Figures in this article reflect prices as of market close on 12/05/2014 unless otherwise specified.

Shortly before Zalando (ETR:ZAL) went public, I wrote a cautiously optimistic article about Europe’s biggest online fashion retailer, putting it on my watch list.

Since then, the company raised over half a billion euros during its initial public offering (IPO), and it has recently published its first quarterly report as a public company. The quarterly results reinforce my optimism, as I will detail below.

Don’t sweat the IPO

Zalando’s listing was a highly anticipated event and the stock was more than ten times oversubscribed. The company set the offer price at €21.50, close to the high end of the range. However, the share lost around 20% of its value in the week following the IPO.

While the IPO was considered by many commentators a disappointment due to the sharp drop in the share price in the first few weeks, long-term investors should pay little attention to these types of short-term drops. Firstly, IPO prices are often overhyped and are followed by short-term price drops. Secondly, the timing was unfortunate as the listing coincided with a brief market correction in general — the DAX dropped almost 10% in the first half of October.

To illustrate this, it’s enough to look at the stock price now: After a better than expected third quarter, the stock price had a strong jump over the last week and was trading 17% above the IPO price.

Strong growth

Revenues were up 24% in the third quarter compared to 2013 and reached €1.5 billion for the first nine month representing a 28% increase. The growth is especially robust at 40% outside the core DACH (Germany, Austria, Switzerland) region which shows that the company’s efforts at geographic expansion are paying off.

Behind this growth there are improving customer metrics. In the third quarter:

  • the number of active customers grew by 15% to 14.1 million,
  • these customers shop more often at Zalando (average orders per active customer grew from 2.7 to 2.8), and
  • the size of each order is also increasing (from an average of 61 to 64 euros).

There is also little reason to believe the company’s growth will be slowing significantly in the near future. According to a Euromonitor International report:

  • The total fashion market in Europe is stable at about €420 billion.
  • Of this, only €38 billion, or 9%, was online in 2013.
  • The online portion has been growing at an average 19% annually over the last five years.

At the same time Zalando, the market leader in the online segment, had less than five percent of the online market based on its reported sales of €1.8 billion in 2013.

To summarize: Zalando is market leader in the fragmented online fashion industry in Europe which is growing rapidly and still has a lot of room to grow based on the low penetration rate of online sales. The company should benefit from the further increase in online penetration rates, and at the same time it is well positioned to capture further market share within the online market.

In fact, during the quarterly earnings call co-CEO Rubin Ritter reaffirmed a yearly revenue growth rate of 20-25% in the mid-term. In 2014 Zalando’s expectation is that revenue growth will be at the high end of this range, even after a slow start in the winter season for the overall industry.

Improving profitability

The company also showed “extremely strong progress” on the profitability side, even “above [Zalando’s] own expectations” — to quote Ritter again. In the third quarter (Q3), earnings before interest and taxes (EBIT) was €-2.6 million compared to €-50.9 million a year ago. For the first nine months of the year, the company actually generated — for the first time in its history — a positive EBIT of €1.0 million.

This improving profitability is the result of the operating leverage starting to kick in with the increasing sales. All major areas driving profitability showed strong improvements (values are for Q3):

  • Gross margins increased from 37.5% in 2013 to 40.7%, driven by more flexibility on the buying side. What does this mean? As fashion is a highly seasonal industry with quickly changing tastes, the more flexibility Zalando has with its suppliers, the smaller is the risk that it ends up with unwanted products in its inventory that it needs to sell at low margins.
  • Fulfillment costs reduced from last year’s 23.5% to 22.7% as a result of warehouse efficiencies. In this aspect, both the overall volume growth and the increase in the average order size play an important role.
  • Marketing costs showed the biggest improvement with a decrease from 19.4% in 2013 to 11.4%. On the one hand, this is driven by the increase in sales: Advertising costs do not have to increase the same extent as sales do. On the other hand, customer acquisition costs (as a percent of total sales) is also dropping, as more and more of the purchases are from existing customers.

Given that the fourth quarter is usually the most profitable, Ritter is very confident that the company will be profitable for the full twelve months of 2014.

On the mid term, increasing revenues will drive further efficiencies and accelerating profits. The DACH region is already clearly profitable with about 4% EBIT margin — if the trend continues, I believe the rest of Europe can break even as well by 2015.

Focus on capital efficiency

Zalando is also putting a lot of focus on improving its cash position. While inventory levels increased in the third quarter by more than €140 million in anticipation of the fourth quarter — which is usually the strongest in terms of sales –, Zalando didn’t have to pay for this increase. In fact, as a result of its favorable agreements with its suppliers, the company’s payables balance increased by more than €200 million in the third quarter. The company also reduced its Q3 capital expenditures from €26 million in 2013 to €18 million in 2014.

As a result, Zalando generated over €80 million free cash flow in the third quarter and had a cash balance of €467 million at the end of the quarter. If you add the €517 million generated from the IPO, the company was sitting on almost €1 billion of cash on the first day of October — which was more than half of the company’s total assets.

A Foolish assessment

Zalando hit it out of the ballpark with its first quarterly results as a public company. It reported healthy topline growth, strongly improving profits and generated an impressive amount of cash. Moreover, as the online fashion industry in Europe is poised for further growth and Zalando is the market leader, I believe the company has still a lot of growth potential ahead of it. This should bring along further efficiencies and lead to strong profit increase in the coming years. Overall, I feel more confident about Zalando than I was before the IPO and I am seriously considering a small investment in the company.

Neuer Motley Fool Sonderbericht

Der neueste Sonderbericht von The Motley Fool ist "Drei internationale Aktien, die jeder Deutsche besitzen sollte". Hier kannst du eine kostenlose Kopie des Berichts erhalten.

Miklos Szekely does not own any of the stocks mentioned. The Motley Fool does not own any of the stocks mentioned.