When I last wrote about the Italian luxury menswear company Ermenegildo Zegna (NYSE:ZGN) in July, it was fresh from its half-year trading update. The numbers looked good, with robust revenue growth, even from the US market, which is fast becoming a thorn in the side of other luxury companies with slowing demand. The company’s ace move of acquiring Tom Ford International [TFI] was really the reason for this.
Historically lagging margins
While the profit figures were not available at the time, the acquisition also indicated promising signs for the company’s margins. This is particularly significant for a luxury brand since it differentiates it from say, fast fashion brands. So far though, Zegna’s margins have lagged, with an operating margin of 9.8% at the end of 2022.
Let me give some context here. This is lower than the operating margin of affordable luxury companies like the Coach and Kate Spade owner Tapestry (TPR), which was at 17.6% at the end of its latest financial year in July 2023.
In fact, it’s even lower than that for the Industria de Diseño Textil (OTCPK:IDEXY), the owner of the popular fast fashion brand Zara, which had an operating margin of 17% for the year ending January 2023. It’s a separate matter that IDEXY has higher margins than comparable companies, but it makes the point that Zegna’s low margins don’t look entirely justifiable.
Margins are looking up now
At the time I last checked, there did, however, seem to be a case for improved margins going forward after its acquisition of TFI. The net margin from its partial ownership of TFI earlier was 5.7%, which is higher than the 3.4% for ZGN as of 2022.
The latest results for the first half of the year (H1 2023), show that the company’s indeed doing better on the margin front across the board (see chart below).
Note: Margins pertain to reported numbers (Source: Ermenegildo Zegna)
Why margins improved
However, interestingly, the improved operating margins are not on account of TFI as I had anticipated but due to other reasons like:
- A lower proportion of the cost of sales in revenues of 35.8% (H1 2022: 38.4%) and just 0.3 percentage points increase in SG&A expenses-to-revenue ratio to 46%. This is notable considering expenses related to TFI-related inventory and other acquisition expenses as well as a rise in operating costs like rents and personnel, higher marketing expenses as well as higher sales volumes.
- Increased proportion of direct-to-customer [DTC] sales to 65% (H1 2022: 59%), reflecting a reduced percentage of the lower margin wholesale sales. Margins were also helped by price increases and reduced end-of-season sales, as part of its strategy. Also, a higher proportion of sales from its essentials, as compared to seasonal collections resulted in lesser inventory management for time-limited inventory.
Segment-wise EBIT margin
As a result, the Zegna segment, which accounts for almost 84% of the company’s total adjusted EBIT, saw a bump up in margin to 15.4% (H1 2022: 12.3%). However, the Thom Browne segment and Tom Ford Fashion dragged it back, with margins of 15.2% (H1 2022: 17%) and 5.7% respectively.
Adjusted EBIT margin by segment (Source: Ermenegildo Zegna)
There are good reasons for the pullback, however. Thom Browne saw higher costs partly resulting from the expansion of the store network, with 13 net store openings in H1 2023. This may well be a step in the right direction, that accelerates future growth for the brand.
For the Tom Ford Fashion segment, the drag was on account of a host of acquisition costs. If it weren’t for these costs, the margin would have been a far healthier 12.6%. And just this alone would have improved the overall adjusted EBIT margin by around 0.5 percentage points. In the cases of both Thom Browne and Tom Ford Fashion, there then appears to be potential for higher margins going forward.
The outlook and market multiples
Even assuming that the margins stay constant in H2 2023, the company’s forward non-GAAP price-to-earnings (P/E) ratio looks potentially further improved since the last I checked at 30.4x. This is partly because of an 8% share price fall since I last wrote, but also because of Zegna’s robust growth. In estimating it, I made the following assumptions:
- The revenue growth will continue to be at 35%, as seen in Q2 2023 following the acquisition of Tom Ford Fashion.
- The adjusted EBIT margin will remain constant at 13.3% from H1 2023
- The ratio of adjusted net profit to adjusted EBIT is taken to be the same as that for their reported counterparts at 44.7% in H1 2023 and this ratio is assumed to stay constant in H2 2023 as well.
In actual fact, the margins could improve going forward, for reasons discussed in the previous section. However, considering the general weakening in economic growth, I’ve also made calculations with an alternate revenue growth assumption of 23.9% based on Zegna’s revenue increase during H1 2023, rather than just Q2 2023.
This results in a forward P/E of 31.8x, which is higher than the last time I wrote, but still lower than when I first initiated coverage on it in January 2023. The average of the two, however, indicates that the ratio is largely unchanged.
I do believe, however, that the key valuation metric to consider is the price-to-sales (P/E) since strong revenue growth is the company’s unique selling point right now. At 1.8x, it’s actually lower than that for other luxury companies like the big one LVMH (OTCPK:LVMUY) at 4.3x, Richemont (OTCPK:CFRUY) at 3.8x and even the poorly performing stock Kering (OTCPK:PPRUY) at 2.8x. This says something.
What next?
On balance, the past P/E, P/S, and peer market multiples indicate that the stock is essentially fairly valued. It could face some competition if peer ratios fall further, on declining confidence as US demand weakens further. But to me, this only makes Zegna stand out more. Despite its still relatively low operating margin, I believe there’s a good case for a premium on the stock. I’m retaining a Buy rating on the stock, with the caveat that the real returns on it might show up only in the medium term.
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