Is There a Dent in the Inditex Armour?

Few consumer goods companies – if any – have outshone Inditex post-2008. The Spanish company’s financial results would make impressive reading in a period of boom, let alone bust. Net income for the full year ending January 2013 was up 22% to 2.3 billion euros, according to the latest report. That puts average annual earnings growth at 17% over the past five years. Over the corresponding period, average earnings growth at H&M, a key global rival, was a lacklustre 2%. Inditex, it would seem, is winning the fast fashion battleground hands down.

We should not get too ahead of ourselves, however. Strong as Inditex’s latest financial results are, there is also the first sign in years of a possible dent in the armour. Yes, earnings were stellar. Yes, new store openings – at an average of 1.3 per day – were bullish. And yes, overseas expansion was spectacular – with China dethroning Italy and Portugal to become the biggest market by stores, after Spain. But, drilling into the full year results, gross margin in the final quarter (November-January) was at its lowest in two years.

China is the key strategic challenge

We have argued before that Inditex needs a new business model for China, which has become the company’s critical growth market. The longer supply chain in China (the flip side of the company’s advantage in Western Europe) is almost certain to apply downward pressure on gross margin. And that is probably the main cause of the dip. As China becomes more important in terms of sales, so the impact on gross margin will become more pronounced.

Inditex has room to adopt a lower margin business model, but that could spook investors (in that sense, Inditex is a victim of its own success). And all sorts of things can go awry if share prices tumble. One potential solution is to hike prices in China –  Zara, after all, has a more upmarket image in China than it does in Western Europe. Alternatively – and more likely, Inditex could look to ramp up local production (a portfolio of Chinese designers could also be a competitive advantage as the fast fashion stakes intensify going forward).

Spain on the wane

It is telling that Inditex conceded a 5% slide in its Spanish sales for 2012. The company has worked hard to dilute dependency on its home market. Equally, sales there have been remarkably resilient despite enormous external pressures. Last year’s contraction was explained by a VAT increase that Inditex did not pass onto customers, but this is a harbinger of the future. Spain, quite clearly, is set to be in the economic doldrums for some years to come. And consumers’ spending power will only get weaker.

Inditex has arguably a more effective business model than any other fast moving consumer goods company in the world. Its owner, Amancio Ortega, is Spain’s richest man, and the third richest man in the world (according to Forbes). That alone speaks volumes. It might seem like nitpicking, therefore, to dig out weaknesses in the company’s latest financial figures. But, no single company is ever bigger than global market forces. To stay ahead of its rivals, Inditex will need to revise its overseas model, most urgently in China. The longer supply chain, in comparison to Western Europe, is not viable into the long-term. In that sense, the dip in quarterly gross margin is a shot across the bows.