Asos's global growth potential still has much to offer investors

Since listing on Aim 20 years ago, Asos has been a resounding business success story and has handsomely rewarded its investors. It has created a market-leading online fashion brand for 20-somethings and taken it from the UK to the rest of the world. 

The track record of success and the huge potential for global growth has seen its shares become very richly valued, but it has not all been plain sailing for the company. Three profit warnings in 2018-19 were of its own making as its new warehouses failed to provide customers with what they wanted in the US and Europe, while a poor Black Friday in 2018 saw it slash prices afterwards to keep customers happy. Profits and the share price collapsed.

2020 saw Asos get back on track, with Covid-19 providing it with some decent underlying growth and some one-off boosts to profits and cash flow. The challenge the company now faces is to keep the strong momentum in its businesses going so that the big investments it has made in recent years can pay off.

The business

Asos operates a global online fashion platform for 20-something consumers. The business is built around its own Asos fashion brands, as well as leading global and local brands. It generated revenues of nearly £3.3bn in 2020 with over £1bn coming from its Asos own-label products.

Unconstrained by the limited selling space faced by high-street shops, Asos offers more than 85,000 different products (shopkeeping units or SKUs) to its customers from more than 850 different brands. To keep its product offer fresh and attractive it adds 5,000 new SKUs to the platform every week.

This business is backed by significant investment in technology and logistics. In order to win and retain fickle and fashion conscious 20-somethings on mobile devices, its apps and websites across the world have to be engaging, innovative and easy to use. The brand is reinforced by investment in social media platforms and gaming platforms.

A lot of attention is currently focused on personalising and localising the customer experience, as well making sure that users get a consistent offer wherever in the world they are shopping.

In order to provide the big range of products and deliver them to customers, Asos’s business is based around three global fulfilment centres in Barnsley, Berlin and Atlanta. A fourth centre is currently being built in Lichfield. These also process, returns along with dedicated returns centres. 

Fast delivery and easy returns is key to keeping customers happy. Next-day delivery is offered in most markets, while returns are free in the UK and Europe and can increasingly be done without completing paper forms. Asos also has its own subscription service in many markets, which offers free next-day delivery on items for a cost of £9.95 a year in the UK.

Having started out in the UK, the business can be considered to be a global one these days with sizable revenues in Europe and the US as well as growing exposure to Australia, the Middle East and Russia.

Business performance

Asos has been able to deliver impressive rates of revenue growth by getting increasing numbers of people to shop with it.

Active customers (defined as someone who has shopped on the Asos site within the past year) and orders have doubled since 2016, but customers are not spending more as shown by the trend in basket size. The conversion rate from site visits to actual orders has stayed at around 3 per cent. Getting this rate of conversion up would have a meaningful impact on revenues and profits and is unsurprisingly the key focus of technology and brand investment.

The impressive rate of revenue growth has come off the back of significant amounts of investment in the business. In fact, revenues have not kept pace with investment. In 2016, £1 of investment was generating £6.50 of sales, but in 2020 it was only generating £2.80.

This can be explained by the immaturity of some investment spending and large cash balances raised in 2020 (I include cash in my calculation of invested capital). The hope now is that revenues will be leveraged off the investment in technology and warehousing to bring return on capital (ROCE) back to where it was just a few years ago. If Asos can do this then its investors should be happy.

High levels of competition mean that Asos is never going to be a business with large operating margins. Any efficiency gains or benefits from operating leverage are likely to be reinvested back into the business to keep sales growing.

Asos’s operating margins are similar to those being earned by bigger German competitor Zalando (Ger:ZAL). I think it's reasonable to think that Asos willl look to keep margins at around the 4 per cent level with profits growth being in line with revenue growth.

Digging down further into Asos’s margins we can see that the performance in 2020 was driven by reductions in distribution, warehousing and marketing costs as a percentage of sales. which offset a continued fall in gross margins.

A shift in sales mix away from occasion wear to casual wear caused by Covid-19 lockdowns, along with higher air freight costs saw gross margins fall in 2020. There was a big benefit from a lower returns rate, which brought down distribution and warehousing costs. Marketing costs were kept in check as the company wanted to avoid stimulating demand that it might not be able to fulfil due to Covid-19-related supply chain constraints. Lower returns gave a net Covid-10 benefit of £45m in 2020 to the business.

The key question is what happens to margins when normal returns patterns come back. How are they going to get to 4 per cent?

The automation of its warehouse in Atlanta will improve efficiencies as will the new warehouse in Lichfield but those benefits are unlikely to be seen until 2023-24. The company is taking out non essential costs and is looking to optimise its marketing spending to get a better bang for its buck.

Distribution efficiency also has the potential to improve as Asos is getting more of its brand partners to deliver directly to its customers rather than it taking delivery first.

The key unknown is what happens to gross margins because they look as if they need to go up. Some analysts have been concerned that Asos’s sales mix has been moving too much towards third party brands where gross margins are lower and away from its own brands.

In 2016, Asos said that its own label sales were 44 per cent of its total revenues whereas last year it was around one third.

The need to get gross margins up explains some of the rationale for the recent purchase of the Topman, Topshop, Miss Selfridge and HIIT brands from the administration of Arcadia. By owning these brands outright Asos can capture all of the gross margins on selling them rather than paying some of it away to Arcadia as it had been doing when they were sold on its platform

The other source of margin expansion is operating leverage on the sizable fixed cost base. Asos will have to keep hold of some of the benefits of this although I expect a decent chunk to be reinvested to keep prices competitive.

One other area of improvement which is needed is in free cash flow generation. The capital intensity of the business has been very high in recent years as evidenced by a rising capex to sales ratio. Investment in some projects was paused in 2020 but this will increase again in 2021 whilst working capital benefits seen last year will reverse this year.

Asos has been spending a greater proportion of its revenues on capex than Zalando. This may all be good from a strategic and competitive positioning  point of view but sooner or later it has to bring larger cash flows back into the business.

Growth outlook and competitive positioning

There are good grounds for thinking that Asos will be able to keep on delivering impressive rates of revenue growth in the years ahead.

First and foremost, it has a favourable wind on its back as more of the global fashion market will continue to see a big shift from the high street to the internet over the next decade. The company has the product offer and range to tap into this across the world and has backed this with big investment in technology, and logistics assets to fulfil it as well as bringing benefits in the customer experience, buying power and stock control. 

Asos is not resting on its laurels and has made good progress with its relaunched face and body product ranges and is growing rapidly in areas such as sportswear. Its Collusion casual wear brand is performing well and there has been a good response to its recently launched AsYou lower priced brand. 

The automation of its US warehouse and the new UK warehouse in Lichfield should help profit margins and generate funds for reinvestment back in the business to improve competitive positioning. When completed Lichfield should be capable of fulfilling £1.2bn of annual sales with a warehouse and staff numbers around half that of its existing Barnsley site.

But profitable growth will not be easy. Companies such as Amazon (US:AMZN) are making a big push into fashion whilst other competitors have made big improvements in their delivery and returns experience which makes it harder for Asos to differentiate itself here. That said, Asos has built an impressive level of brand strength which makes it a fearsome competitor itself.

Another key issue is how easy it will be to keep off existing customers and how much it will cost to bring on new ones. There is also the issue of what Asos can offer today’s 20-somethings when they become 30-somethings in the future but this does not seem to be a pressing issue right now.

The recent purchase of the Arcadia brands looks to be a very good one that will enhance margins and deliver a decent return on the c£300m investment. The partnership with Nordstrom in the US is also a very encouraging development for future growth in this key market.

Right now, things are going well for Asos. It continues to win more customers and sales for the first four months of 2020/21 have increased by 23 per cent with lower returns boosting profits by another net £40m (after Covid-19 related costs are taken into account). Analysts upgraded 2021 profit forecasts on the back of January’s trading statement and the company should report a very strong set of half year results in early April.

At 5,382p, the shares are not cheap on 35.7 times the next 12 months’ EPS, but for a company back on track with the size of global growth opportunity on offer they still look worth backing for the long term.