An E-Commerce IPO to Put on Your Watch List

Shortly after Alibaba’s (NYSE: BABA) IPO — expected to be the largest global IPO ever — another e-commerce company will go public as well. Zalando, Europe’s biggest online fashion retailer, will have its IPO on October 1 in Frankfurt. The company plans to raise between €507 and €633 million for 11.3% of the equity, effectively valuing Zalando between €4.5 billion and €5.6 billion.

Should you buy the stock on IPO day? I don’t think so. While Zalando is on my watch list, I would not buy the stock immediately. I have a few concerns about the long-term risks ahead of the business, which I would like to further analyze.  Also, as I will explain below, I try to avoid investing on day 1 in general.

The company today

Zalando was established in 2008 in Germany as an online shoe store. The company quickly expanded its product offerings and its geographical reach, and in 2013 generated over €1.7 billion revenues in 15 European countries. Based on the 29% year-over-year growth rate seen in the first six months, 2014 revenues should be well over €2.0 billion.

                                   Source: 2013 Annual Report; DACH = Germany, Austria, Switzerland

Zalando still needs to turn profitable, but if the trend of the first half year continues, it has every chance to do so in 2014 (see table below).

                                                       Source: Zalando Fact Sheet; % of revenues

After significant margin erosion in 2013, driven partly by investments in the company’s infrastructure, margins have started to improve in 2014. Sales costs and administrative costs continue to drop as a percentage of revenues. As a result, the company for the first time in its history managed to have positive results in the first half year. Moreover, the historically most profitable fourth quarter — with the highest sales volumes and highest margin percentage — is still ahead.

What makes Zalando attractive as an investment?

• Strong brand: Zalando, thanks partly to an excellent ad campaign, managed to build up strong brand awareness. Its online portal is the most visited fashion website outside of China. In the long run, a strong brand can help keep marketing costs in check.
• Strong position in mobile: In Q2 2014, over 40% of site visits was through mobile devices, and according to a 2013 study, Zalando has the best tablet site in the fashion industry. This gives extra edge by further strengthening brand awareness and gaining market share through in-store comparison shopping.
• Leadership team: Zalando is still run by its two founders, David Schneider and Robert Gentz, with Rubin Ritter joining in 2010. Senior management owns about 6% of the company. Moreover, 17% of the company belongs to the Samwer brothers, who are also majority owners of Rocket Internet, an investment company specializing in Internet start-ups all around the world (outside of the U.S. and China). The link to Rocket Internet’s operational expertise and financial resources has been very helpful in the past and should serve well in the future, too. The fact that all of the major owners plan to keep their shares is also a positive sign.

What are some of my key concerns about the company?

• Inventory risk: Fashion retail is a fickle business, and customer preferences can change very fast. As a result, there is a significant risk that a portion of the inventory cannot be sold. This is further increased by Zalando’s free return policy (which results in a 50% return rate). In 2013, the company increased the inventory reserves from €23 million to €58 million. This meant an increase from 9.7% of total inventory to 17.5%, and had a negative €35 million impact on 2013 profits, representing 2% of sales.
• Margin risk: Zalando has so far managed to avoid excessive discounting and is focusing more on the brand experience. As a result, it still has relatively high gross margins of over 40%. As the company keeps expanding, it will need to look for newer and newer product categories, some of which may not be able to command the same margins, which can lead to margin erosion. As a comparison, Amazon.com’s (FRA: AMZ) gross margin was 27% in 2013, and this already included the non-retail, higher margin businesses as well.
• Competition risk: Even though Zalando is a big player in Europe within its own market, it is still a very small company compared to Amazon.com and Alibaba in the overall e-commerce industry. Until now, there has been relatively little overlap with the two giants. Sooner or later, though, I expect this to change – either because Zalando decides to expand into the others’ markets, or because one of the 800-pound gorillas (or both) decides to focus more on Zalando’s markets. When this happens, Zalando’s profits will be put under a lot of pressure.

Overall thoughts on investing in newly public companies

Investing in the right businesses early on in their life as a publicly traded company can bring very high returns. As only one example, a $1,000 investment in Amazon’s IPO on day 1 in 1997 is worth over $187,000 today.

Still, jumping into a stock on IPO day may not be the best strategy. It makes often more sense to wait a few months or quarters before investing. The main reasons for this are:

• Lack of information: There is usually less information available about companies before they become public – and what is available is often a decision of the company itself -, making it more difficult to make a proper assessment of their value. Companies sometimes artificially improve their results before going public in order to appear more profitable. As more information (both financial and otherwise) becomes available after going public, better decisions can be made whether an investment is worth it, and if yes, at what price.
• Built-up hype: The goal of the IPO – from the company’s standpoint – is to get the highest price for each share issued. As such, I disagree with people who say Facebook’s (ETR: FB2A) IPO was a failure. Good investment banks will often find the best immediate price levels and market them relentlessly to investors. Once the hype and euphoria subsides, prices often come back to Earth — Facebook is a very good example — and investors can buy the stock at a discount.

Waiting a few weeks, months or quarters after the IPO gives you time to learn more about the company’s financials, its potential for the future, and also about the leaders running it. Also, chances are good that you can buy the stock at a price below the day 1 price — and even if the stock keeps on climbing and doesn’t return below the IPO level, if you really think the company is a good long-term investment, it will still be a good one a few months from now as well.

As for the Amazon IPO? For the first month and a half after going public, the share price was below the day 1 closing price. If you happened to invest $1,000 at its lowest level, it would be worth over $231,000 today.