it's a real asset :)
Shareholders' Equity
€2,705.6M
Calculated as Total Assets (€8,242.8M) minus Total Liabilities (€5,537.2M) plus Brand value (€400M)
Currently, the company has a market cap of €6.9B. This means the equity premium (extra money we're paying for future returns) is €4.2B. Let's see how long it'll take us to get our money back using a discounted free cash flow model later in the analysis. But first, we need to understand both risks and opportunities to estimate our future growth projections and discount rate.
Risk
It is important to understand what makes an investment risky and what is the worst case scenario of it. This will help us estimate the discount rate and the probability of the company's growth.
Management
Assessing how management works is key to investing - at the end of the day, we're giving them our money to invest in the company and make it grow. Well, most of what I checked about Zalando didn't really please me. First, management incentives aren't fully aligned with what I expect from a company I'm investing in. Yes, they're incentivized to grow EBIT, which is very important for company growth, but there are also incentives related to ESG. Now don't get me wrong, I'm all for ESG, especially for a company in the fashion industry, but I think the priority should be growing the company first, then focusing on ESG. The company hasn't even been growing for the past couple of years. I also like to check employee satisfaction, and I was surprised to read this from software engineers on the Blind forum:
'Constantly changing priorities, management couldn't care less, nobody knows what they're doing'
There are many comments with the same message - you get the point. Finally, the CFO is leaving, which isn't necessarily a bad thing but it's something to keep in mind.
P.S. Nothing screams 'German company' more than seeing management addressed as 'Dr.' in front of their names.
Europe
Europe's been struggling lately: an aging population, stagnant growth, and a messy regulatory landscape. Germany - the powerhouse that makes up 25% of the EU's economy - is in a particularly tough spot, dealing with an industrial slump since 2017. If the economy stays in this decline, Zalando's going to have a hard time keeping its growth engine running.
Opportunities
I always try to think what opportunities does this company have and what are the probabilities of it. Here are some of the opportunities I see for Zalando:
Europe's smaller cities
As a customer of Zalando, I've had two different experiences with the company. The first was when I used to live in a small city of 200,000 people. Zalando for me at that time was an essential service, as I didn't have access to many different stores where I lived. I then moved to a much bigger city, where I have access to lots of stores. I don't need to use Zalando anymore, and if I want to check out a brand, I can usually just go to a physical store. I believe the real opportunity for the company lies in those smaller cities. I estimate there are around 500 cities in Europe with populations between 100,000 and 400,000. These cities will drive the company's future growth because they're where Zalando can win on convenience rather than price.
Logistics optimization
In some ways, we can think of Zalando as a logistics company. The company has been investing heavily in its logistics network and is even offering logistics solutions to others. We are already seeing quarter-over-quarter declines in fulfillment costs. I see significant room for improving the costs of fulfillment and delivery. As the company grows, the fulfillment costs should decrease due to economies of scale. This will help the company increase its margins.
The rise of indie fashion brands
This is my favorite opportunity for Zalando. We have been seeing a huge rise in indie fashion brands - these are the new brands that are challenging the incumbents. It is now easier than ever to start a fashion brand and sell it online. As AI gets better, it will get even easier. The challenge for these brands is to gain more reach, and this is where Zalando's customer base comes in. There are already some indie brands selling on Zalando, such as Fat Moose and Thinking Mu, but this is just the beginning. I think Zalando will be the go-to place for indie brands to sell their products in Europe.
Social commerce
One year ago, Zalando made an ambitious leap into social commerce with its new Stories feature, positioning itself to challenge giants like Instagram and TikTok in the social shopping arena. While early results are promising, this feature is barely scratching the surface of its potential. Sitting on a goldmine of over 100 million app downloads, Zalando can create a niche social media platform to engage its customers and drive sales.
Discounted Free Cash Flow Model (numbers in millions)
Zalando has a big negative net working capital. Meaning the company sells its products before it pays its partners and suppliers. This is a great thing because it means the company can grow without needing to raise more money. However, it makes the discounted free cash flow model a bit more tricky. We can't really use the cash flow as reported because it includes money that Zalando will pay later, so we will subtract net working capital from our initial free cash flow. The initial free cash flow will be for FY'24, which we'll estimate by taking the cash flow from the last three quarters and adding the cash flow from Q4 of last year. Then we'll subtract net working capital to get the actual free cash flow.
- Initial FCF estimate for 2024: €147.6 + €710.4 - €446 = €412
- Growth for the first 2 years of 20%. I got those from analysts' estimates.
- 8% growth for the next 8 years. This will come from combination of optimization in development, marketing and logistics.
- 3% growth for the next 5 years. Inline with inflation.
- Discount rate of 7%. This is because the investment is a bit risky, which we will discuss in the next section.
The Verdict
When I'm evaluating a company, I like to answer these key questions:
- Is it a good company with a solid business model and economic moat?
- Is it obviously undervalued?
- If it isn't undervalued, what price would make it a good investment?
To answer these questions: yes, I believe Zalando is a good company with a strong business model. However, I think at the current market cap of €6.9B, it's somewhere between fairly priced and slightly undervalued. For me, a no-brainer buy would be at €6.4B, which is around €24 per share with current outstanding shares. I'll set up an alert for €24, if nothing change, I will be buying at that price.
Q4 is Zalando's money-maker - when the company makes most of its profits. I'll keep an eye on the company's initiatives throughout the quarter and see if any developments could change our valuation.
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