Analysis of business activity: Burberry

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Analysis of business activity: Burberry

  1. 1. 3 March 2004 BRBY.L OUTPERFORM* Equity Research Price (02 March 04): 351p Europe/United Kingdom Luxury Goods MARKET WEIGHT research team Anaïs Lallich 44 20 7888 0413 anais.lallich@csfb.com Neville Pike 44 20 7888 0338 neville.pike@csfb.com Burberry Group Rich pickings? OUTSTANDING TRACK RECORD OF VALUE CREATION We believe management has created outstanding shareholder value by turning around the existing business and making sensible acquisitions of brand licensees and distributors. STRONG GROWTH PROSPECTS Burberry brand sales exceeded £2bn in 2002/03 but are mainly generated through licence and wholesale channels in Japan, Spain and the US. In our view, capture of a greater share of the brand value chain offers further value-creating growth potential. We believe possible integration of distribution in Japan (not currently in our estimates) is the main positive catalyst for Burberry. INITIATE WITH AN OUTPERFORM RATING, TARGET PRICE 400P We believe Burberry has an attractive valuation and lower transactional FX exposure than its luxury goods peers. We initiate coverage of Burberry with an Outperform rating and a target price of 400p. The GUS lock-up is due to expire in November 2004. We see this as a potential opportunity to invest rather than stock overhang. FOR IMPORTANT DISCLOSURE INFORMATION relating to analyst certification, the Firm’s rating system, valuation methods and potential conflicts of interest regarding companies that are the subject of this report, please refer to the Disclosure Section at the end of the report. U.S. Regulatory Disclosure: CSFB does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
  2. 2. Burberry Group 3 March 2004 OUTPERFORM* Burberry Group BRBY.L 351 (p) 700 400.00 (p) 600 LUXURY GOODS 500 Price (02 Mar 04) Target price (12 months) Analyst's Coverage Universe MARKET WEIGHT * Stock ratings are relative to the coverage universe in each analyst's or each team's respective sector. Weighting (vs. broad market) Year 3/02A 3/03A 3/04E 3/05E Revenues (£ m) 499.2 593.6 670.7 104.3 135.7 162.3 85.1 130.4 146.3 269.60 325.30 376.62 426.98 12.13 14.64 18.14 20.25 24.9 27.5 27.9 27.2 28.94 23.98 19.34 17.34 181.45 138.98 127.09 124.69 200 Mar-02 180.9 84.8 300 731.6 EBITDA (£ m) 400 Pre-tax profit (£ m) IC (p m) CSFB adj. EPS (p) ROIC (%) P/E (x) P/E rel (%) Jul-02 Nov-02 Mar-03 Price Jul-03 Nov-03 Price relative 1mth 3mths 12mths Absolute (%) 2.0 -22.0 30.0 Relative (%) -1.7 -25.5 0.8 Performance over ROIC/WACC 30% 25% Dividend 2003 (p) 3.01 Dividend yield (%) 0.9 Net debt/equity (3/04E, %) 34 Free float (%) -22.6 20% 495.20 Number of shares (m) 15% 7.6 10% Current WACC (3/04E, %) 5% Historical valuation Year 3/02A 3/03A 3/04E 3/05E Y/E closing price (p) 490.00 312.00 351.00 351.00 Market cap. (£ m) 1,145.9 1,175.5 1,738.2 1,738.2 End year debt (£ m) -21.3 -79.6 -103.6 -103.6 Other liabilities (£ m) 20.0 29.2 29.2 29.2 1,144.56 1,125.12 1,663.73 1,663.73 0% 31 Mar 02A 31 Mar 03A ROIC 31 Mar 04E WACC 31 Mar 05E REV/IC Op. margin Key historical ratios 1.90 25% 1.85 Enterprise value (£ m) 20% 1.80 EV/Revenue (x) 2.3 1.9 2.5 2.3 EV/EBITDA (x) 11.0 8.3 10.3 9.2 15% 1.75 1.70 EV/IC (x) P/E at closing price (x) 4.2 3.5 4.4 3.9 21.3 19.3 17.3 5% 1.65 40.4 10% 1.60 0% 31 Mar 02A 31 Mar 03A 31 Mar 04E 31 Mar 05E Rev/IC Op. margin Strategic analysis Existing strengths: Strong and proven management team. Licensing growth delivers high incremental return on incremental capital. Heritage products. Flexibility in production process. Lower transactional exchange exposure than luxury goods peers. Existing weaknesses: Low vertical integration hinders capture of margin on manufacturing. Low gearing into potential Japanese upside. Apparel segment, which has increased fashion risk, accounts for most of company's profits. Scope for further repositioning? Existing opportunities: Retail network expansion and widening of distribution. Expansion of Burberry brand. Development of accessories in Spain and especially Japan. Increased distribution of Burberry London (Intl) line, especially in Japan. Existing threats: Control over licence and wholesale accounts. Company is monobrand and trademark check is core, so increased fashion risk? Reliance on third parties in Japan. Company description Burberry is a global high-end apparel company that has recently grown into a multiproduct lines business through brand extension. 2 EV/EBITDA (at historical prices) 12.0 10.0 8.0 6.0 4.0 2.0 0.0 31 Mar 02A 31 Mar 03A 31 Mar 04E EV/EBITDA 31 Mar 05E Source: FTI, Company data, Datastream, CSFB (EUROPE) LTD. Estimates The price relative chart measures performance against the FTALLSH index On 02/03/04 the FTALLSH index closed at 2267.9 On 02/03/04 the spot exchange rate was £0.66/eu 1. - eu1.22/US$1
  3. 3. Burberry Group 3 March 2004 Figure 1: Burberry Investment Summary 4 4 4 3 Catalysts OUTPERFORM Risk Containment 351.0p 400.0p 14.0% Business Momentum Investment Rationale Value - 3 As of 2-Mar-04 Mar 04E Mar 05E Current P/E (x) EV/EBITDA (x) Fundamentals 3 Value Share price Rec. and Target price Potential up/downside (%) 4 At TP Trading Range* 24.0 12.4 27.3 14.6 11.1x to 20.1x 6.7x to 11.6x Mar 04E Mar 05E 130 146 162 181 PBT EBITDA Current 19.3 10.3 * Average year high and year low since July 2002 Catalysts - 4 - Development of retail square footage with a focus on increasing retail presence in the US and non Japan Asia. - Repositioning of men apparel segment. - Development of accessories. - In the medium-term, we believe Burberry will have the opportunity to extract value from improving its supply chain management. - Possible integration of distribution in Japan (not currently in our estimates) is the main positive catalyst for Burberry - We believe this will likely be through development of accessories within Burberry London (International) line - Intentions of GUS? Risks Containment - 4 - Outsourcing of production activities provides increased flexibility - Lower transactional exposure combined with lower inventory holding period imply low risk profile BUT - Burberry is mono-brand and trademark check is core so increased fashion risk? - GUS fundamentally seller: overhang or opportunity to invest? Business Momentum - 3 - We believe creation of shareholder value to date has been in part as a result of astute picking of low hanging fruits after years of brand neglect. In our view, the challenge now is to find significant value enhancing growth opportunities. - In the future, we believe that Burberry's advantage from superior pricing power may be diminishing. - After strong share price performance post listing, share price momentum has recently slowed - Burberry has underperformed our CSFB Luxury Goods Index by 10% since 20/11/2003. EPS Sensitivity 10% Turnover 1% EBITA margin BRBY.L 9.9% 4.4% Revenue growth Mar 04E* EPS Growth Mar 03A EPS CAGR Mar04E-Mar06E BRBY.L 13.2% 20.7% 12.1% * Excluding FX effects Fundamentals - 4 - Strong and proven management team. - Outstanding track record of shareholder value creation since April 2000. - Low vertical integration into production provides flexibility and low transactional exchange exposure. - Growth in licensing activities delivers high incremental ROIIC but upside in revenues is limited to increased royalties - High fixed assets and working capital efficiency Investment Rationale - 4 - Burberry has strong fundamentals and an outstanding track record of value creation from expansion and acquisitions of brand licensess and distributors - We believe Burberry has substantial scope to develop sales of Burberry branded products and capture a greater share of the brand value chain - Key long-term catalyst is development of sales of International Burberry London line in Japan, mainly through accessories. - Relative valuation offers potential upside. Source: Company data, CSFB estimates 3
  4. 4. Burberry Group 3 March 2004 Investment summary Burberry brand sales exceed £2bn Outstanding value creation Burberry is a high-end apparel (60% of 02/03A revenues) and accessories (29% of 02/03A revenues) business. According to company data, total global retail value of products sold under the Burberry name exceeded £2bn in the year ending March 2003. Burberry’s business model has evolved substantially over the past few years after concerted management focus instigated by the company’s main shareholder, GUS Plc, in 1997. Through turnaround of a neglected brand and sensible acquisitions, Burberry has delivered outstanding shareholder value (average incremental return on incremental invested capital of 34.7% over the last three reported years). However, in our view the current focus of distribution on licensing (10% of 02/03A turnover but 45% of EBITA) in Japan and wholesale (52% of 02/03A turnover) in Spain and the US effectively leaves the company with a low gearing to upside potential in consumer demand in these key markets (Japan represents over 50% of brand sales, and Spain and the US together account for around 25%). We believe Burberry has opportunities for future value creation through expanding sales of Burberry-branded products and especially seizing opportunities to capture a greater share of the brand value chain. Main positive catalyst is Japan, in our view In particular, we believe the key positive catalyst for the stock will be the actions taken with regard to Japan. The main licences on this market will likely run until 2020, but the licence on the Burberry London (International) line will expire in June 2005. The Burberry London (International) line has been key to the successful repositioning of the Burberry brand in Europe and in the US, and we believe there is substantial scope to develop sales of this product line in Japan, mainly through accessories. Other positive catalysts include . . . In our view, other key positive catalysts for the stock include the development of retail square footage with a focus on increasing retail presence in the US (where the group has just 26 directly operated stores (DOS) compared with 86 for Louis Vuitton and 39 for Polo Ralph Lauren) and non-Japan Asia; the repositioning of the men apparel segment and the development of accessories. Also, in the medium term, we believe Burberry will have the opportunity to extract value from improving its supply chain management. Burberry is not a traditional luxury goods company. Rather, we believe Burberry's business model has attributes of both retail and luxury goods companies. Figure 2: Summary drivers of value Burberry LVMH Richemont Swatch 3 3 2 3 3 2 2 3 5 4 2 2 2 2 3 5 4 1 4 W orking capital 5 1 4 4 3 2 3 Vertical integration 1 2 4 4 3 1 3 Management 4 3 2 5 4 1 4 Design / quality 3 3 3 3 3 3 3 21.0 People Hermès 3 Pricing power Operational Gucci 4 Business mix Structural Bulgari Geographical mix 16.0 22.0 29.0 23.0 13.0 22.0 Total Low score 1 2 3 4 High score 5 Source: CSFB research 4
  5. 5. Burberry Group Business model between relevant retail and luxury goods companies A preferred play in the sector 3 March 2004 Overall, Burberry is not highly vertically integrated. Most of production activities are outsourced and integration into retail though increasing still remains rather low. Significantly, the company has a degree of natural hedging against currency movements as it has a high diversity of cost and revenue split on the wholesale and retail segments. Also, because Japan is operated as a licence, Burberry has much lower transactional exchange exposure on the yen. This lower transactional exposure, combined with a lower inventory holding period (117 days in 2002/03A), implies that Burberry has a lower risk profile than other luxury goods companies. Although diversification of sourcing has helped flexibility and costs, paradoxically, it does lower the degree of strength obtained from brand legitimacy. In terms of other risks, the extension of activities in Japan will likely be a difficult task, requiring brand migration and careful management of existing relationships. In addition, we believe Burberry has higher fashion risk as it is mono-brand and relies heavily on check. Our overall assessment of the investment case for Burberry within our luxury goods universe has been made according to five criteria: Value (how inexpensive is the stock); Catalysts (what company-specific events will make the stock perform); Risk (risk factors relating to the stock); Business momentum (is business getting better); and Fundamentals (best fit with our drivers of value in the sector). Figure 3: Investment summary Burberry Value Catalysts Risks Business m om entum Fundam entals Investm ent Rationale Recom m endation Current Price P/E m ultiple at current price 2003E 2004E Target Price Bulgari Gucci Herm ès LVMH Richem ont Sw atch 3 4 4 3 4 2 2 2 2 3 2 3 5 3 4 3 3 3 4 5 4 3 3 4 4 2 2 3 2 2 4 3 3 3 4 4 2 4 2 3 3 4 OUTPERF. UNDERPERF. NEUTRAL NEUTRAL 351.0 p € 7.3 € 69.8 € 164.0 € 62.5 SFr 33.7 SFr 166.3 19.3 17.3 26.1 23.6 21.6 27.8 29.7 26.7 28.1 22.8 22.0 18.3 19.8 16.8 400.0 p € 6.3 € 73.2 € 145.0 € 62.5 SFr 24.0 SFr 185.0 Low score 1 2 OUTPERF. UNDERPERF. 3 4 OUTPERF. High score 5 Source: Datastream, CSFB estimates GUS relationship A further factor in the Burberry investment case concerns the position of GUS. In July 2002, Burberry was partly listed on the London Stock Exchange. GUS today owns approximately 66% of Burberry and has for several years described this investment as a non-core holding. We believe GUS’ placing of an 11% stake in Burberry in November 2003 reinforced market expectations that Burberry’s free float could increase substantially over the next few years. GUS’ lock-up expires in November 2004; we see this as an opportunity to invest rather than stock overhang. Initiating with an Outperform rating and a 400p target price In summary, our view is that Burberry has strong fundamentals and long-term catalysts, together with an outstanding track record of value creation. We initiate coverage of the stock with an outperform rating and a 12-month share price target of 400p, based on DCF valuation. This represents a 14% potential premium to the closing price on 2 March 2004. 5
  6. 6. Burberry Group Importance of contribution from licensing . . . but wholesale and retail EBITA growing 3 March 2004 Figure 4: Turnover and EBITA by class of business As of March 2001 As of March 2003 Turnover Turnover 90% 89% 57% EBITA 55% EBITA 43% 45% 11% 10% Wholesale & Retail Wholesale & Retail Licence Licence Source: Company data, CSFB estimates Asia Pacific represents 25% of Burberry’s reported turnover, but Japan alone accounts for over half of Burberry brand sales Figure 5: Turnover by geography, 02/03A Asia Pacific 25% Figure 6: Turnover by product category, 02/03A Other 1% Women 33% Men 27% Europe 50% Licence 10% North America 24% Others 1% Source: Company data Accessories 29% Source: Company data Figure 7: Burberry sales and EBITA by channel and geography (02/03A) Burberry - Sales by channel and region of destination Importance of Spanish wholesale operations to turnover Wholesale Retail Licence Total UK 11% 10% 0% 21% RO Europe 22% 7% 0% 30% Americas 9% 14% 0% 24% Japan 1% 0% 8% 9% RO Asia 8% 8% 0% 15% Total sales 52% 38% 10% 100% RO Asia 4% 5% 0% 10% Total EBITA 28% 27% 45% 100% Burberry - EBITA by channel and region of destination Contribution of Japan licensing agreements to group profitability UK 6% 7% 2% 15% RO Europe 12% 5% 2% 20% Americas 5% 10% 2% 17% Japan 1% 0% 38% 39% 0-5% Wholesale Retail Licence Total 5-9% 10-19% 20% + Source: Company data, CSFB research. * Assumes consistent margin across regions—CSFB assumption 6
  7. 7. Burberry Group 3 March 2004 Figure 8: Stores A s of H1 results 160 Korea acquisition in June 2002 added 47 concess ions 23 80 23 62 120 64 18 14 6 17 6 41 47 49 Mar 01 45 10 34 40 Mar 02 Mar 03 Sept 03 0 Mar 00 DOS Conc essions Outlet stores Source: Company data Figure 9: Efficiency Matrix Figure 10: Average IC & Turnover growth 600 3.0 Avg. Inv. Capital Turns Burberry’s efficiency profile has changed substantially, mainly as a result of acquisition of Spanish licensee 140% Sector Avg. NOPAT Mg. Mar-00 100% 2.5 Mar-01 400 Mar-03 Mar-04E 2.0 Mar-02 60% 200 Mar-05E 1.5 20% Sector Avg. IC x 1.0 0 5% 10% 15% 20% -20% Mar-00 Mar-01 Mar-02 Mar-03 Mar-04EMar-05EMar-06E Average IC NOPAT Margins Turnover Growth Av. IC Growth Source: Company data, CSFB estimates Source: Company data, CSFB estimates Figure 11: Price and Price Relative Figure 12: Summary of brands 3/3/04 Main lines 450 Burberry Prorsum (High fashion range) 400 Burberry London International (Core collection) 350 Spain Thomas Burberry 300 Burberry London 250 Japan Burberry London 200 Burberry Blue Label 150 Burberry Black Label Scotch House 100 J A S Burber ry Gr oup O N D J F M A M J J A S O N D Burber ry Gr oup relative to Lux ury Goods Nar r ow Index Sour ce: DATASTREAM Others Accessories (Handbags, scarves, shoes) Product Licences (Fragrances, Eyewear...) Source: Datastream 7 Source: Company data, CSFB estimates
  8. 8. Burberry Group 3 March 2004 Strategic assessment Burberry’s distribution is focused on wholesale and licensing Burberry is a high-end apparel (60% of 02/03A revenues) and accessories (29% of 02/03A revenues) business. Although Burberry has achieved significant retail expansion over the past few years, the distribution still is mainly focused on wholesale (52% of 02/03A turnover) and licensing (10% of 02/03A turnover but 45% of EBITA). Key to Burberry are the management of licensing relationships in Japan (Sanyo Shokai and Mitsui & Co) and wholesale relationships in the US, and in Spain (El Corte Ingles). Burberry also has licensing agreements for certain growing product lines such as Eyewear, Fragrances, Timepieces, Childrenswear, etc. Licensing implies lower gearing to potential upside in consumer demand On the positive side, growth in licensing activities requires little additional capital and has high EBITA margins and so delivers high incremental return on incremental invested capital. However, if demand rises, Burberry's upside potential in revenues is limited to increased royalties, which represent only a fraction of sales under its brand name. It does not benefit from any operational gearing on licensed products. Also, the importance of wholesale and licensing operations raises control issues, as Burberry effectively relies on external parties for a large part of group EBITA. Outsourcing of manufacturing activities Over recent years, Burberry has reduced the level of in-house manufacturing activities to concentrate on core outerwear products where the brand has the greatest legitimacy. This ensures that Burberry retains key manufacturing skills, while allowing it to fully capture the value that is added on products that have less fashion risk. Integration into manufacturing is lowest on fashion lines and non-core products, which exhibit greater volatility. In this case, products are sourced from third parties mainly located in Europe. This provides increased flexibility and reduces transactional exposure but reduces the margin and value capture from manufacturing. SWOT analysis A summary SWOT analysis is given in Figure 13. Figure 13: Burberry: SWOT analysis Existing Strengths - Strong and proven management team - Licensing growth delivers high incremental return on incremental capital - Heritage products - Flexibility in product sourcing - Lower transactional exchange exposure Existing Weaknesses - Low vertical integration reduces capture of margin and value from manufacturing - Low gearing into Japanese upside - Apparel segment which has increased fashion risk still accounts for most of company's profits Opportunities - Retail network expension + Widening of wholesale distribution - Extension of apparel offering - Further development of accessories in Spain and especially in Japan - Increased distribution of Burberry London (International) line, especially in Japan Threats - Conflicting interests of GUS and external Burberry shareholders? - Reliance on 3rd parties in Japan - Control over licensees and wholesale accounts - Company is mono-brand and trademark check is core so increased fashion risk? - Counterfeiting Source: CSFB research 8
  9. 9. Burberry Group 3 March 2004 Drivers of value We have identified seven key drivers of value in the luxury goods sector, our ‘design for success’. For further detailed discussion on the drivers of value, please refer to our report, Luxury goods: Handbags at five paces, dated 12 May 2003. Positioning between relevant retailers’ and luxury goods companies’ business models We illustrate in Figure 14 the positioning of Burberry's business model with respect to each of these seven drivers. Clearly, Burberry is not a traditional luxury goods company. Rather, we believe Burberry's business model shares common features with those of relevant retailers and luxury goods companies. This positioning in Figure 14 is not qualitative and does not intend to define ‘good’ versus ‘bad’ but rather to enable better assessment and understanding of Burberry's business model. We position Burberry by reference to two competitive sets made of independent European quoted companies covered by CSFB research. The luxury goods competitive set is made of Bulgari, Gucci, Hermès, LVMH, Richemont and Swatch. We assume a relevant retail competitive set includes: Hugo Boss, Hennes & Mauritz and Inditex. Figure 14: Positioning of Burberry's business model Retail Luxury Goods Geographical Mix Structural Business Mix Pricing power Operational Working capital Vertical Integration Management People Design / Quality Source: CSFB research On four out of the seven identified drivers, we believe Burberry is more comparable to companies included in our relevant retail set. 1) Regarding geographical mix, Burberry has low transactional exposure due to outsourcing of production activities, which allows production in various countries and currencies. Also, the company has much lower transactional exchange exposure to the yen because Japan is operated as a licence. 9
  10. 10. Burberry Group 3 March 2004 2) Working capital analysis shows that Burberry's cash conversion cycle is short due to inventories, including low raw materials and WIP materials and mainly finished goods. This is a direct consequence of the importance of third-party suppliers, which effectively take on a large share of Burberry's inventories. 3) Burberry is not highly vertically integrated. The company is responsible for or oversees the design of all ranges and lines but has deliberately limited production capacities. Despite recent acquisitions of licensees in Spain and distributors in Korea and the Asia Pacific, combined with ambitious retail extension, over 50% of the total global retail value of products sold under the Burberry name are sold through licensees in Japan and 52% of reported turnover in 02/03A was realised through wholesale distribution. 4) On management, CEO Rose Marie Bravo has a retail and wholesale background having previously served as President of Saks Fifth Avenue in the US and Chairman and CEO of Macy's Magnin speciality division. Burberry's business mix consists almost entirely of apparel and accessories. We position it mid-way between our relevant retail and luxury goods companies set, as Burberry’s business mix seems comparable to that of H&M, Hugo Boss and Inditex but also to that of Gucci and Hermès. On pricing power, Burberry has common characteristics with both competitive sets. On one hand, Burberry sells premium products in a high-quality distribution network. This positioning is synonymous with higher prices and higher distribution costs. However, the company has much lower transactional exchange exposure than the luxury goods companies and therefore does not need to make up as much revenue in times of adverse exchange-rate movements. Also, Burberry has in the past increased fees due by its Japanese licensees, Sanyo Shokai and Mitsui & Co. On design and quality, Burberry is clearly akin to the luxury goods companies set. Burberry has core heritage products, a high fashion range (Burberry Prorsum) launched in 1999, a core high-end Burberry London (International) product line and a wellrecognised Design Director, Christopher Bailey, who previously worked at Gucci and Donna Karan. Assessment of performance against drivers of value Armed with the diagram shown in Figure 14, and assessing the positioning of Burberry's business model, we will now evaluate the company's performance relative to its peer group. Figure 15 below summarises our assessment of the performance of Burberry alongside the companies of the luxury goods universe for each of the seven drivers of value. This analysis is made in both relative and absolute terms. We look at how companies compare with one another, but we also set our analysis in a broader context and assess their performance on an absolute basis. 10
  11. 11. Burberry Group 3 March 2004 Figure 15: Summary drivers of value Burberry LVMH Richemont Swatch 3 3 2 3 3 2 2 3 5 4 2 2 2 2 3 5 4 1 4 Working capital 5 1 4 4 3 2 3 Vertical integration 1 2 4 4 3 1 3 Management 4 3 2 5 4 1 4 Design / quality 3 3 3 3 3 3 3 21.0 People Hermès 3 Pricing power Operational Gucci 4 Business mix Structural Bulgari Geographical mix 16.0 22.0 29.0 23.0 13.0 22.0 Total Low score 1 2 3 4 High score 5 Source: CSFB research Geographical mix Vertical integration 2 1 4 4 3 1 3 Bulgari Burberry Gucci Hermès LVMH Richemont Swatch Burberry reports in British pounds. Assuming no variation from exchange rates as of 5 January 2004, we expect a favourable euro movement of 7.3%, an adverse yen movement of 2.0% and an adverse US dollar variance of 10.3% for the year ending March 2004. We expect that the trade-weighted impact of exchange movements on Burberry revenues will be –0.5%. Figure 16 and Figure 17 below show Burberry's geographical mix of revenues and currency exposure. Figure 16: Geographical mix of revenues Figure 17: Estimated currency mix 02/03A 02/03A Asia Pacific 25% Other 1% Japanese Yen 23% British Pound 21% Europe 50% North America 24% Source: Company data US Dollar 24% Euro 32% Source: Company data, CSFB estimates However, the revenue exposure is only one element of the equation. From discussion with Burberry management, we understand that the Burberry London (International) and Burberry Prorsum lines are manufactured as follows: 20% in the UK, 70% in Italy and 10% in other countries including the US, where Burberry owns a factory. Burberry London (Spain) and Thomas Burberry (mainly sold in Spain) are manufactured locally out of Spain, Portugal and Morocco. Finally, the Japanese lines, Burberry Blue and Black labels, Burberry London and Scotch House are made 100% locally. 11
  12. 12. Burberry Group 3 March 2004 The diagram shown in Figure 18 is a simplified presentation of Burberry's exchange rate exposure. It shows how Burberry is positioned compared with the relevant retail and luxury goods competitive sets by reference to two metrics: diversity of revenue split (X axis) and diversity of cost split (Y axis). Figure 18: Summary presentation of exchange-rate exposure 3 - Deflationary pressures 4 - Hedged Diversity of cost split Retail 1 - Domestic Goods Burberry 2 - Transactional exchange exposure Corner shop Luxury Goods Diversity of revenue split Source: Company data, CSFB estimates - Quadrant 1 (low diversity of cost split and revenue split) “corner shops”, i.e. local retailers of locally produced goods, which due to the domestic nature of their business do not have exchange exposure. - Quadrant 2 (low diversity of cost split and high diversity of revenue split) includes luxury goods companies, which typically sell their products globally but manufacture them in euros or Swiss francs. The value proposition of these products is often closely linked to particular geographical regions (e.g. Swiss watches). This discrepancy between cost and revenue currencies gives rise to transactional exchange-rate exposure, accentuating the impact of adverse currency movements, especially if inventory turns are low. - Quadrant 3 (high diversity of cost split and low diversity of revenue split) includes retailers, which source their products from a wide variety of regions and in a variety of currencies but sell them in a small number of markets. The ability to source products from a variety of third parties in all countries gives rise to intense competition on prices and therefore leads to deflationary pressures. - We position Burberry in Quadrant 4, i.e. high diversity of cost and revenue split. On the wholesale and retail segments (i.e. 90% of 2002/03A turnover), we believe that Burberry has a natural hedge against currency movements, as it manufactures products in several different countries and currencies and sells them in the US, Asia Pacific and 12
  13. 13. Burberry Group 3 March 2004 Europe. Also, because Japan is operated as a licence, Burberry has much lower transactional exposure on the yen. Figure 19 shows our estimates of Burberry's split of sales and cost of goods sold (COGS) by currency for the year ending March 2003. Figure 19: Split of turnover and cost of goods sold by currency (02/03A) COGS Pound (£) Euro (€) Dollar ($) Yen (¥) Total Pound (£) 5% 16% 21% Turnover Euro (€) Dollar ($) 6% 5% 26% 12% 7% 32% 24% Yen (¥) 23% 23% Total 16% 54% 7% 23% 100% Source: Company data, CSFB research From the analysis shown in Figure 19, we conclude that Burberry is long US dollar revenues and long euro costs with a neutral exposure to the yen. Therefore, we believe that Burberry has lower transactional exchange exposure than other luxury goods companies. Business mix Busine ss m ix 2 2 3 5 4 2 2 Bulgari Burberry Gucci Herm ès LVM H Richemont Swatch The luxury goods companies show a great diversity of business mix across a variety of different product areas including, fashion and leather, watches and jewellery, perfumes and cosmetics, wines and spirits and luxury retailing. Being mainly focused upon one of these segments—"fashion and leather"—through its womenswear, menswear and accessories product categories, Burberry is more narrowly focused. While the fashion and leather segment is our preferred luxury segment, we believe Burberry has increased fashion risk relative to its luxury goods peer group due to three main reasons. 1) The company is mono-brand. 2) The apparel segment accounts for a vast majority of revenues and profits. 3) The trademark check remains core even if its visibility has been subtly adjusted over the past few years. Today, the apparel collection is made up as follows: 10% with the check as an obvious logo, 10% with the check as a seasonal variation, 40% with the check as a lining and the remaining 40% of the collection is check free. However, it is fair to point out that the various Burberry product lines provide the company with a reasonable range of price points. 13
  14. 14. Burberry Group 3 March 2004 Pricing power Pricing power 2 2 3 5 4 1 4 Bulgari Burberry Gucci Hermès LVMH Richemont Swatch The ability to raise prices without negatively affecting demand is, in our view, critical to long-term value creation in luxury goods. This is particularly so at a time of downward pressure on revenues resulting from adverse currency movement. Looking at EBITA margin relative movement (as we had previously done for the rest of the Luxury Goods sector) does not provide very useful information on pricing power in the case of Burberry, considering the changes the company has been through over recent years. However, the analysis in Figure 20 leads us to conclude that Burberry does have pricing power. Retail sales (excluding the impact of the Korea acquisition) have increased over the last few years, quicker than retail square footage, leading to a progression in retail sales per square foot. In the meantime, EBITA margin on the Wholesale and Retail channel has increased. If sales per square foot have increased as well as margins, then this is prima facie evidence that the growth has been achieved without having to resort to additional discounting. Figure 20: Extension of retail sales and square footage (excl. impact of Korea acquisition) £ in millions, unless otherwise stated Mar-01 Retail Sales Mar-02 Mar-03 Mar-04E 143.2 156.9 228.4 262.7 288.9 9.6% 45.6% 15.0% 10.0% 262,774 310,073 353,273 393,593 18.0% 13.9% 11.4% 597 737 744 734 9.6% 12.1% 13.5% 13.8% Revenue Growth Retail Square footage (sq ft m) Retail Square Footage Growth Retail Sales per square foot (£) Wholesale and Retail Margin 7.6% Mar-05E Source: Company data, CSFB estimates Our analysis is backed by discussions with the company, which confirmed that EBITA margin progression over recent years was partly explained by increased prices, together with increased volumes. Pricing has increased as part of the repositioning, and Burberry today sells premium products in a high quality distribution network. Higher prices partly compensate for higher distribution costs. Company policy is to pass the adverse impact of exchange rates on to customers. Management stated that for the Spring 2003/04 collection, US dollar denominated retail prices would increase by about 3%. As regards next autumn’s collection, US dollar denominated retail prices should increase by 3–4%. Although these increases are lower than those announced by other luxury goods companies, including LVMH, an important factor to take into account is that Burberry has lower transactional exchange exposure than other European luxury goods companies and therefore does not need to make up as much revenues in times of adverse exchange-rate movements. Finally, Burberry has increased royalty fees due by its Japanese licensees, Sanyo Shokai and Mitsui & Co. The Japanese licensing agreement was renegotiated in late 2000 and runs until 2010, with a ten-year renewal close based on volumes. The next and last increase in royalty fees will take place in January 2005 and will represent £3m. From then on, there will be no increases until 2010. In the future, we believe that Burberry's advantage from superior pricing power may however be diminishing. Retail prices have increased as part of the repositioning which 14
  15. 15. Burberry Group 3 March 2004 is now largely complete. In addition, there is no further increased in Japanese royalties planned until at least 2010 and possibly 2020. Working capital Working capital 1 5 4 4 3 2 3 Bulgari Burberry Gucci Hermès LVMH Richemont Swatch We believe that inventory holding periods become highly significant during periods of fluctuating exchange rates. After successive adverse foreign-exchange movements in recent years, companies with high inventory holdings and transactional exposure are effectively locked into sustained downward pressure on margins, in our view. With a low inventory holding period (117 days in 2002/03A) and a low transactional exposure, Burberry has a risk profile lower than companies in our luxury goods competitive set. The table in Figure 21 shows the details of Burberry's cash conversion cycle as well as the average inventory holding period for the luxury goods and relevant retail competitive sets. For the purpose of this analysis, we show inventories of "watches and jewellery" companies (Bulgari, Richemont and Swatch) separately. Figure 21: Burberry working capital analysis and inventories comparison 2000 2001 2002 2003E 2004E 2005E 157 23 -29 151 121 60 -44 137 121 57 -40 138 117 53 -38 132 117 53 -38 132 117 53 -38 132 Burberry Inventory - future days COGS Days sales in trade receivables Accounts payable (days COS and SG&A) Cash conversion cycle Inventory: Luxury Goods competitive set (excluding Watches and Jewellery)* Gucci Hermès LVMH Average 168 209 265 214 205 224 292 240 213 236 274 241 200 210 265 225 200 210 260 223 200 210 250 220 588 371 198 386 657 461 227 448 599 440 240 426 600 420 226 415 610 405 224 413 610 405 225 413 Inventory: Watches and Jewellery companies* Bulgari Richemont Swatch Average Inventory: Relevant Retail competitive set* Hennes & Mauritz 108 82 75 Hugo Boss Inditex Average 121 70 100 149 83 105 162 72 103 Source: Company data, CSFB estimates *Based on future days COGS. Inventory turns are closest to our relevant retail set of companies and especially H&M. However, it is important to point out that even if Burberry has lower inventories than companies in the luxury goods sector, it still bears an indirect economic risk. Production by third parties is made at the request of Burberry and, if a supplier does not manage to sell its stock of Burberry-branded products through the ‘fault’ of Burberry, then Burberry will generally either purchase the inventories or compensate the supplier through other means. Discussions with management confirmed that although Burberry does not own the title to inventories held at third parties, it does bear a degree of economic risk attributable thereto. 15
  16. 16. Burberry Group 3 March 2004 The acquisition of the Spanish licensing operations, in June 2000, has contributed to better working capital management. The Burberry Spain acquisition included a welldeveloped supply chain capability, which has been inspirational to the rest of the company. In addition, Burberry has begun a pilot programme looking at direct shipping of finished goods from suppliers to wholesale accounts in specific regions, which also contributes to shorten the company's cash conversion cycle. Vertical integration Vertical integration 2 1 4 4 3 1 3 Bulgari Burberry Gucci Hermès LVMH Richemont Swatch Overall, Burberry is not highly vertically integrated. Most of production activities are outsourced and integration into retail though increasing still remains rather low, with a marked preponderance of wholesale and licensing activities. On balance, we prefer companies that are highly integrated into production, as it reinforces the legitimacy of the brand, and into retail, as it enables higher capture of margin and economic value from these elements of the product value chain. Figure 22 shows fixed asset efficiency for Burberry compared with our luxury goods set and our relevant retail set. Burberry fixed asset turns are relatively high, and if the intensity had been calculated based on the retail value at brand sales, rather than reported turnover, then the fixed asset turns would have been much greater and the level of vertical integration indicated manifestly lower. Figure 22: Retail distribution and fixed asset efficiency 1999 2000 2001 2002 45 34 -24.4% 4.3 2.6% 41 20.6% 4.0 2.8% 47 14.6% 3.7 3.2% 7.7 4.8 3.6 3.4 5.3 4.1 8.0 3.7 3.1 2.9 4.3 3.9 8.8 2.8 3.0 3.3 4.6 3.6 7.4 10.6 2.5 7.5 6.6 2.6 8.7 6.0 3.0 Burberry Number of directly operated stores Growth in number of stores Fixed Assets turns * D&A (excl. G/W) to sales 3.9 2.5% Fixed Asset turns of Luxury Goods competitive set * Bulgari Gucci Hermès LVMH Richemont Swatch 7.2 3.6 3.3 3.0 6.1 3.6 Fixed Asset turns of Relevant Retail competitive set * Hennes & Mauritz Hugo Boss Inditex 11.0 10.0 2.3 Source: Company data, CSFB estimates. * Excluding adjustment for operating leases due to lack of comparable data. In terms of integration into manufacturing, Burberry is responsible for or oversees the design of all ranges and lines but has chosen to limit in-house production capacities. The strategy adopted as part of the brand repositioning has been to maintain manufacturing competency in core outerwear products and outsource the rest of the production to specialised third-party suppliers with few long-term agreements. 16
  17. 17. Burberry Group 3 March 2004 As regards integration into retail, despite recent acquisitions of distributors in Spain (June 2000), Korea (March 2002) and Asia Pacific (December 2001) and ambitious retail extension, over 50% of the total global retail value of products sold under the Burberry name are sold through licensees in Japan and 52% of reported turnover in 02/03A was realised through wholesale distribution. The table in Figure 22 highlights the growth in directly operated stores. Yet retail represented only 38% of turnover in the year ending March 2003. Total retail selling space expanded from approximately 260,000 square feet as of March 2002 to approximately 360,000 square feet as of March 2003 (including 50,000 square feet attributable to the ‘Korea’ acquisition), and company guidance suggests above 400,000 square feet of selling space as of March 2004. Looking at licensing and wholesale arrangements, Burberry has long lasting and key relationships with Sanyo Shokai and Mitsui & Co, its Japanese licensees, and with wholesale accounts in the US and especially in Spain (El Corte Ingles). Burberry also has licensing agreements for certain growing product lines such as Eyewear, Fragrances, Timepieces, Childrenswear, etc. On the positive side, licensing growth delivers high incremental return on incremental capital and outsourcing of production provides added flexibility. However, we believe low vertical integration hinders the capture of margin and also economic value on manufacturing, and the licences in Japan result in a low gearing into potential upside. Also, the high importance of licensees and wholesale accounts raises control, dependence and legitimacy issues, in our view. Overall, Burberry’s fixed asset turns are - Higher than for Hermès, LVMH and Gucci, as the company is less vertically integrated and captures lower value from the product chain. - Lower than for Bulgari and Richemont. But in the case of watches and jewellery companies, fixed asset intensity is less of an issue because the cost of materials and the inventory holdings period are so high. - Lower than for H&M and Hugo Boss, which is to be expected in our view, considering H&M and Hugo Boss are pure retailers. We believe that the low level of integration of Burberry represents an opportunity for the company. In our view, Burberry has scope to increase integration into distribution, particularly in Japan. Management Management 3 4 2 5 4 1 4 Bulgari Burberry Gucci Hermès LVMH Richemont Swatch Consistent with plans to reinvent Burberry as a luxury brand, a new management team was hired by GUS Plc from 1997. The most publicised of these appointments was the hire of Rose Marie Bravo to the position of CEO. Ms Bravo had previously worked as President of Saks Fifth Avenue in the US and had an extensive knowledge of merchandising and distribution, together with a valuable wholesale understanding and network. Management has focused on: 1) eliminating inappropriate wholesale accounts, mainly to put an end to parallel trading; 2) renegotiating Japanese licences agreements; 17
  18. 18. Burberry Group 3 March 2004 3) closing unprofitable and non-core retail stores; and 4) acquiring the Spanish licensee and the Asian and Korean distributors. Our assessment of management has been made on the premise that management should be judged on its historical record and on the merits of the strategy for taking a group forward and should be held to account for its performance in successfully delivering against this strategy. As shown in Figure 23, Burberry has consistently delivered incremental return on incremental capital. Incremental ROIIC has averaged 34.7% between the last three reported years. Figure 23: Returns on invested capital and incremental invested capital £ in millions, unless otherwise stated Mar-00 Mar-02 Mar-03 Mar-04E Mar-05E Mar-06E 86 13 30.1% Invested capital NOPAT @ 30% tax ROIC ROIIC Mar-01 238 48 29.7% 23.1% 270 63 24.9% 47.7% 325 82 27.5% 33.2% 377 98 27.9% 31.8% 427 109 27.2% 22.0% 498 123 26.5% 19.0% Source: Company data, CSFB estimates We believe management has delivered outstanding value creation in turning Burberry around, both through existing operations and acquisitions. Management has a proven ability to generate returns. In our view, the challenge now is to find significant valueenhancing growth opportunities. Figure 24 shows the direction of our invested capital turn and NOPAT margin assumptions going forward. We believe ROIC improvement will be driven by margins rather than invested capital efficiency. Figure 24: Efficiency matrix 3.0 Mar-01 Invested Capital Turns Mar-00 Sector Avg. NOPAT Mg. 2.5 Mar-03 2.0 Mar-02 Mar-04E Mar-05E 1.5 Sector Avg. IC x 1.0 WACC line at 7.6% 0.5 0.0 0% 2% 4% 6% 8% 10% NOPAT Margins Source: Company data, CSFB estimates 18 12% 14% 16%
  19. 19. Burberry Group 3 March 2004 Design/quality De sign / qua lity 3 3 3 3 3 3 3 Bulgari Burberry Gucci Hermès LVMH Richemont Swatch In 1998, Roberto Menichetti joined Burberry as Design Chief and Creative Director. The following year, Burberry launched the high-fashion Prorsum range, featured at the Milan fashion week. This range is the source of inspiration of other Burberry lines. It was established to reinforce Burberry’s luxury goods positioning and be a source of indirect marketing through the attraction of considerable media attention. In May 2001, Christopher Bailey was appointed to replace Mr Menichetti. Mr Bailey joined from Gucci, where he had been working since 1996 as Senior Designer, and previously worked as a designer for Donna Karan. Also, as part of the repositioning, the Burberry London (International) line has been upgraded through the rationalisation of sourcing, pricing and product variations. In our view, the absolute core business of a luxury goods company is in product design and brand management, as this establishes the ‘DNA’ of a brand. It follows then, that design and quality of products is a key driver of value creation. As with management, design and quality in the luxury goods industry is linked to abilities, personality and the reputation of certain high-profile ‘stars’—and there are many of these in the sector. If evaluation of management is unavoidably highly subjective and also highly contentious, then in our view, the evaluation of design and quality issues is the most highly subjective and potentially the most contentious. Accordingly, we do not distinguish between the merits of the various companies. 19
  20. 20. Burberry Group 3 March 2004 Relationship with GUS GUS originally acquired Burberry in 1955. After Burberry's repositioning in the late 1990s, GUS decided to float 23% of Burberry on 18 July 2002. After a further placing in November 2003, GUS’ remaining shareholding in Burberry is approximately 66%. Relationship agreement Ongoing relationships between GUS and Burberry are regulated by the "Relationship Agreement" signed on 11 July 2002. The rights and obligations of GUS under this agreement depend on the percentage of issued share capital held by GUS and are summarised in Figure 25 below. Figure 25: Summary presentation of relationship agreement Currently GUS owns 66% of Burberry Majority shareholding (>50%) - GUS has the right to appoint the Chairman of BRBY’s board - GUS is provided with BRBY’s business plan after board approval Controlling shareholding (>30%) -GUS can appoint up to 1/3 of directors - GUS provided with specific information (incl. management accounts, board minutes and press releases) - GUS does not take any action with could prejudice BRBY’s listing Minimum Shareholding (15%) -Independence of BRBY is maintained in accordance with listing rules and majority of non-executive directors on BRBY’s board are independent - 2/3 of BRBY’s executive directors independent from GUS - GUS is entitled to nominate one of the directors - Directors who have a conflict of interest are not entitled to vote at board’s meetings - All transaction are conducted at arm’s length and on a normal commercial basis - BRBY provides certain legal and regulatory information to GUS Source: Company data, CSFB research We believe there is an inherent risk associated with GUS’ controlling shareholding in Burberry. GUS interests could conflict with those of external Burberry shareholders. In addition, GUS has the discretion to sell a further stake of its shareholding in Burberry or transfer a controlling interest in Burberry to a third party, which could adversely affect the price of Burberry's shares. Following the 11% placing in November 2003, GUS undertook to not sell further shares in Burberry for a period of 360 days from the date of completion of the placing (24 November 2003). Burberry is considered as a non-core holding by GUS GUS has for several years described Burberry as a non-core holding. We believe that under Lord David Wolfson, GUS’ CEO until the late 1990s, GUS considered selling the business but couldn’t find an offer that it thought the business deserved. In order to maximise value for its shareholders ahead of a potential exit, GUS has been a willing provider of support and capital. GUS appointed Rose Marie Bravo and provided management support in Burberry’s renegotiation of its Japanese licensing agreements. 20
  21. 21. Burberry Group 3 March 2004 Under GUS’ control, Burberry has been given the funds to buy control of operations in Spain and Asia Pacific ex-Japan and to build out a store network. Burberry is an important provider of liquidity to GUS From the point of view of GUS’ shareholders, we believe this loyalty has paid off. Burberry represents 8.9% of March 2004E and 9.7% of March 2005E sales, and 16.0% and 17.1% of the respective years’ operating profits. GUS’ 66% stake in Burberry would be worth £1,319m at CSFB’s target price of 400p. This dwarfs our projected year-end net debt of £957m and provides considerable liquidity to balance the company’s significant off-balance-sheet lease liabilities, which we estimate at about £3.46bn following the acquisition of Homebase in November 2002. This presents GUS with an interesting conundrum about how best to make use of the proceeds of any further reduction in its stake, as full repatriation would likely tend to reduce its credit rating, which is only just investment grade (Moody’s Baa1 stable and Standard & Poor’s BBB+ positive). We do not believe that GUS would incur any tax liability on the disposal under current UK tax policy, so tax efficiency would not affect GUS’ decision-making about how to exit its position, in our view. GUS Analyst: Nathan Cockrell +44 20 7888 0320 21
  22. 22. Burberry Group 3 March 2004 Financial analysis and projections Background Brief history Burberry was founded in 1856 when Thomas Burberry, then aged 21, opened an outfitters shop in Basingstoke. Business flourished and several years later, in 1879, Burberry invented gabardine, a weatherproof and resistant fabric. This process, which was patented in 1888, is at the root of the company's development. Interestingly, Burberry lived around the same time as Louis and Georges Vuitton. In fact, in 1888 also, Georges Vuitton invented and patented the chequered canvas pattern and a few years later, in 1896, he registered the Louis Vuitton Monogram canvas as a trademark. In the early 1900s, Burberry was chosen as a supplier of officers' raincoats to the British army. During the First World War, the original raincoat design was adapted, leading to the creation of the ‘trench coat’ and a few years later, the Burberry check, registered as a trademark, was introduced as a lining. Building on the company's success, Burberry expanded internationally, selling its products in France, the US and Japan. In 1955, Burberry was acquired by GUS. Over the following decades, we believe that implemented distribution strategies for retail, wholesale and licensing channels lacked focus and resulted in Burberry exercising lower control over its brand. Additionally, the company suffered from a lack of investments in key operational and support functions, in our view. In the late 1990s, GUS decided to reposition the brand "in line with its luxury heritage" and hired a new management team, led by Rose Marie Bravo. This strategy having been successful, GUS decided to crystallise part of Burberry's value, which resulted in the partial flotation on 18 July 2002 of 23% of the company. After a further placing in November 2003, GUS’ remaining shareholding in Burberry is approximately 66%. Figure 26 summarises Burberry’s brands, and Figure 27 shows Burberry’s turnover by geography. Figure 26: Summary of brands Figure 27: Turnover by geography 02/03A Main lines Burberry Prorsum (High fashion range) Burberry London International (Core collection) Asia Pacific 25% Other 1% Spain Thomas Burberry Burberry London Europe 50% Japan Burberry London Burberry Blue Label Burberry Black Label Scotch House North America 24% Others Accessories (Handbags, scarves, shoes) Product Licences (Fragrances, Eyewear...) Source: Company data 22 Source: Company data, CSFB research
  23. 23. Burberry Group 3 March 2004 EVA® analysis Figure 28 plots invested capital turns against NOPAT margins over the period March 2000A—March 2005E. Figure 28: Efficiency matrix Figure 29: Average IC & turnover growth 600 Avg. Inv. Capital Turns 3.0 140% Sector Avg. NOPAT Mg. Mar-00 2.5 100% Mar-01 2.0 Mar-02 400 Mar-03 Mar-04E 60% 200 Mar-05E 1.5 20% Sector Avg. IC x 1.0 0 5% 10% 15% NOPAT Margins 20% -20% Mar-00 Mar-01 Mar-02 Mar-03 Mar-04EMar-05EMar-06E Average IC Turnover Growth Av. IC Growth Source: Company data, CSFB estimates Impact of Burberry Spain acquisition on efficiency profile Source: Company data, CSFB estimates The chart illustrates that the efficiency profile of Burberry has substantially changed over the last few years (by way of additional explanation, the further away a point on the chart is from the origin, the higher the ROIC). 1) Burberry's average invested capital turns decreased substantially in the year to March 2002, reflecting mainly the impact of the Burberry Spain (June 2000) and Asia (December 2001) acquisitions. Notably, the £151m acquisition in Spain represented a modest 7.6 EBIT multiple. In addition, the upgrade and extension of the retail network weighed on asset efficiency. 2) However, the decrease in asset efficiency was compensated by a substantial increase in NOPAT margins between March 2000 and March 2002, mainly due to the Burberry Spain acquisition and the renegotiation of the Japanese licensing agreements. The Spanish licensing operation had a hefty operating margin (+15% in the year to March 2000, +14.4% in the year to March 2001). Figure 28 also illustrates that: - Invested capital turns are still well above the sector average. This is consistent with lower integration into manufacturing and the importance of licensing and wholesale operations. - NOPAT Margins are above the sector average. This is explained by the licensing activities, which have very high EBITA margin. In the year to March 2003, licensing represented 45% of EBITA with an EBITA margin of 89.7% compared with 12.1% for the 'Wholesale and Retail' segment. In Figure 29, we illustrate that, according to our forecasts, Burberry continues to steadily invest capital to sustain future growth in turnover. 23
  24. 24. Burberry Group Outstanding creation of shareholder value through existing business and acquisitions 3 March 2004 In our view, too much attention is paid to the absolute level of ROIC in any one year relative to WACC, rather than the directional movement of the ROIC-WACC spread. Invested capital is essentially an historical figure and is therefore of less relevance. What matters to value creation is how incremental capital is invested in the business to derive incremental returns to shareholders. In our view, within the luxury goods sector, Burberry has been second to none in terms of value creation over the period since April 1999. As shown in Figure 30, using a standard cash tax rate of 30% throughout the period (to better enable comparison across periods and groups), incremental ROIIC over the period March 2000 to March 2003 was 28.7%, well above the company's WACC of 7.6%. Our conclusions from this analysis are: - Through the repositioning of the brand, Burberry has created outstanding shareholder value. We believe that this has been in part a result of astute picking of low-hanging fruits after years of brand neglect, as well as sensible brand extension and acquisitions. - Historical acquisitions (Spain, Asia, Korea) have proved that they have contributed to shareholder value. The Spanish licensing operations were acquired for £151.1m, a very reasonable 7.6x EBIT multiple. Also, the acquisitions in Spain, Asia and Korea offer great development potential, in our view. - Going forward, our estimates assume that EBITA margins are going to improve slightly. Regarding the 'Wholesale and Retail' segment, we assume changes in business mix, sourcing and pricing will drive EBITA margins up. On the 'licence' segment, we believe that the EBITA margin will benefit until March 2005 from the last scheduled increases in fees payable by the Japanese licensees (representing around £3m each year). We assume net working capital will grow in line with sales (i.e. NWC turns will remain constant), and we increase fixed assets in line with sales growth, taking into account Burberry's retail expansion plans. This results in ROIC at 28.1% in the year to March 2004E, 26.8% in the year to March 2005E and 25% in the year to March 2006E. Figure 30: Returns on invested capital and incremental invested capital £ in millions, unless otherwise stated Mar-00 Mar-01 Mar-02 Mar-03 Mar-04E Mar-05E Mar-06E Invested capital NOPAT @ 30% tax ROIC ROIIC 86 13 30.1% 238 48 29.7% 23.1% 270 63 24.9% 47.7% 325 82 27.5% 33.2% 377 98 27.9% 31.8% 427 109 27.2% 22.0% 498 123 26.5% 19.0% NOPAT @ cash tax rate 13 29.4% 46 28.6% 22.2% 63 24.9% 53.3% 82 27.5% 33.2% 98 27.9% 31.8% 109 27.2% 22.0% 123 26.5% 19.0% ROIC ROIIC Source: Company data, CSFB estimates 24 Incremental Mar-00 Mar-03 to Mar-03 to Mar-06 239 173 69 41 28.7% 23.7% 69 28.9% 41 23.7%
  25. 25. Burberry Group 3 March 2004 Projections Figure 31 shows a summary of our projections for the group. The details of our estimates are shown in Figure 51 to Figure 53. Figure 31: Burberry: Summary of earnings data £ in millions, unless otherwise stated Mar-02A EBIT Margin (%) Net income CSFB EPS (Pre GW & excep.) (p) Mar-03A Mar-04E Mar-05E Mar-06E 499.2 Turnover 593.6 670.7 731.6 796.3 85.4 17.1% 56.5 12.13 110.3 18.6% 52.2 14.64 133.6 19.9% 85.3 18.14 149.5 20.4% 95.9 20.25 168.9 21.2% 108.9 22.82 Source: Company data, CSFB estimates We believe that several sales, profitability and capital efficiency drivers provide Burberry with interesting growth opportunities in the years ahead. Sales projections and drivers Sales projections Our revenue assumptions are given in Figure 32. The headline growth in revenue results from combination of assumptions regarding the underlying organic growth in turnover and the effects of changes in foreign-exchange rates. Figure 32: Burberry: Revenue growth assumptions Headline Organic Mar-02A Wholesale Retail Licence Total Burberry Mar-03A Mar-04E Mar-05E Mar-04E Mar-05E 20.9% 9.6% 16.8% 16.7% 6.3% 45.6% 9.0% 18.9% 11.5% 15.0% 13.0% 13.0% 8.0% 10.0% 11.0% 9.1% 11.1% 15.8% 14.6% 13.2% 12.2% 15.0% 13.8% 13.5% Source: Company data, CSFB estimates We have assumed that exchange rates remain constant at levels as of 5 January 2004: euro/pound = 1.49, dollar/pound = 1.89 and yen/pound = 201.5. On the basis of such consistency, we expect that the average euro exchange rate for 2003/04E relative to the pound will strengthen by 7.3% on top of a 3.8% positive variance in 2002/03A. For the dollar, we estimate a negative currency impact of 10.3% in 2003/04E on top of an 8% adverse movement in 2002/03A. For the yen, we estimate the adverse currency variance in 2003/04E to be 2.0% on top of a 5.2% adverse variance in 2002/03A. Sales drivers We believe that Burberry should benefit from substantial top-line growth opportunities in the coming years thanks to: - sustained growth in retail square footage; - development in the US and non-Japan Asia; and - repositioning of men apparel and development of accessories In addition, we believe there is further upside potential in revenues to be gained from the development of the Burberry London (International) line in Japan. This is not currently factored into our estimates. 25
  26. 26. Burberry Group 3 March 2004 Sustained growth in retail square footage Retail square footage will expand by around 12% in 2003/04E and then by around 10% for the next two years According to company guidance, retail square footage will expand by around 12% in the year to March 2004 and then by around 10% for the next two years. This sustained retail expansion should drive top-line growth. By way of comparison, we estimate that Louis Vuitton DOS have increased from 244 to 318 since 1998, which we believe represents an average yearly increase in retail square footage of 15%. Figure 33: Burberry: Expansion of retail franchise Mar-02A Mar-03A Mar-04E Mar-05E Mar-06E 37% 12% 10% 10% 97,226 43,200 40,320 44,352 262,774 360,000 403,200 443,520 487,872 41 47 Square Footage Growth Incr. Retail Square Footage Retail Square Footage @ YE Number of DOS @ YE 19% attributable to Korea acquisition Source: Company data, CSFB estimates In particular, Burberry plans to focus retail expansion on the US and Non-Japan Asia (see below). In addition, we believe that Burberry may look to open a new DOS in Madrid (Currently Burberry has only one DOS in Spain, in Barcelona, opened in Summer 2002). Also, the company says Italy is an important market. So far, there is only one Burberry store in Milan, which opened in Fall 2003. However, on Friday, 27 February, Burberry announced plans for a new 8,000 square feet store in Rome, on Via Condotti, to open in late 2004. Development in the US and non-Japan Asia Retail expansion in the US Completion of Asian acquisition integration Burberry had 47 DOS as of March 2003, including 26 stores in the US. The company believes that there is room for further retail expansion in this market and plans to open three or four new stores a year. The US market represented 24% of revenues in 2002/03A, helped by wholesale contribution. By way of comparison, Louis Vuitton currently has 86 stores and Ralph Lauren 39 stores in the US. As regards non-Japan Asia, acquisition of distributors in the region were made only recently (Korea in March 2002, Hong Kong, Singapore and Australia in December 2001). Burberry believes there is still work to be done on the integration of these acquisitions in order to maximise their potential upside. Burberry will accompany development these regions by gradually adding stores in order to increase its retail presence. 26
  27. 27. Burberry Group 3 March 2004 Repositioning of menswear and further development of accessories Burberry is originally a men’s brand Burberry has four main product segments: womenswear, menswear, accessories and licences (Figure 34). Figure 34: Turnover by product category 2002/03A Women 33% Men 27% Licence 10% Others 1% Accessories 29% Source: Company data, CSFB research Menswear is the least invested of these categories, even though Burberry was originally a men’s brand. This is due to the fact that Burberry's repositioning has been driven by an initial focus on womenswear and later accessories. Figure 35 and Figure 36 clearly demonstrate the discrepancies in terms of growth patterns between the different segments. Management has said that Burberry will now focus its efforts on menswear, as it believes this segment can be developed further. Menswear represented 27.4% of turnover as of March 2003 and womenswear 33.3%. However, in terms of brand sales, the two segments generated approximately the same value. This is due to the fact that part of menswear is licensed. Figure 35: Detailed progression of menswear and womenswear sales Mar-00A Mar-01A Mar-02A Mar-03A £73.8m 32.7% £142.4m 33.3% 93.0% £149.4m 29.9% 4.9% £162.8m 27.4% 9.0% £63.4m 28.1% £134.7m 31.5% 112.5% £165.2m 33.1% 22.6% £197.9m 33.3% 19.8% Menswear Sales % of turnover Growth YOY Womenswear Sales % of turnover Growth YOY Source: Company data Accessories could represent 35% of turnover in the medium term In addition, management believes there are opportunities to further develop the accessories segment. This segment is mainly made up of handbags, scarves and shoes, with handbags being the largest accessories product category. Accessories rose 27
  28. 28. Burberry Group 3 March 2004 from 22.2% of turnover in the year to March 2000 to 28.6% of turnover in the year to March 2003. The company believes that accessories could represent 35% of turnover in the medium term. One of the drivers of this progression is expected to be shoes, which were launched in Autumn/Winter 2002 and are designed to complement the apparel collection. In accordance with management’s comments, we believe that accessories represent only a small percentage of sales in Spain and Japan. These two markets therefore will be areas of focus for the development of the accessories segment. Figure 36: Detailed progression of accessories sales Mar-00A Sales % of turnover Growth YOY Mar-01A Mar-02A Mar-03A £50.2m £98m £125.8m £169.5m 22.2% 22.9% 95.2% 25.2% 28.4% 28.6% 34.7% Source: Company data Further development of Burberry London (International) line in Japan In addition, we believe there is further upside potential in revenues to be gained from the development of the Burberry London (International) line in Japan. This is not currently factored into our estimates. Burberry has eight main product lines worldwide. Burberry Prorsum is the high-fashion range, Burberry London (International) is the core collection, and Thomas Burberry is sold mainly in Spain together with Burberry London (Spain). Burberry Blue and Burberry Black labels are sold exclusively in Japan, as well as Scotch House and a locally sourced Burberry London line (see Figure 54 for details of Burberry lines and positioning). The Burberry London (International) line has been key to the repositioning of the Burberry brand, and we believe there is further scope to develop sales of this product line, especially in Japan. Currently, the Burberry London (International) line is hardly developed in Japan compared with Burberry Blue and Burberry Black labels, Burberry London (Japan) and Scotch House. After the expiration of the international Burberry London (International) licence in June 2005, Burberry will have the flexibility to freely develop this line in Japan. We believe this represents a substantial opportunity in terms of top-line growth, especially with the development of Burberry London (International) accessories. In order to avoid confusion between the Burberry London (International) and Burberry London (Japan) lines, we illustrate in Figure 37 their characteristics and positioning. 28
  29. 29. Burberry Group 3 March 2004 Figure 37: Characteristics and positioning of Burberry London (International) and Burberry London (Japan) lines Burberry London (International) line Burberry London (Japan) line - Core collection - Sold only in Japan and made locally - High-end positioning - High quality apparel but lower positioning than Burberry London (International) line (lower price point) - Key to the turnaround of the Burberry brand -Strong womenwear and accessories segments -Main markets currently are in Europe and the US - Products mainly sourced in Europe and the UK - Weaker accessories mainly due to licenses held by small local manufacturers Source: Company data, CSFB research A summary of the main implications of the relevant Japanese licensing agreement is shown below, in Figure 38. Figure 38: Summary presentation of relevant Japanese licensing agreements Burberry London (International) line Burberry London (Japan) line - Mitsui and Sanyo have an exclusive agreement to distribute the Burberry London (International) products in Japan. - Mitsui and Sanyo have the right to design, market and distribute Burberry London (Japan) products until 2020. - These distribution arrangements expire in June 2005. - 16 licensees in Japan produce accessories for the local Burberry London (Japan) line. These arrangements expire in June 2005. After June 2005, Burberry effectively has “carte blanche” to develop the Burberry London (International) line in Japan. Development of accessories will be facilitated by expiration of licensing agreements on accessories of Burberry London (Japan) line. Source: Company data, CSFB research In Japan, Mitsui & Co. and Sanyo Shokai have the exclusive right to sell the Burberry London (International) products until June 2005. They also have the licence to sell the locally sourced Burberry London (Japan) products until 2020, as part of the Japanese licensing agreement, which also includes Burberry Blue and Burberry Black labels. Also, a group of other licensees in Japan has the right to produce the accessories range of the Burberry London (Japan) line. Mitsui and Sanyo assist Burberry in monitoring and managing these licensees; these arrangements terminate in June 2005. Taking these elements into consideration, we believe that when Burberry will have the opportunity to freely develop the Burberry London (International) line in Japan, after June 2005, the company will focus initially on the accessories segment. In our view, the development of accessories of the Burberry London (International) line would be facilitated by the termination of licensing agreements on accessories of the Burberry London (Japan) line. 29
  30. 30. Burberry Group 3 March 2004 In our view, the opportunity to develop Burberry London (International) accessories in Japan after June 2005 is compelling. 1) Currently, sales of accessories in Japan are limited. According to Burberry management, the locally sourced Burberry London line is made of high-quality apparel, but accessories are weaker, mainly because they are not manufactured by Mitsui & Co. and Sanyo Shokai but by smaller local players. 2) Over the last few years, Burberry has substantially developed accessories sales in Europe and the US, which in our view provides the company with valuable experience in this segment. 3) Through the Japanese licensing agreements, Burberry benefits from Mitsui’s capabilities in supply-chain management and logistics and Sanyo’s abilities to design, produce and distribute Burberry’s apparel. In our view, these long-lasting relationships are key to the success of the Burberry brand in Japan. As mentioned above, it is a group of smaller licensees that produces accessories for the Burberry London (Japan) line. Therefore, the initial focus on accessories within the Burberry London (International) line should allow Burberry to not directly compete with its two main licensees and therefore should not have an adverse impact on Burberry’s relationships with Mitsui and Sanyo. 4) Accessories generally have higher gross margin relative to apparel partly because of the higher proportion of continuity products and lack of size differences (except for shoes). 5) The higher proportion of continuity products and lack of size differences (except for shoes) referred to in point 4 should also facilitate adaptation to the local market. Apparel products require cutting and sizing adjustments, which is not the case for accessories. In addition, we believe the greater proportion of continuity products could facilitate logistics aspects. 6) Accessories have a wide range of price points, which should provide accessible entry points to the Burberry brand. In the longer term, we would expect Burberry to continue to develop other product ranges within the Burberry London (International) line in Japan. Capture of a greater share of the product value chain in Japan represents a great opportunity with substantial upside potential, in our view. However, we believe it is fair to point out that development of Burberry London (International) line is not without risk and challenges. In order to achieve successful roll-out of accessories in Japan, Burberry might need to first establish the premium positioning of the Burberry London (International) line in Japan, as distinct from the lower positioned Burberry London (Japan) line. Also, Burberry will have to continue managing its licensing relationships with Mitsui and Sanyo on the other product lines. 30
  31. 31. Burberry Group 3 March 2004 Profitability estimates and drivers Going forward, we estimate that Burberry should be able to further improve its EBITA margins by 121bps by March 2006 (see Figure 39 for details). This is broadly consistent with management guidance. For the 'Wholesale and Retail' segment, we believe changes in business mix, retail presence, pricing and supply-chain management should drive EBITA margins up. On the 'licence' segment, we believe that the EBITA margin will benefit until March 2005E from the last scheduled increases in fees payable by the Japanese licensees (representing around £3m each year). Figure 39: EBITA margins assumptions by class of business Mar-00A Wholesale & Retail Licence Total Burberry Mar-01A Mar-02A Mar-03A Mar-04E Mar-05E Mar-06E -3.4% 81.5% 8.2% 7.6% 86.2% 16.1% 9.6% 89.0% 18.1% 12.1% 89.7% 19.7% 13.5% 88.5% 20.9% 13.8% 89.0% 21.3% 14.5% 89.0% 22.0% Source: Company data, CSFB estimates We believe that the main drivers of the reasonable improvement in profitability that we expect at Burberry are the following: - improved business mix; - increased retail presence; - price increases; - supply-chain management; and - increase in fees on Japanese licences. Improved business mix Development of accessories In our view, the development of the accessories segment will be an important factor behind margin improvements in coming years. In fact, accessories generally have higher gross margin due to the absence of size differences and the higher proportion of continuity products. Handbags are the largest accessories product category for Burberry, and cashmere scarves have historically been a core product. However, the positive impact on profitability is slightly mitigated by the growing importance of shoes, which require a wide assortment of sizes and variations. Increased retail presence Burberry is guiding to sustained retail expansion over the coming three years. Figure 40 shows the split of Burberry sales by channel as of March 2003. 31
  32. 32. Burberry Group 3 March 2004 Figure 40: Turnover by channel (02/03A) License 10% Wholesale 52% Retail 38% Source: Company data Retail channel effectively captures the entire mark-up on products as opposed to wholesale Figure 41 shows the growing importance of retail sales within Burberry. This increased focus on retail should contribute to higher EBITA margins as sales through the retail channel effectively capture the entire mark-up on products as opposed to just the wholesale margin. Figure 41: Progression of retail sales £ in millions, unless otherwise stated Mar-00A Mar-01A Mar-02A Mar-03A Mar-04E Mar-05E Mar-06E 99.1 44% 143.2 33% 44.5% 89.5% 156.9 31% 9.6% 16.7% 228.4 38% 45.6% 18.9% 262.7 39% 15.0% 13.0% 288.9 39% 10.0% 9.1% 314.9 40% 9.0% 8.8% Retail Sales Retail Sales as a % of turnover Retail Sales Growth YOY Burberry Total Sales Growth YOY Source: Company data, CSFB estimates Price increases Company policy is to pass the adverse impact of exchange rates on to customers. Management stated that for the Spring 2003/04 collection, dollar-denominated retail prices would increase by about 3%. As regards next fall’s collection, dollar-denominated retail prices should increase by 3–4%. Although these increases are lower than those announced by other luxury goods companies, including LVMH, an important factor to take into account is that Burberry has lower transactional exchange exposure than other European luxury goods companies and therefore does not need to make up as much revenue in times of adverse exchange-rate movements. 32
  33. 33. Burberry Group 3 March 2004 Supply-chain management Burberry also has purchasing power with its third-party suppliers; especially when increasing the size of an order, the company has room for negotiating lower prices. As well, we believe there is value to be extracted from inventory management, but this will take time and we currently assume that inventories grow in line with sales, i.e. inventory turns remain constant. Increase in fees on Japanese licensing agreements The Japanese licensing agreement with Sanyo Shokai and Mitsui & Co was renegotiated in late 2000 and runs until 2010, with a ten-year renewal clause based on volumes. The final increase in royalty fees (before 2010) is due to take place in January 2005 and will represent £3m. From then on, there will be no increases until at least 2010. 33
  34. 34. Burberry Group 3 March 2004 Invested capital movements Going forward, we maintain working capital turns constant, assuming working capital grows in line with sales in accordance with Burberry’s guidance. We also grow capex in line with sales so that there effectively is enough capital to pay for top-line growth. See Figure 42 for more details. Figure 42: Average IC and turnover growth 600 140% 100% 400 60% 200 20% 0 -20% Mar-00 Mar-01 Mar-02 Average IC Source: Company data, CSFB estimates 34 Mar-03 Mar-04E Turnover Growth Mar-05E Mar-06E Av. IC Growth
  35. 35. Burberry Group 3 March 2004 Valuation and catalysts for change Discounted free-cash-flow analysis In order to value Burberry, we have taken into account a discounted free-cash-flow model. We also show in this section a comparison with multiples of industry peers and the results of our analysis under the CSFB HOLT valuation framework. Discounted free-cash-flow valuation In order to assess the impact of Burberry's future value creation in our valuation, we have used a discounted free-cash-flow model to convert future free cash flows into an equivalent share price. Figure 43 sets out our detailed projections for Burberry, which take into account only the development of the existing business and not possible future acquisitions. Figure 43: Summary of DCF assumptions Mar-04E 13.0% Mar-05E 9.1% Mar-06E 8.8% Mar-07E 7.0% Mar-08E 7.0% Mar-09E 7.0% Mar-10E 7.0% Mar-11E 7.0% Mar-12E 7.0% Mar-13E 7.0% 20.9% 14.0% 21.3% 14.3% 22.0% 14.7% 22.0% 14.7% 22.0% 14.7% 22.0% 14.7% 22.0% 14.7% 22.0% 14.7% 22.0% 14.7% 22.0% 14.7% Change in Working Capital (% of sales) 2.2% 1.5% 1.5% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% Capex (% of sales) 9.0% 9.0% 9.0% 7.0% 7.0% 7.0% 7.0% 7.0% 7.0% 7.0% Cash tax rate (%) 33.0% 33.0% 33.0% 33.0% 33.0% 33.0% 33.0% 33.0% 33.0% 33.0% Sales Growth (%) EBITA Margin (%) NOPAT Margin (%) Competitive Advantage Period Terminal growth rate (%) WACC (%) Cost of debt (%) Cost of equity (%) Debt (as a % of debt + equity) 10 years 0 7.6% 3.5 7.6 0 Source: CSFB estimates In our discounted cash-flow model, the value per share with reference to any one year is equal to the present value of cumulative cash flows to that point, plus a terminal value based on the following year’s NOPAT (discounted at WACC) with no growth in perpetuity. We have set our fair value against a ten-year competitive advantage period The horizon that any particular investor will wish to look at depends upon the assessment of long-term growth prospects for the company and/or perceived risk. The CAP might reasonably be extended where a company has a superior business model and/or there are significant barriers to entry such that supernormal growth and superior returns on invested capital might be maintained in the longer term. In the case of Burberry, we have taken the assumption of a ten-year CAP, in line with the rest of the luxury goods sector. Fair value of 391.9p, based on our DCF, using effective tax rates Using the company’s real tax rate, our DCF model leads to a fair value of 391.9p per share, on the basis of a CAP of ten years and no growth thereafter (Figure 44). Using the company’s effective tax rate (currently 33%) is the best approach, in our view, as it is sustainable and more conservative. 35
  36. 36. Burberry Group We estimate a fair value of 412.4p, using a standard tax rate of 30% 3 March 2004 For reasons of consistency and better comparability across the sector, we have also taken into account a standardised 30% tax approach in our valuation process. On this basis, our DCF model leads to a fair value of 412.4p per share on the basis of a CAP of ten years and no growth thereafter (Figure 44). Figure 44: DCF based on accounting tax rate and cash tax rate Mar-04E 1 DCF based on accounting tax rate (33%) Fair value per share Current share price % up/downside DCF based on standard tax rate (30%) Fair value per share Current share price % up/downside Mar-05E 2 Mar-06E 3 Mar-07E 4 Mar-08E 5 Mar-09E 6 Mar-10E 7 Mar-11E 8 Mar-12E 9 Mar-13E 10 294.8 p 316.7 p 325.7 p 336.8 p 347.9 p 358.8 p 369.7 p 380.6 p 391.4 p 391.9 p -18.3% -12.3% -9.8% -6.7% -3.6% -0.6% 2.4% 5.4% 8.4% 8.6% 307.8 p 331.1 p 341.0 p 352.9 p 364.7 p 376.5 p 388.2 p 399.9 p 411.5 p 412.4 p -14.7% -8.3% -5.5% -2.2% 1.0% 4.3% 7.5% 10.8% 14.0% 14.2% Source: CSFB estimates Alternatively, at the current price of 351p per share and based on our projections and the company's accounting tax rate, the market-implied competitive advantage period is six years. Figure 45 shows the detail of our DCF model based on Burberry's accounting tax rate. 36
  37. 37. Burberry Group 3 March 2004 ® Figure 45: Burberry: EVA /DCF valuation £ in millions, unless otherwise stated Mar-04E 1 Net Sales Growth Operating costs Op cost % Depreciation Depn % EBITA EBITA margin Taxes on EBITA Cash tax rate NOPAT Depreciation Gross Cash Flow Change in op. net working capital Change in wc % Capex - tangible and intangible Capex % Gross investments Free Cash Flow Discount rate (%) Discounted FCF Cumulative Free Cash Flow Residual value (t+1) PV of residual PV of cumulative free cash flow Net (Debt) Cash PV of Equity Outstanding shares Value per share Mar-05E 2 Mar-06E 3 Mar-07E 4 Mar-08E 5 Mar-09E 6 Mar-10E 7 Mar-11E 8 Mar-12E 9 Mar-13E 10 671 732 796 852 912 976 1,044 1,117 1,195 1,279 12.99% 508 75.81% 22 3.31% 140 20.88% (46) 33.00% 94 22 116 (15) 2.2% (60) 9.00% (75) 41 1.00 41 41 9.08% 551 75.28% 25 3.41% 156 21.31% (51) 33.00% 104 25 129 (11) 1.5% (66) 9.00% (77) 52 0.93 49 90 8.85% 592 74.38% 29 3.61% 175 22.01% (58) 33.00% 117 29 146 (12) 1.5% (72) 9.00% (84) 62 0.86 54 144 7.00% 634 74.38% 31 3.61% 188 22.01% (62) 33.00% 126 31 156 (17) 2.0% (60) 7.00% (77) 80 0.80 64 208 7.00% 678 74.38% 33 3.61% 201 22.01% (66) 33.00% 134 33 167 (18) 2.0% (64) 7.00% (82) 85 0.75 64 271 7.00% 726 74.38% 35 3.61% 215 22.01% (71) 33.00% 144 35 179 (20) 2.0% (68) 7.00% (88) 91 0.69 63 335 7.00% 776 74.38% 38 3.61% 230 22.01% (76) 33.00% 154 38 192 (21) 2.0% (73) 7.00% (94) 98 0.64 63 397 7.00% 831 74.38% 40 3.61% 246 22.01% (81) 33.00% 165 40 205 (22) 2.0% (78) 7.00% (101) 105 0.60 63 460 7.00% 889 74.38% 43 3.61% 263 22.01% (87) 33.00% 176 43 219 (24) 2.0% (84) 7.00% (108) 112 0.56 62 522 7.00% 951 74.38% 46 3.61% 281 22.01% (93) 33.00% 189 46 235 (26) 2.0% (90) 7.00% (115) 120 0.52 62 584 1,374 1,374 41 74 1,490 1,545 1,436 90 74 1,600 1,653 1,428 144 74 1,646 1,769 1,420 208 74 1,702 1,893 1,412 271 74 1,758 2,025 1,404 335 74 1,813 2,167 1,396 397 74 1,868 2,319 1,389 460 74 1,923 2,481 1,381 522 74 1,978 2,556 1,322 584 74 1,980 505.3 294.8 p 505.3 316.7 p 505.3 325.7 p 505.3 336.8 p 505.3 347.9 p 505.3 358.8 p 505.3 369.7 p 505.3 380.6 p 505.3 391.4 p 505.3 391.9 p Source: CSFB estimates 37
  38. 38. Burberry Group 3 March 2004 Comparable valuation analysis We believe Burberry competes with the following (non-exhaustive) list of brands: Armani, Donna Karan, Ermenegildo Zegna, Gucci, Hugo Boss, Max Mara, Prada, Ralph Lauren, etc. However, many of these brands are owned by private companies or are part of bigger luxury groups. For our comparable valuation analysis, we believe that in addition to the European luxury goods companies, the valuations of European and US branded apparel companies provide relevant points of comparison for Burberry. Figure 46 shows that Burberry's valuation on a P/E multiple basis is lower than the valuation of the luxury goods set. The luxury goods competitive set trades on a market capitalisation weighted P/E of 29x for 2003E and 24.1x for 2004E. Burberry has a P/E of 19.3x for March 2004E (2003E) and 17.3x for March 2005E (2004E), which represents a discount of 33% and 28%, respectively, compared with the Luxury goods set. Also, Burberry’s P/E multiples appear lower than our relevant retail set (European branded apparel). European branded apparel companies trade on a market capitalisation weighted P/E of 23.8x for 2003E and 19.4x for 2004E. We include the valuation of US branded apparel companies for illustrative purposes. US branded apparel companies generally trade on lower P/E multiples. We believe the company most comparable to Burberry is Polo Ralph Lauren, which trades on a March 2004E P/E of 18.6x and a March 2005E P/E of 14.0x. Figure 46: Comparable valuation table Ticker Company LFY Current Target Rating Price Price 351 p 400 p BULG.MI Bulgari GCCI.AS Gucci HRMS.PA Hermès LVMH.PA LVMH CFR.VX Richemont (Luxury) UHR.VX Swatch European Luxury Goods Dec-02 € 7.3 Jan-03 € 69.8 Dec-02 € 164 Dec-02 € 62.5 Mar-03 33.7 CHF Dec-02 166.3 CHF HMb.ST Hennes & Mauritz BOSG_p.F Hugo Boss ITX.MC Inditex European branded apparel Nov-03 201.5 SKr Dec-02 € 18.7 Jan-03 € 17.9 JNY Jones Apparel LIZ Liz Claiborne RL Polo Ralph Lauren TOM Tommy Hilfiger US branded apparel Dec-03 Dec-03 Mar-03 Mar-03 BRBY.L Burberry Mar-03 $ 37.7 $ 37 $ 33.5 $ 16.2 2004E PE PE 2002 2003E 2004E at Tgt Price O 24.0 19.3 17.3 19.8 € 6.3 € 73.2 € 145 € 62.5 24 CHF 185 CHF U N N O U O 25.0 21.6 27.3 37.4 23.6 19.3 30.0 26.1 27.8 29.7 28.1 37.2 19.8 29.0 23.6 22.6 26.7 22.8 30.6 16.8 24.1 20.3 23.8 23.6 22.8 21.8 18.7 22.3 160 SKr € 17.6 € 17 U N N 26.1 17.7 24.6 25.2 23.7 16.2 25.0 23.9 20.2 14.4 18.7 19.4 16.1 13.5 17.8 16.6 39 $ 39 $ na 21 $ N N O O 15.2 14.5 18.1 11.6 15.0 13.7 13.4 18.6 11.1 14.0 12.3 12.1 13.9 12.4 12.5 12.8 12.8 15.4 16.2 13.6 Source: Company data, CSFB estimates. Note: Share prices are as of 2 March 2004. 38
  39. 39. Burberry Group 3 March 2004 Share-price performance Burberry was listed on the London Stock Exchange on 18 July 2002 with an initial offer price of 230p. Since then, Burberry’s share price has risen by approximately 52%, outperforming the FTSE All Share by 45.2% and our CSFB Luxury Goods Narrow index by 25%. However, over recent months, Burberry’s share-price momentum has slowed. Since 20 November 2003, Burberry has underperformed the FTSE all shares by 12.8% and our Luxury Goods Narrow index by approximately 10%. Burberry reported its H1 results to September 2003 on 18 November and on 19 November, GUS announced its intention to place about 11% of its stake in Burberry, taking its shareholding down to around 66%. Figure 47: Burberry share-price performance 3/3/04 450 400 350 300 250 200 150 100 J A S Burber ry Gr oup O N D J F M A M J J A S O N D Burber ry Gr oup rel at e to Lux ury Goods Nar r ow Index iv Sour c e: DATASTREAM Source: Datastream 39
  40. 40. Burberry Group 3 March 2004 CSFB HOLT valuation The basic concept of the CSFB HOLT approach is to get to the underlying cash returns of a business and to minimize the impact of different accounting practices. One of the central pieces in the CSFB HOLT framework is the cash flow return on investment, or ® ® CFROI . To calculate CFROI CSFB HOLT takes the historical gross investment (the cash invested in the business) and inflation-adjusts it to bring it into line with current prices. It then looks at the cash flows from these investments, again in current prices. Finally it translates the ratio of gross cash flow to gross investment into an internal rate of return by recognising the finite economic life of depreciating assets and the residual life of non-depreciating assets, such as working capital and land. This internal rate of return is directly comparable to a market-derived cost of capital also calculated by CSFB HOLT. We present a more detailed explanation of the CSFB HOLT methodology in Appendix 2 (pages 48–52). We believe that the CSFB HOLT default scenario is not appropriate The CSFB HOLT warranted price for Burberry is 316p based on consensus estimates, a potential downside of approximately 10% from recent trading levels. We believe that the CSFB HOLT default scenario is not appropriate for three main reasons. 1) Asset growth rates are overstated in forecast years. The CSFB HOLT methodology assumes that the capital structure remains constant and that all of the free cash flow generated by Burberry will be invested back in the company. Despite the opportunities in Japan, this is unlikely, in our view. ® 2) CFROI s in the default scenario fade over the five-year forecast window. We believe ® Burberry will increase its CFROI s over the coming years, mainly through increases in EBITA margins (See Projections section on page 25). 3) We believe Burberry’s fade window should be extended from five to ten years to reflect the value of the Burberry brand. Burberry today is a high-end apparel and accessories business with core heritage products. Market implies slightly increasing CFROI® over the ten-year window and modest asset growth Current market expectations from CSFB HOLT. To reach an approximate warranted price of £3.52 (around which the stock has been trading recently), CSFB HOLT ® methodology implies that CFROI will slightly increase from 14% at t+1 to 16% at t+10, with a real asset growth rate fading from 7.5% to 4% over the ten-year forecast window. We believe this represents conservative margin improvement assumptions, in line with company guidance and modest asset growth rates, considering Burberry's retail expansion plans. 40
  41. 41. Burberry Group 3 March 2004 Figure 48: Burberry Relative Wealth Chart at current price Source: CSFB Holt Our fair value of 400p implies increased asset growth rate under CSFB HOLT ® In order to reach our target price of 400p, we assume that CFROI s improve from 14.0% in t+1 to 16% in t+10 similarly to our ‘implied at market’ scenario described above. However, we increase asset growth rate so as to take into account Burberry's future growth opportunities, and especially what we see as the company’s ambitious retail expansion plans. 41
  42. 42. Burberry Group 3 March 2004 Figure 49: Burberry Relative Wealth Chart at target price Source: CSFB HOLT Looking at the valuation matrix at target price illustrates that, assuming margins grow in line with company guidance, an increase in warranted share-price depends on asset growth (Figure 50). Growth t+10 Figure 50: Burberry: CSFB HOLT Valuation Sensitivity Matrix at target price 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 12% 2.77 2.88 3.00 3.12 3.26 3.41 3.57 3.74 3.93 4.13 Source: CSFB HOLT 42 13% 2.96 3.08 3.21 3.35 3.50 3.67 3.84 4.03 4.24 4.46 14% 3.15 3.28 3.42 3.58 3.74 3.92 4.12 4.33 4.55 4.80 CFROI (t+10) 15% 3.34 3.48 3.64 3.81 3.99 4.18 4.40 4.62 4.87 5.14 16% 3.53 3.69 3.86 4.04 4.24 4.45 4.68 4.92 5.19 5.48 17% 3.72 3.89 4.08 4.27 4.48 4.71 4.96 5.23 5.51 5.82 18% 3.92 4.10 4.30 4.51 4.74 4.98 5.25 5.53 5.84 6.16 19% 4.12 4.31 4.52 4.75 4.99 5.25 5.53 5.84 6.16 6.51
  43. 43. Burberry Group 3 March 2004 Catalysts for change Following on from our strategic and financial analysis, we believe the determinant factor likely to positively affect the valuation of Burberry will be the actions taken with regard to Japan. In the year ending March 2003, sales at retail value exceeded £1bn in the Japanese market but represented less than 10% of the company’s reported turnover. The main licenses on this market will likely run until 2020, but the licence on the Burberry London (International) line will expire in June 2005. The Burberry London (International) line has been key to the successful repositioning of the Burberry brand in Europe and the US, and we believe there is substantial scope to develop sales of this product line in Japan, mainly through accessories. In our view, other key positive catalysts for the stock include: - development of retail square footage with a focus on increasing retail presence in the US and non-Japan Asia; - repositioning of men’s apparel segment; - development of accessories; and - in the medium term, we believe Burberry will have the opportunity to extract value from improving its supply-chain management. For further discussion on catalysts, please refer to the Projections section on page 25. 43
  44. 44. Burberry Group 3 March 2004 Figure 51: Burberry: Profit and loss account £ in millions, unless otherwise stated 1999/2000 2002/2003 2003/2004E 2004/2005E 499.2 593.6 670.7 731.6 796.3 (223.1) 204.7 (248.1) 251.1 (261.3) 332.3 (295.1) 375.6 (321.9) 409.7 (350.4) 446.0 (87.1) SG&A Amortization of GW Total Operating Profit 2001/2002 427.8 (120.1) 105.6 Cost of sales Gross profit 2000/2001 225.7 Total turnover 2005/2006E (160.8) (4.9) 85.4 (215.6) (6.4) 110.3 (235.6) (6.4) 133.6 (253.8) (6.4) 149.5 (270.7) (6.4) 168.9 18.5 (136.0) (3.6) 65.1 Non-operating/exceptionnal items Profit on ordinary activities before interests 0.0 19 2.9 68 0.0 85 (22.0) 88 134 149 169 Interest income (expense), net Other financial income (expense) Financial income, net Profit on ordinary activities before taxation 2.9 0.6 3.5 22.0 5.1 7.4 12.5 80.5 (0.5) (0.1) (0.6) 84.8 (1.0) (2.2) (3.2) 85.1 (3.2) 130.4 (3.2) 146.3 (3.2) 165.7 Income tax Consolidated net income (6.6) 15.4 (26.1) 54.4 (28.3) 56.5 (32.9) 52.2 (45.2) 85.3 (50.4) 95.9 (56.8) 108.9 3.1p 3.0p 3.1p 3.0p 3.0p 10.9p 10.7p 11.2p 11.1p 10.3p 11.3p 11.2p 12.3p 12.1p 11.2p 10.5p 10.3p 14.9p 14.6p 13.4p 17.2p 16.9p 18.5p 18.1p 16.9p 19.4p 19.0p 20.7p 20.2p 19.0p 22.0p 21.6p 23.3p 22.8p 21.6p 498.2 498.2 506.3 498.2 498.2 506.3 498.2 498.2 506.3 498.1 498.1 506.2 495.2 495.2 505.3 495.2 495.2 505.3 495.2 495.2 505.3 (18.3) (18.3) - - (219.0) (15.0) (234.0) 3.0p 3.5x (16.5) (16.5) 3.3p 5.2x (18.2) (18.2) 3.7p 5.3x (20.0) (20.0) 4.0p 5.5x (2.9) 54.4 56.5 (181.8) 68.8 77.8 88.9 19 19 80 69 104 90 136 117 162 140 181 156 204 175 Earnings per share Basic Diluted Basic - Adjusted Diluted - Adjusted (CSFB EPS) IBES Definition (Diluted, clean of exceptionals only) Number of shares: Total shares outstanding (m) Average shares outstanding (m) Fully diluted shares (m) Dividend Dividend paid to GUS - pre-flotation Dividend payable Total dividend Dividend per share Dividend cover Retained earnings EBITDA EBITA Source: Company data, CSFB estimates 44
  45. 45. Burberry Group 3 March 2004 Figure 52: Burberry: Balance sheet £ in millions, unless otherwise stated 1999/2000 2000/2001 2001/2002 2002/2003 2003/2004E 2004/2005E 2005/2006E Cash and cash equivalents Inventories Trade debtors Prepayments and accrued income Deferred tax assets Other debtors Trading balances owed by other GUS Group companies Other Current Assets Total current assets 13.3 51.6 14.0 8.0 3.7 0.8 18.3 73.7 70.5 13.5 8.5 1.0 30.2 82.3 77.7 12.1 7.8 1.5 86.6 83.8 86.1 11.3 18.3 6.1 110.5 94.4 97.0 11.3 18.3 144.3 103.2 106.1 11.3 18.3 168.2 112.4 115.5 11.3 18.3 0.3 0.9 0.3 0.2 1.1 91.7 1.9 186.4 1.8 211.9 6.3 292.4 6.3 337.8 6.3 389.5 6.3 432.0 Net PP&E Intangible assets Investment Total non-current assets 57.5 0.0 0.0 57.5 100.2 89.9 0.1 190.2 124.4 95.8 0.1 220.3 161.4 123.7 3.4 288.5 199.6 117.2 3.4 320.2 240.6 110.7 3.4 354.7 283.6 104.2 3.4 391.2 149.2 376.6 432.2 580.9 658.0 744.2 823.2 1.0 9.4 17.2 3.8 6.6 26.6 32.2 18.9 8.9 27.0 37.3 28.9 14.0 45.4 24.3 108.6 23.8 125.9 7.0 26.9 54.5 22.1 10.0 30.6 151.1 7.0 30.3 57.9 22.1 11.5 30.6 159.4 7.0 33.1 61.9 22.1 13.2 30.6 167.9 7.0 36.1 65.3 22.1 15.0 30.6 176.0 0.0 0.6 4.8 5.4 6.3 15.2 6.8 28.3 0.0 23.1 0.8 23.9 0.0 35.2 4.6 39.8 0.0 35.2 4.6 39.8 0.0 35.2 4.6 39.8 0.0 17.1 4.6 21.7 98.4 239.7 282.4 390.0 458.8 536.5 625.5 1.1 122.2 25.2 47.1 704.1 (509.7) 390.0 1.1 122.2 25.2 47.1 704.1 (440.9) 458.8 1.1 122.2 25.2 47.1 704.1 (363.2) 536.5 1.1 122.2 25.2 47.1 704.1 (274.2) 625.5 Total assets Short-term debt Trade payables Accruals and deferred income Corporation tax Dividends payable Other Current Liabilities Total current liabilities Long-term debt Other non-current liabilities Provisions for liabilities and charges Total non-current liabilities Net Assets Called up share capital Share premium account Revaluation reserve Capital Reserve Other Reserve Profit and Loss account Total Shareholders' funds 98 45 282 98.4 Source: Company data, CSFB estimates 240 239.7 282.4

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