Zaras business model drives value rather than volume gains

Zara's business model drives value rather than volume gains

Spanish retail giant Inditex, owner of the Zara brand, is the clear winner in the fast fashion space, analysts believe, with the competitive distance between the company and its peers continuing to increase thanks to its efficient business model. 

Despite having a higher-cost business model, Inditex has a "true" fast fashion proposition thanks to its agile supply chain, which provides it with a sustainable competitive advantage and pricing power, according to Bernstein analysts Jamie Merriman and Jennifer Wong. 

The Spanish fashion giant operates a 3-5 week design-to-delivery cycle for around 50% of its products and a cycle of 10-12 weeks for an additional 15% of product. This compares to 20-25% of production coming from relatively short lead time locations at rivals Primark and Hennes & Mauritz (H&M); likely with a 10-12 week lead time, largely from Eastern Europe. 

Bernstein believes H&M and Primark have average lead times on around 80% of their products, which take around 6-9 months to produce in Asia, using the remainder of production to meet changing fashion trends. 

"These differences have big implications for the cost structures, pricing, and ultimate operating models of Inditex, H&M and Primark," Merriman and Wong say. "We believe that ultimately Zara's business model is founded on a view that fashion is fleeting and that the biggest risk to profit comes from discounts. For H&M and Primark, the value proposition that they offer customers is first about low price – offering the best value to customers, which has enabled both retailers to drive volume growth and share gains."

Inditex model

Zara's business model of driving value rather than volume gains is designed to reduce the risk that clothes are no longer fashionable by the time they reach the store, leading Inditex to choose more unconventional sourcing, distribution and pricing mechanisms. 

Bernstein estimates the company sources 50% of its product from Spain, Portugal and Morocco to enable faster lead times. However, this comes at a price. The analysts believe the cost of sourcing from these countries is around 45% more expensive than sourcing from China. And around 15% of product is sourced from relatively fast Turkey, which is around 37% more expensive than China.

Merriman and Wong add: "Inditex believe the speed that comes from proximity sourcing is worth the price if it helps them reduce markdowns. In addition, Inditex believe the risk of having to markdown outweighs the benefit of sourcing in larger scale and achieving a lower unit cost. As a result, they source in relatively small volumes for any given design, hoping to sell out of each design and thereby reduce markdown risk. This also supports Inditex's plan to create scarcity for their products, as lower quantities have conditioned customers to buy products at full price, as they cannot count on getting them at a discount."

Another method of reducing the risk of markdown is through the use of a centralised distribution platform. Rather than forecasting how much of a given SKU will sell in a certain region over months, Inditex maintains a single stock position and replenishes stores two or more times per week.

Primark and H&M model

Primark's first principle, on the other hand, is to never be beaten on price, while H&M describes its offering as "fashion and quality at the best price." As the analysts explain: "This has meant both retailers use their considerable scale to achieve low prices from manufacturers, largely in Asia, and have passed on this value to clients in the form of low prices, undercutting smaller retailers who may not have a direct supply chain, or who are generally subscale."

Primark sources around 75% of its products from Asia and just 25% from Europe. This broadly allows the retailer to have very low cost on the majority of its products, and still chase recent trends with the quicker supply chain of Europe. 

Similarly, H&M sources around 80% of its products from Asia and the remaining 20% from Europe. Both companies source in large volumes in order to lower unit cost, and their markdowns are also likely lower than the market, given their prices are so low to begin with. They do, however, run more risk of missing a fashion trend or seeing higher markdowns driven by unseasonable weather than Inditex, the analysts say. 

The two retailers also send merchandise directly to country-level distribution centres in order to reduce shipping cost. The flipside to this, however, is the increased markdown risk given the need to make bets earlier in the product cycle about fashion trends. 

Price points

The difference in the business models of the three retailers invariably means the average price points of their product will vary. 

Merriman and Wong explain that, given Inditex's ability to deliver on-trend fashion faster than most peers, in relatively scarce quantities, Zara's products are typically priced at a premium to the market. 

In the UK, Kantar estimates Zara's average selling price of womenswear at around GBP24, compared to a market average of around GBP12. For H&M and Primark, who are focused on leaner supply chains with local scale, average pricing for womenswear is at around GBP10 and GBP4, respectively.

Yet despite the vastly different pricing and business models of the three fashion retailers, the gross margins of Inditex and H&M have converged in the past five years and are now at similar levels, according to Bernstein. 

"With an estimated 140% price premium at Inditex, this suggests that their unit cost of production is around 140% of H&M's. On the other hand, we believe Primark supports its below market pricing by accepting a lower gross and operating margin than peers, which has successfully led to market share gains. Key to this strategy is Primark's ability to recoup margins through driving significant sales volume and therefore operating leverage through the store."

Indeed, Paul Lister, responsible for Primark's ethical trading team, told just-style earlier this year that the retailer chooses not to replicate the margins of its competitors, which can be up to 20% compared to that of Primark's at 10-13%. This, he says, gives the retailer "less room to manoeuvre".

How Primark balances ethics and ultra-low prices

Competitive advantages and risks 

Sizing up the benefits and risks of each business model, Merriman and Wong see Inditex as a clear winner within fast fashion, despite having a higher-cost business model.

"Inditex's 'true' fast fashion proposition, enabled by an agile supply chain (which acts as a significant barrier to entry), provides it with a sustainable competitive advantage and pricing power.

"While the low-price point strategy of H&M and Primark has driven higher market share gains and broader customer reach than Inditex's model, we believe the competitive risks to the model are greater. Indeed, we believe the recent margin performance of H&M reflects that of an 'old' value retailer now being undercut by a 'new' competitor (Primark)."

Merriman and Wong believe H&M will need to price more correctly globally if it is to defend its gross margin as cost price inflation, low priced competition and longer term investments continue to add pressure.

"We believe Inditex has the best business model of any apparel retailer, and in our view, the competitive distance between Inditex and peers is only increasing," they explain. "We expect Inditex to deliver a total shareholder return of around 17% over the next five years. We also expect cash flow generation to improve as Inditex shifts to less capital intensive, higher ROIC (return on invested capital) growth as the revenue mix shifts to e-commerce. We believe this merits a higher multiple than investors have paid historically."

A separate article on just-style last week took a closer look at some of the secrets of success for the fast fashion model:

Why fast fashion isn't a case of one size fits all