Is ASOS plc Overvalued?

Posted on 14/06/2011

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Taken from the company’s own website, ASOS plc describes itself as:

ASOS is a global online fashion and beauty retailer and offers over 50,000 branded and own label product lines across womenswear, menswear, footwear, accessories, jewellery and beauty with approximately 1,500 new product lines being introduced each week. Aimed at fashion forward 16-34 year olds globally, ASOS attracts over 13 million unique visitors a month and as at 31 March 2011 had 5.3 million registered users and 3.0 million active customers from 160 countries (defined as having shopped in the last 12 months).

The company has a phenomenal track record, having grown revenues and earnings rapidly over the past few years, as shown in the table below.

This has been converted into exceptional share price growth, as shown in the chart below.

However, the shares now trade at a price of 2,466p, giving the company a market capitalisation of £1.85bn.  This is equivalent to 96x FY11 adjusted diluted earnings per share and 67x FY12E earnings.  Now, clearly the company is on a roll and is likely to continue growing revenues and earnings over the next few years, but this doesn’t necessarily mean the shares are good value.  I’ve reverse-engineered a discount cash flow model in order to understand what level of growth is required to justify the current share price.  Ordinarily, investors make projections for the future cash flow that will be generated by a business and then discount these back in order to estimate the fair value of the share price.  I often like to conduct this process in reverse, beginning with the current share price and using a process of iteration (trial and error) to calculate the rate of cash flow growth that the market has “baked-in” to the share price.

Given the rapid growth of ASOS plc, I have used a three-phase growth model: a high growth phase for the first five years, a medium-growth phase for the second five years, followed by a slow-growth phase thereafter.  I also use a cost of equity capital (another name for “target return”) of 10%, which I would view as relatively aggressive for such a young company.  My findings are as follows: in order to justify the current market capitalisation the company will need to earn free cash flow of £20m in FY12, grow FCF at 35% per annum for the following five years, then  at 18% per annum for the next five years, and finally at 5% per annum for each year thereafter.  Critically, this first assumption relies on the £26m capex spend in FY11 to genuinely be a one-off (ASOS plc separately reported £15.1m of capex for a new distribution centre).  Although these rates of growth are certainly possible, companies that manage to achieve them are relatively few and far between.  In addition, the small amount of fixed assets employed in ASOS’s business (only £25m) versus the company’s market capitalisation (£1.85bn) means that potential returns are extremely high for new entrants with deep pockets.  With such value-creation, it’s very hard not to see many new competitors entering the online retail business over the next few years.

The company’s own forecast is to grow revenue to £1bn by FY15, which would represent 31% per annum growth.  Therefore, the company also has to exceed its own targets in the near-term simply to justify the current share price.  My view is that ASOS plc is a great business and will likely grow revenues and earnings for many years to come.  However, at the current share price, the rates of growth required to deliver satisfactory returns to investors are simply too high and provide too great a probability of a downside surprise.  ASOS shares are priced-for-perfection and any less than this will likely see a significant de-rating of the shares.  Therefore, I reckon investors should avoid ASOS plc.

Disclosure: No position.

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Posted in: Investment Ideas