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Morningstar | Cutting Samsonite’s FVE to HKD 34 on Lowered Global Sales Growth and Margins

We are cutting our fair value estimate on narrow-moat Samsonite to HKD 34 from HKD 38.50 after reducing our global sales growth outlook and margins as consumers shift to lower-priced models. While we think Samsonite’s current share price reflects the slower global sales, outperformance is unlikely until the risk of further tariff hikes minimizes. A second tariff hike, which would add 15% in its import duties from China to the U.S. market, could hurt earnings in 2019 and lead to a reduction in our fair value estimate, but free cash flow should remain adequate to cover financing costs. We think Samsonite is likely to reduce marketing and distribution expenses to mitigate margin pressure.

Samsonite’s fourth-quarter performance will be weak, with revenue growth likely to slow to 2.4% year over year and EBITDA to decline 5.4%. Volume sales in the U.S. likely fell because of a product price hike of 7%-8% that was introduced to mitigate a 10% rise in import tariffs on the China-made luggage. While weaker U.S. sales were largely reflected, it is our cut in expectations for Asian sales that is more significant because of a shift to more mass-market brands, which also affects profit margins.

We now see 2018 revenue and EBITDA growth at 9% and 6%, around 100 basis points lower than our original assumption, while our 2019 growth expectations are cut by around 250 basis points for revenue to growth of 4.7% and 160 basis points for EBITDA to 5.6%, with a stronger rebound in 2020. We think that the weak consumer sentiment in Asia will remain for the first half of 2019. EBITDA margin, however, should improve by 20 basis points in 2019 as management reduces its store expansion and marketing spending. Net income rises 26% in the absence of one-off finance charges that dampen 2018 income.

With former CFO Kyle Gendreau at the helm, we think there will be more emphasis on controlling cost, which is probably more prudent in the current environment. As a result, there will be a focus on inventory management, which should help lower inventory turnover days back to the 120-130 historical average from around the 142 we expect in 2018. The group is also expected to ease back on store openings globally, with emphasis on enhancing store profitability. This will help cut distribution expenses as a portion of sales to 30.7%, which would be in line with 2017 and lower than the 32% projected for 2018. Coupled with flexibility in reducing its marketing budget, we think the company should be able to raise its EBITDA margin despite a decline in gross profit margins that result from the shift in product mix to lower-margin mass-market luggage.

Overall, we’re likely to see revenue grow at an average 7.3% through 2022 instead of the 7.8% we assumed previously. Our midcycle margins continue to reflect a stronger EBITDA margin of 18.8% relative to the 15.6% we anticipate in 2018, but well below our original assumption of 20.9%. The main reason for the reduction in our midcycle assumption is our belief that gross margin improvement will be slower than we previously factored in to reflect the negative impact of this slowdown. We also factor in slower economic growth in China in the event of lingering trade risks. As a result, we think five-year free cash flow CAGR will be at 32.2% instead of our last forecast of 34.9%.

Should the U.S. and China fail to find a trade truce in March, a second tariff hike, which equates to an additional 15% in import duties for its China-made luggage into the U.S., is likely to lead to a price rise of Samsonite group luggage by around 12%-13%. However, unlike the one-time price hike imposed in 2018, this price increase will have to be spread over a longer period. It would be too damaging to volume sales for prices to rise annually by such a sizable amount. In this situation, Samsonite is unlikely to be able to mitigate the higher costs and we expect EBITDA margin to slip to around 13.4% in 2019 and 14.1% in 2020 from our base-case estimate of 15.8% and 16.9%. We could see 2019 earnings decline 17.6% year over year to USD 168 million in this case.

While the company is not shifting its current supply sources out of China, it expects to reduce its dependency on these sources from over 90% to around 80% in 2019 by reallocating a portion of its U.S. sales to South East Asian based manufacturers. Over the longer term, growing needs will be sourced from other parts of Asia to diversify its risk.