Disruption in the fashion industry: Levers to create value in the future

Fashion and apparel companies have created strong value compared with other consumer sectors, but much of that value has come from sales growth. Moving forward, these companies will need to identify other sources of sustainable value creation.

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Disruption in the fashion industry Levers to create value in the future

Contacts

Amsterdam Behdad Shahsavari Partner +31-20-504-1944 behdad.shahsavari @strategyand.pwc.com Berlin Dr. Sven Massen Partner +49-30-88705-876 sven.massen @strategyand.pwc.com Düsseldorf Peter Heckmann Partner +49-211-3890-122 peter.heckmann @strategyand.pwc.com

London Jon Crawford Principal +44-20-7393-3474 jon.crawford @strategyand.pwc.com Milan Luigi Pugliese Partner +39-02-7250-9303 luigi.pugliese @strategyand.pwc.com Paris Olivier de Cointet Principal +33-1-44-34-3131 olivier.decointet @strategyand.pwc.com

Vienna Harald Dutzler Partner +43-1-518-22-904 harald.dutzler @strategyand.pwc.com Willibald Kofler Principal +43-1-518-22-906 willibald.kofler @strategyand.pwc.com Dr. Alexander Sova Principal +43-1-518-22-923 alexander.sova @strategyand.pwc.com

Zurich Carlos Ammann Partner +41-43-268-2144 carlos.ammann @strategyand.pwc.com

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About the authors

Harald Dutzler is a partner with Strategy& based in Vienna. He is a member of the consumer goods practice with extensive experience in the fashion industry. Dr. Alexander Sova is a principal with Strategy& based in Vienna. He is a member of the consumer goods practice leadership team, with extensive experience in providing strategic advice to companies in the fashion and fast-moving consumer goods industries. Willibald Kofler is a principal with Strategy& based in Vienna. He is a member of the consumer goods practice and focuses on strategy development, transformation programs, and organizational design.

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Executive summary

In recent years, increasing vertical integration and the relentless rise of online sales have created fundamental structural shifts in the fashion industry. At the same time, fashion cycles are shortening in both the luxury and low-end segments, as companies address the changing buying behaviors of their target audiences. Surprisingly, despite the market turbulence and ongoing structural and economic challenges, key fashion industry players have delivered excellent performance for investors compared with other consumer goods sectors. However, our analysis found that the performance has been driven primarily by sales growth achieved through the expansion of proprietary retail space. Concurrently, manufacturers and wholesalers are confronting growing pressures on their margins. Going forward, relying on further expansion of retail space as the primary lever for value creation puts companies at risk, especially in the light of ever-steepening online competition. The fashion industry faces the urgent need to rethink its strategy and identify alternative levers for sustainable growth.

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Recent sources of growth and shareholder value

We conducted a time series analysis using financial data from publicly traded fashion companies from 2008 — the year of the financial crisis — through 2013 (see Exhibit 1, next page). We found that the fashion industry has been able to generate significant total shareholder return (TSR) during the past six years (see Exhibit 2, page 7 ). The annual TSR growth rate of the world apparel market was 10 percent during the period. Key European fashion players topped the global index at 12.1 percent. In addition, the fashion industry outperformed several other consumer goods sectors, including cosmetics and electronics. More detailed analyses revealed that value creation for the fashion industry has been rooted primarily in revenue growth. For example, for both top- and mid-tier performers, revenue was the single most important driver. Revenue accounted for nearly 9 percent of the average 21 percent TSR performance within the top-ranked group. For mid-tier performers, revenue accounted for approximately 7 percent (see Exhibit 3, page 8, and Exhibit 4, page 9). For 10 of the 14 top- and mid-tier companies analyzed, revenue was a major factor. In contrast, revenue was not a significant factor for companies at the bottom of the list in TSR rankings. Expanding proprietary retail space has been the major driver of sustained revenue increases. Traditionally, wholesale and retail businesses have acted as gatekeepers between apparel manufacturers and their consumers. However, the growing margin demands of increasingly dominant retail chains, and the need for more control over customer relationships, drove many fashion brands to bypass established retail partners and develop direct-to-consumer channels through vertical integration. Such direct-to-consumer sales bolstered both revenue and profitability. In addition, direct-to-consumer sales helped manufacturers gain better insights into customer needs and behaviors. Those insights, in turn, allowed fashion companies to respond more quickly and effectively to new trends.
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Expanding proprietary retail space has been the major driver of sustained revenue increases.

Exhibit 1 Analysis of total shareholder return for European fashion retailers, 2008−13
Rank 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 Company Foot Locker Hermès Inditex Gerry Weber Hugo Boss Ralph Lauren Burberry Giordano Gap Columbia Sportswear Luxottica Adidas Hennes & Mauritz LVMH Kering Ahlers Group American Eagle Outfitters Puma Head TSR (%) 22.1 21.5 20.5 20.4 20.3 19.6 19.4 14.8 11.9 11.5 11.4 11.2 9.9 9.9 8.2 4.8 –1.5 –1.7 –5.5 Change in TSR 1.3 –1.0 –1.2 –8.0 1.6 –0.2 1.0 –3.5 2.6 5.7 2.6 4.7 3.7 –2.6 0.7 1.0 –5.0 1.2 6.7 Change in rank (4) — — (1) (6) (5) — — (10) (15) — (13) (14) (9) (12) — — — —

Note: TSR = total shareholder return, including dividends and any repurchase of shares. Source: Bloomberg financial data; Strategy& analysis

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Exhibit 2 Total shareholder return for different consumer goods sectors, 2008−14
Six-year compound annual growth rate, since May 2008, in %
CAGR

12.1
10

10.0

9.8

9.5 7.5 6.2

5

5.2 3.9

0

–1.7
European fashion companies World apparel index World retail index World beverages index World food index World cosmetics index World textiles index World electronics index World home furnishings index

Source: Bloomberg financial data; Strategy& analysis

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Exhibit 3 Drivers of total shareholder return for European fashion companies

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13.3

8.8 6.9 6.2 5.2 4 2.6 2.8 0.7 0.7 0.2 2.3 0.8 2.8 2.4     0.9

0.2

-0.9 -1.9

-4.6

Revenue 5.4%

EBITDA margin 0.5%

EV/EBITDA 3.3%

MC/EV 1.1%

Number of shares 0%

Dividend yield 3%

TSR 12.1%

Base value

Market multiple

Financial policy

Total Upper quartile Middle half Lower quartile

Note: EV = enterprise value; MC = market capitalization. Source: Bloomberg financial data; Strategy& analysis

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Exhibit 4 Main drivers of TSR for select fashion companies
Compound annual growth rate, 2008−14

Main driver/CAGR 2014 Upper quartile Foot Locker Hermès Inditex Gerry Weber Hugo Boss AG
22.1% 21.5% 20.5% 20.4% 20.3%

Main driver/CAGR 2013

EBITDA margin Revenue Revenue / market multiple Revenue Revenue

+18% +15% +10% +9% +7%

EBITDA margin Revenue Revenue Revenue Revenue

+22% +16% +11% +10% +8%

Middle half Ralph Lauren Burberry Giordano Gap Columbia Sportswear Luxottica Group Adidas Hennes & Mauritz LVMH
14.8% 11.9% 11.5% 11.4% 11.2% 9.9% 9.9% 19.6% 19.4%

Revenue Revenue EBITDA margin EBITDA margin Market multiple Revenue Revenue Revenue Revenue

+7% +15% +8% +5% +14% +7% +6% +9% +10%

Market multiple Revenue EBITDA margin EBITDA margin Market multiple Revenue Revenue Revenue Revenue

+8% +15% +11% +6% +8% +7% +8% +9% +11%

Lower quartile Kering Ahlers Group American Eagle Outfitters Puma Head
8.2% 4.8% –1.5% –1.7% –5.5%

EBITDA margin Market multiple Leverage Market multiple Leverage

+12% +11% +4% +18% +9%

EBITDA margin Dividend yield Dividend yield Market multiple Leverage

+15% +5% +4% +11% +9%

Source: Bloomberg financial data; Strategy& analysis

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Manufacturers such as Gerry Weber, Burberry, and Inditex have made significant investments to expand their own retail space as a foundation for increasing sales and revenues. For instance, between 2008 and 2013, Gerry Weber expanded its own retail space by 27 percent, and the company’s retail revenue kept pace with an annual growth rate of 26 percent, while wholesale revenue declined 1 percent. Burberry expanded its own retail space (both shops and flagship stores) by 12 percent a year from 2008 through 2013. Retail revenues grew well beyond that pace, at a rate of 24 percent, which boosted selling-space productivity by 11 percent. Inditex shows a similar pattern, though retail productivity remained flat (see Exhibit 5, next page).

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Exhibit 5 Retail versus wholesale productivity for select fashion companies, 2008−13

Gerry Weber
852

Burberry
2,240
16% CAGR

Inditex
15,945
11% CAGR

6% CAGR

627 113 364
26% CAGR -1% CAGR

9,435 1,080 9,435 574 1,680
24% CAGR 2% CAGR

514

488

15,945

11% CAGR

505 2008 2013 2008

560 2013

Retail Wholesale

2008

2013

Sales in € millions

Sales in € millions

Sales in € millions

Retail space in thousands m2: 38 124
26% CAGR

Retail space in thousands m2: 69 120
12% CAGR

Retail space in thousands m2: 1.914 3.161
11% CAGR

3,784 2,926
-5% CAGR

14,016

11% CAGR

4,928

5,044

0% CAGR

8,355

2008

2013

2008

2013

2008

2013

Productivity in € retail sales/m2

Productivity in € retail sales/m2

Productivity in € retail sales/m2

Note: Exchange rate of respective fiscal year-end applied. Numbers may be rounded. Source: Company data and annual reports; Strategy& analysis

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Creating value in the future

Our analysis has shown that value creation strategies based primarily on retail space expansion won’t deliver sustainable growth in the medium or long term. First, the most attractive locations have already been taken, so there are fewer “white spots” available to fill. In addition, consumers are increasingly changing their buying behaviors and channel preferences, primarily by moving online. The consequences for fashion industry leaders are clear: More than ever before, they need to refocus on a few truly differentiating core capabilities to create sustainable value in the future. In our view, these four key success factors need to be at the top of the agenda (see Exhibit 6, next page): • Stringent customer focus and brand profile • Seamless cross-channel integration • Renewed focus on physical retail • Operational excellence Stringent customer focus and brand profile On average, customers spend less time shopping for fashion products than they used to. Because of that, brands are becoming important points of reference, and shoppers typically have two to four preferred brands. As a result, the number of fashion brands has increased significantly in recent years. However, brands that are undifferentiated, or positioned too broadly, lack a clear profile and will struggle to maintain their relevance and appeal to consumers. Therefore, the company’s most important strategic objective must be to align the positioning of branded labels to their identified, relevant customer segments.

Consumers are increasingly changing their buying behaviors, primarily by moving online.

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Exhibit 6 Trends impacting future retail success

“Know me”

“Engage me”

“Make it easy for me”
Seamless cross-channel integration

“Wow me”

“Make it work”

Consumer and industry trends:

Stringent customer focus and brand profile

Renewed focus on physical retail

Operational excellence

Personalization Tailored, curated assortment and products

Big data Crowdsourcing Direct interaction and dialogue

Online/offline channels New technologies

New store formats Experience

Supply chain In-store marketing

Megatrends:

Lifestyle transformation New mobility and changing work patterns

Connectivity and productivity Digitalization, virtualization, and increasing connectivity

Educated individualism Consumer sophistication driving complexity of preferences and products

Volatility Shorter fashion cycles, raw material prices

Source: Strategy& analysis

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Esprit is a prime example of how losing customer focus and weakening the brand profile can have serious consequences. By pursuing various strategies and design directions, the company diluted its previously clear position as a young and affordable lifestyle brand. Instead of strengthening the brand’s positioning in line with its core values, the company significantly reduced investments in marketing, product quality, and proprietary retail space. As result, Esprit experienced a significant decline in value as it steadily lost ground to its competitors. The imperative to create clear brand profiles poses challenges for companies trying to expand into new categories by leveraging existing brands. To enter a new category successfully and credibly, the brand must have significant power and appeal. In most cases, developing targeted sub-brands, or even introducing a completely new brand, can be a more promising proposition. Seamless cross-channel integration The relentless advance of consumers using multiple channels is blurring the boundaries between physical retail and e-commerce. To capitalize on this trend, fashion apparel companies must successfully link their offline and online strategies. Analysis shows that fashion players offering multiple parallel and integrated sales channels drive greater customer loyalty. Loyal customers spend significantly more at these companies than at those offering only a single channel. Orchestrating and aligning the online and physical worlds, and successfully integrating additional channels such as mobile or HbbTV, will be key to achieving sustainably higher sales and better margins. Many companies are focusing diligently on improving the integration of their offline and online channels, confirming the Strategy& perspective that there are key success factors that fashion retailers must master and link together in a comprehensive strategy (see Exhibit 7, next page). Renewed focus on physical retail According to the market research institute IFH, fashion is the largest online category in Germany and saw €8.8 billion (US$11.1 billion) in online sales turnover during 2012. With a growth rate of almost 17 percent, it is also the fastest-growing category. A recent Strategy& analysis found that the online share of fashion sales in Germany is expected to more than double, from 14 percent today to 30 percent by 2020. At the same time, the 28.5 million square meters of physical fashion retail space in Germany will drop by 16 percent to 24.0 million square meters (see Exhibit 8, page 16). Small to medium14 Strategy&

Fashion players offering integrated sales channels drive greater customer loyalty.

Exhibit 7 Cross-channel retail essentials and key success factors

2. Creative and innovative customer experience
Value creation across the “customer journey,” supported through process innovation

8. Targeted analytics and customer insight
Business intelligence as analytical backbone of cross-channel sales; customer insight with big-data tools

3. Unique products and pricing
Product portfolio split and pricing across channels; product innovation

1. Customer-centric, cross-channel way to play 7. Empowering information technology
Technological foundation for cross-channel sales; e-commerce capabilities; back-end architecture Strategic positioning with supporting capabilities to meet changing market conditions and consumer behavior

4. Brand and customer interaction management
Customer interaction management; cross-channel branding strategy and approach to customer communication; optimization of traffic in channels

6. Enabling operating model
Organizational transformation (including cultural transformation); governance and processes

5. Optimized supply chain management and logistics
Supply chain aspects, including logistics

Source: Strategy& analysis

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Exhibit 8 Expected impact of online sales on fashion retail space in Germany, 2012−20

30% 28.5%

+109%

-16%

24%

14%

2012

2020

2012

2020 Source: Strategy& analysis

Online share of total sales revenue
(in % of total category sales in Germany)

Retail footprint
(in millions of square meters)

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sized multibrand stores will drive this decline and will also be the most affected by it. Large retail chains will cope with lower sales space productivity by investing in special offline shopping experiences that boost their e-commerce sales. Small, exclusive fashion boutiques, on the other hand, will continue to be popular with consumers because of their specialized product portfolios and personalized service. The traditional role of physical stores is being eroded by mobile and Web applications and online services that provide product information, price comparisons, and the ability to test and try out products. In light of this erosion, conventional retailers must become more responsive to the changing needs of their customers. Shopping as a leisure activity must become a different — and more enjoyable — experience than customers can find online. To provide such an experience, fashion retail has to offer new and innovative formats that go beyond traditional size categories (for example, in the location and purpose of stores). Flagship stores, flexible formats such as pop-up stores, virtual showrooms, and pick-up and drop-off points can add value and create special experiences that eBay, Zalando, and Amazon cannot match. Burberry and Adidas already offer entire collections using relatively small amounts of store space by allowing customers to try out products virtually with digital touch screens. Operational excellence The speed of change in the fashion industry has increased significantly. Today, the average cycle for a collection is only four to six weeks. At the same time, pressure on operating margins is building, driven by raw material prices and declining retail productivity. In the coming years, operating margins will play an even more important role in increasing value. Companies have several levers they can pull in order to increase that value. Purchasing optimization. Commodity market volatility and changing regulations require that traditional procurement processes be replaced by more flexible and strategic approaches. Differentiated logistics and supply chains. More sophisticated service-level segmentation, faster throughput times, and greater flexibility require differentiated logistics and supply chain operations in order to meet the requirements of different product groups and category economics. Management of portfolio complexity. Active and ongoing management of products, collections, and portfolios is essential. Fashion companies need to control complexity by managing
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Flexible formats such as popup stores can add value and create special experiences.

regional collections and developing new designs that are tightly linked to downstream value chain needs. Effective pricing strategy and managing promotions for results. Validating and enhancing the relevance and effectiveness of pricing and discount strategies is central. Fashion companies must understand customer behavior and base any changes on an extensive analysis of spending data. In-store execution. Decision makers must reexamine the traditional character of in-store execution and presentation of collections, taking into account the changing nature of customer interactions and shopping behavior. We also see a critical need to redefine sales-area productivity and cost management by bringing them into sync with the new market reality and looking at profitability from a network perspective instead of a single-store view. Pulling the above levers requires commitment from the top level of management, along with an appropriate management model that promotes and embeds excellence and continuous improvement in all affected operational units.

Look at profitability from a network perspective instead of a single-store view.

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The bottom line: Develop core capabilities now

In recent years, the fashion industry’s above-average TSR has been rooted mainly in revenue growth due to expanding proprietary retail space. However, the growth potential through this approach is finite. Fashion industry leaders must rethink the drivers of value in the future, by addressing a few well-aligned core capabilities. Those capabilities will be different for every company and should be built on the organization’s existing strengths and competencies. We see four success factors that will be particularly important in the fashion industry in the coming years: a stringent customer focus and brand profile, seamless cross-channel integration, a renewed focus on physical retail, and operational excellence. Future market success will depend greatly on how quickly fashion industry players address these central themes with a coherent and consistent approach to their existing business models.

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