RECOMMEND: Buy InditexDifferentiated Global Retail Can Grow and Generate CashValueTrap5/11/2010ITX SM: €48.00

I recommend we buy Inditex, a premier global fashion retailer. Inditex is built on information and logistics excellence, which provide both velocity and margin advantages and create high returns on capital with strategic defensibility. Inditex is vertically-integrated and leverages that integration to pass on its low costs to customers in the form of more interesting and unique fashions, more exciting and stimulating shopping environments, social involvement program important to customers, and low prices. Inditex’s main retail banner is Zara, which has 1,600 outlets around the world. Inditex has seven other banners, almost exclusively in clothing, which bring the store total to 4,607 globally. 70% of the company’s stores are located in Western Europe, with 52% in the PIIGS nations. Inditex is very much like Yum! Brands, however, in that 27% of its locations are found in emerging markets. Overall, Inditex operates in 75 countries and is growing at nearly ten times the rate in emerging markets as it is in developed markets. The company currently has more than 1,200 stores in emerging markets. That level of commitment to emerging markets is not an experiment; it a real part of the company’s business today and a large part of its incremental growth economics.

Inditex is a growth company with a growth multiple, but I believe the business model, its execution, the high insider ownership level and capital stewardship, and the pristine balance sheet deserve a higher valuation. I believe Inditex can grow its topline at a 10%+ rate over 5-10 years, grow the bottom line at a 12-14% rate, and grow FCF per share at a 15% to 18% rate as the growth slows to a more mature company at the end of ten years. While Europe can get a lot worse from here and provide a better entry point on the stock, I believe the current stock price offers an attractive entry point today. I am setting my CTV at €63.25, up 32%, for a 3-5 year IRR of 13.0% to 17%.

Inditex has 623M shares outstanding for a market cap of €29.9B, cash of €2.4B, and debt of €40M for an enterprise value of €28.0B. It is trading at 20.6x and 18.6x my 2011E and 2012E (Jan) EPS of €2.33 and €2.58, 19.8x and 17.3x consensus EPS of €2.42 and €2.77, at FCF yields of 5.0% and 4.9% on FCF per share of €2.41 and €2.35, and at a 2.5% dividend yield.

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Description. Inditex is Spanish designer, manufacturer, and retailer of clothing with a business model unlike almost all other retailers. The company designs its own clothing, which is manufactured in workshops in Spain and North Africa, and ships inventory in very sparing quantities to its 4,600 stores worldwide twice a week. The stores start a season with very little inventory and each store provides feedback to the parent on what is working, what customers want, what customers don't want, and what competitors are doing. Rather than ordering a huge load of inventory at the beginning of the season and taking a big risk on fashion that will either be a hit or need to be discounted heavily to move (the "push" model), Inditex operates on a "pull" model where the market decides in real time what it wants.

300 designers at Inditex can accommodate market feedback immediately and order garments to be manufactured on a 10-14 day turnaround by hundreds of piecework shops that can put together simple components sent to them by Inditex. Inditex pulls the raw materials from its own voluminous stock of inventory and everything is distributed through its nine million square feet of logistics

centers in Europe. Inditex turns out 20,000 stock keeping units (SKU) every year vs. 200-2,000 at traditional retailers, according to writer Jim Suroweicki1.

Low inventories mean better returns on capital, but that's not the primary reason to keep inventory velocity up. Inventory velocity is an outgrowth of

the business model aim of adapting to customer desires in the shortest time possible. This allow the company to react to a fast-moving product market, keep the lowest possible lead times, and diminish fashion risk to the greatest extent possible.2 Inventory velocity isn't the highest in the industry. There is a good deal of raw materials, work in process, and work in transit. Low inventories in the store mean fresher inventory and more traffic, however, which means more delighted customers, lower mark-downs, and higher margins. As I have discussed with retail in the past, customers must have a sense of surprise, delight, and value to hold a retailer in high esteem (whether low-price or high price does not matter to the concept of “value,” which means getting what one pays for or better). This is why LVMH fashion director Daniel Piette called Inditex retail concept Zara, "Possibly the most innovative and devastating retailer in the world."3 It has low costs, low prices, and the most responsive fashion model in the world with the least amount of fashion risk.

Inditex is very productive on the store level, considering its average €15 to €20 price point. Its sales per square foot rank among the highest in apparel retail.

Exhibit 1: Sales Per Square Foot, 5-Year Average. Global Apparel Retail1 James Surowiecki, The Widsdom of Crowds (New York: Doubleday, 2004), 192.2 Inditex press kit: http://www.inditex.es/en/press/information/press_kit3 http://edition.cnn.com/BUSINESS/programs/yourbusiness/stories2001/zara/

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"Possibly the most innovative and devastating

retailer in the world." -- LVMH Fashion Director Daniel Piette on Zara

Source: Bloomberg, Company filings, Santander, VT

Company Ticker Market Cap Sales / Sq FtNext plc NXT LN $6,081 $1,314Fast Retailing 9983 JP $14,419 $1,313Urban Outfitters URBN $5,879 $844Inditex ITX SM $34,317 $840J. Crew JCG $2,708 $753Limited Brands LTD $8,222 $708H&M HMB SS $47,410 $636Abercrombie & Fitch ANF $3,443 $476Ann Taylor ANN $1,271 $453Gap Stores GPS $15,277 $410Nordstrom JWN $8,721 $408Talbot's TLB $842 $377Men's Wearhouse MW $1,126 $297TJX Stores TJX $18,040 $245

It is vital to remember 27% of Inditex sales are generated in emerging markets when considering sales productivity at Inditex versus its competitors. Some analysts complain that if Inditex is so responsive and differentiated, its sales per square foot should lead the industry. That would be a more valid comment if its competition operated in emerging markets to the same extent Inditex does. Competitor Next generates 95% of sales in the UK alone, Fast Retailing generates 94% of its sales in Japan and Europe, and 100% of Urban Outfitters' sales come from OECD countries. On an purchasing power parity (PPP) basis (which matters to margins since 50% of store costs are personnel costs, which are dictated by PPP), the sales productivity comparisons are probably much closer. Inditex's proportion of sales in emerging markets is higher than some consumer staples companies, which are some of the best vehicles for accessing the secular growth of emerging markets via established, highly liquid Western companies. Inditex's productivity and growth profile are further highlighted by its differentiated footprint.

Inditex stores undertake almost no traditional advertising and marketing. Whereas many retailers allocate 3-4% of revenue to advertising, Inditex allocates those expenses to "Top locations in the most important shopping areas of the world’s largest cities. In many cases, historic buildings in emblematic areas or spaces with a singular architectural appearance are chosen."4

4 2008 Annual Report.

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Exhibit 2: Zara Facades, InteriorSource: Company presentation

Zara understands shopping is more than a commercial transaction. Shopping is a vital cultural undertaking that can be entertaining. According to retail consultant Paco Underhill, author of Why We Buy and Call of the Mall, the amount of money a customer spends in a store is positively correlated with the amount of time they spend in the store. This is why Costco can sell 8 caret diamonds next to snow tires and $150 a bottle wine. It provides a treasure hunt environment with stunningly low prices (average mark-up about 12%); it keeps people in the store. Jordan's Furniture in New England offers a carnival-like atmosphere that keeps the family in the store. Malls offer recreation, a relatively safe and pleasing environment with entertaining engagements, and provide the same important outlet for civilization provided by "souks, bazaars, arcades, bourses, and markets of olden days."5

Concepts. Inditex operates eight concepts, led by Zara, and has 4,607 stores located around the world. 73% of these are located in developed markets and 27% are located in emerging markets. Inditex operates in 75 countries and 75% of its growth last year took place in emerging markets. This is an unusual retailer in this regard; most consumer discretionary and retail does not provide such direct access to emerging markets in such a high proportion to the overall business. As we can see below, Inditex is primarily a Western European retailer with a high proportion of its stores in Spain (41%) and PIIGS countries (52%).

Exhibit 3: Geographic Distribution of Inditex StoresSource: Company filings, VT

5 Paco Underhill, Call of the Mall (New York: Simon & Schuster, 2004), 4.

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Zara offers fashions for males and females of all ages. Low-price, highly fashionable items are offered in differentiated, attractive retail spaces in "A" locations around the world. There are 1,608 Zara locations generating an average sales of €4,468K per store. 2009A EBIT margin was 15.6% with a 19% ROIC6. Zara accounts for 35% of global locations with about a third of these located in Inditex's home country of Spain.

Bershka concentrates on females and males age 13 to 23. Fashions are cutting edge with stores intended as "meeting points for fashion, music and street art." Bershka has 651 stores doing average sales of €1,843K per store. 2009A EBIT margin was 16.7% with a 38% ROIC.

Other Concepts.

Pull & Bear. This is a casual clothing concept for females and males age 14 to 28. This is an A&F-like concept in age group and merchandising approach. This concept has 626 stores generating average sales of €1,191K per store. 2009A EBIT margin was 15.6% with a 19% ROIC.

Stradivarius. This concept offers casual "urban" fashion to young women age 15 to 25. Stradivarius has 515 stores doing average sales of €1,304K per store. 2009A EBIT margin was 21.2% with a 48% ROIC.

Massimo Dutti. This concept offers international fashion for males and females of all ages. Massimo Dutti has 497 stores doing average sales of €1,493K per store. 2009A EBIT margin was 14.8% with a 48% ROIC.

6 Concept-level ROIC does not adjust for operating leases.

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2008 2009Stores, Developed Markets 3,275 3,363 % of total 77% 73%Stores, Emerging Markets 989 1,244 % of total 23% 27%Stores, Western Europe 3,166 3,230 % of total 74% 70%Stores, Spain 1,896 1,900 % of total 44% 41%Stores, PIIGS 2,353 2,393 % of total 55% 52%

CY

Oysho. This concept offers women the "latest trends in loungewear, lingerie, and undergarments.” Oysho has 392 stores doing average sales of €632K per store. 2009A EBIT margin was 13.6% with a 17.6% ROIC.

Zara Home. This concept offers home textiles and accessories. Zara Home has 261 stores doing average sales of €888K per store. 2009A EBIT margin was 10.3% with a 15.6% ROIC.

Recent Results. Inditex generated a compounded comparable store sales growth rate of 4.0% between 2003 and 2009 with a 6.5% growth rate in the first three years and a 1.6% growth rate in the second three, which were dominated by recessionary conditions in most of its markets. From 2003 to 2009, the company grew revenue at an 18.6% compounded rate and EBIT at an 18.4% compounded rate, with EBIT margin ranging from 15.8% in CY 2003 to a high of 20.1% in CY 2006, and back again to 15.6% in CY 2010. This is an impressive full cycle performance that encompasses EU-27 GDP growth of 0.5 to 1.2% in 2003, 2.7% to 3.4% in 2006, and declines of (2.2%) to (5.0%) in 2009.

Over this time, the company grew its store base at a 16% annual clip without degrading economics and while delivering a very high percentage of net income to free cash flow.

Sources and Uses of Cash. Over the last ten years, Inditex has generated cumulative net income of €7,745M and cumulative FCF of €6,737, for a very impressive 87% conversion of net income to FCF given compounded EPS and FCF growth rates of 20% and 45%, respectively, over this time frame.

Exhibit 4: Cumulative Cash Sources and Uses, 2001-2010€ in millions

Source: Company filings, VT

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Account Cumulative Source / (Use)Net income € 7,745D&A € 3,541Gross cash flow € 11,866Working capital € 578Net cash flow from operations € 12,445Capex (€ 5,708) % of D&A 161%FCF € 6,737 % of net income 87%Net debt issuance / (repayment) (€ 318)Issuance of equity € 21Share repurchase € 0Dividends (€ 2,960) % of FCF 44%Net change in cash € 2,228

The working capital efficiency of a company adding 3,500 stores over this period is remarkable. This supports the fundamental story the company's production and logistics model is very different from other apparel and allows the company to focus on providing a differentiated shopping environments in dedicating around €800K per store in leasehold improvements and furniture, fixtures, and equipment. This works out to a hefty $226 per square foot. Inditex achieves a fair return on this sizable investment, however, as we see below in lease-adjusted ROIC implied by 2010 and 2011 consensus estimates (using an 8% cap rate on pretax rental expenses across the universe):

Exhibit 5: Lease-Adjusted ROIC, Apparel RetailSource: Bloomberg consensus, VT

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Company Ticker ROIC Rank2010E 2011E AvgFast Retailing 9983 JP 178% 103% 141% 1Burberry Group BRBY LN 16.9% 17.0% 17.0% 2J Crew Group JCG 16.7% 16.9% 16.8% 3H&M HMB SS 16.5% 16.8% 16.6% 4KappAhl KAHL SS 15.0% 15.5% 15.3% 5Esprit Holdings 330 HK 14.5% 15.1% 14.8% 6Urban Outfitters URBN 13.7% 14.3% 14.0% 7TJX Stores TJX 13.4% 13.3% 13.3% 8Next plc NXT LN 13.5% 12.8% 13.1% 9Nordstrom JWN 12.6% 13.4% 13.0% 10Inditex ITX SM 12.8% 13.1% 12.9% 11Gap Stores GPS 12.2% 11.7% 12.0% 12Limited Brands LTD 9.9% 10.3% 10.1% 13Chico's FAS CHS 9.2% 10.9% 10.1% 14Ted Baker TBK LN 9.7% 10.0% 9.9% 15Ann Taylor ANN 6.8% 7.4% 7.1% 16Abercrombie & Fitch ANF 6.4% 7.4% 6.9% 17Talbot's TLB 6.0% 7.0% 6.5% 18Men's Wearhouse MW 6.0% 6.4% 6.2% 19Stockmann STCBV FH 4.9% 5.4% 5.1% 20

Fast Retailing, parent company of ultra-hot Japanese apparel retail Uniqlo, tops the list, though something that far off the pale probably has a unique denominator issue in the calculation of ROIC. Fast Retailing is clearly an interesting and profitable business model, focusing on fast inventory turnarounds and low prices, though it is not vertically integrated like Inditex. Marketing executive David McCaughan from McCann Worldgroup discussed the company at the CLSA Japan forum; please click here for my write-up of this presentation).

Inditex is probably more cyclical, given higher fixed costs, and has a deeper "V" through the cycle. It continually reinvests excess returns back into its stores and products as well as processes its customers take an interest in, such as green initiatives and local philanthropy. While the company generates excellent gross margin of 57% and EBIT margin of 15.6%, its lease-adjusted ROIC of 17% in 2009 and 12.6% in 2010 (Jan) indicate it is not overly extractive. At this level of return, it is getting paid to expand quickly and expand its moat. Comparing this reinvestment ethic with its lean working capital model and low prices, Inditex is reminiscent of Costco and Amazon.com. The company isn't trying to maximize return on capital; it is trying to maximize competitive advantage and NPV per share.High Insider Ownership. It is hardly surprising Inditex would focus on competitive advantage and NPV per share. The company is 59% owned by founder and Chairman Amancio Ortega Gaona and shares outstanding have grown at a 0.1% compound rate over the last ten years. Common stock and paid-

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in-capital for this €29.0B market cap company amount to €114M. This is a company that doesn't throw around capital to aggrandize itself or its management.

What Is Discounted in the Stock? Varying capital intensity, sales growth, and margins and maintaining a constant ten-year competitive advantage period (CAP), the following scenarios solve for today's share price of €46.59.

Exhibit 6: Market-Implied Scenario: Sales GrowthSource: VT

We see comps well below nominal Spanish GDP growth implied by 10-year treasuries, EBIT margin and ROIC expanding on a more mature store base, and tepid topline growth driving even more subdued FCF per share growth. This is a plausible scenario if Spanish, European, and global GDP grow at very low rates over ten years and if Inditex maintains its competitive position but doesn't expand at a very high rate. I believe Inditex will continue to pursue in entrepreneurial fashion global growth opportunities and that its business model will allow it to maintain its competitive position or increase it. A more likely scenario would be higher growth that fails to produce good margins or gets bogged down with too much capital.

Exhibit 7: Market-Implied Scenario: MarginsSource: VT

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2010A 2020E 10-Yr CAGRSales € 11,084 € 16,739 4.2%Stores 4,607 5,756 2.3%Sales / Store € 2,453 € 2,926 1.8%EBIT Margin 15.6% 17.7%EBIT € 1,729 € 2,963 5.5%ROIC 12.6% 14.8%EPS € 2.11 € 3.75 5.9%FCF per Share € 2.94 € 3.58 2.0%

2010A 2020E 10-Yr CAGRSales € 11,084 € 28,541 9.9%Stores 4,607 8,106 5.8%Sales / Store € 2,453 € 3,598 3.9%EBIT Margin 15.6% 11.9%EBIT € 1,729 € 3,396 7.0%ROIC 12.6% 13.5%EPS € 2.11 € 4.30 7.4%FCF per Share € 2.94 € 3.87 2.8%

In this scenario, store growth keeps up at a rapid clip and comps do well, but at the expense of discounting and less overhead absorption. EBIT margin declines by nearly 400 bps and FCF per share growth falls by 90%, to 2.8% from the 33% rate accomplished from 2000 through 2009. I believe an entrepreneurial founder used to decades of success could let returns slip over time because the founder has lived through rough patches and survived, because optimists can rationalize away problems, or because they're so satisfied they won't change things until it's too late.

Exhibit 8: Market-Implied Scenario: Capital IntensitySource: VT

This is the "Taj Mahal" model in which the founder or ambitious followers build temples to themselves or the retail gods and forget about incremental returns and cash flow. Sales and EPS grow at good rates, but ROIC and FCF get blown up and the stock goes nowhere for years.

I believe all of these scenarios are possible, but lower in likelihood. The company has been operated very intelligently by Gaona since he founded it in the 1970s. Despite being one of the world's 10-15 wealthiest individuals, Gaona does not

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2010A 2020E 10-Yr CAGRSales € 11,084 € 28,541 9.9%Stores 4,607 8,106 5.8%Sales / Store € 2,453 € 3,598 3.9%EBIT Margin 15.6% 17.7%EBIT € 1,729 € 5,052 11.3%ROIC 12.6% 10.2%EPS € 2.11 € 6.38 11.7%FCF per Share € 2.94 (€ 3.56)

appear to be driven by fame or outward trappings of success. He rarely allows interviews or photographs, doesn't live a new billionaire lifestyle, and has not wasted capital growing the company. The next generation could blow it, however. Daughter Marta Ortega Pérez, 26, being groomed as Gaona's successor, inherited her father's reticence toward publicity, appears well-grounded, having started on the bottom rung of the company ladder, and was an economics major as an undergrad. That doesn't ensure one knows the first thing about business, but business doesn't appear to be a passing dilettante interest for Perez, either.

Long-Term Growth. Inditex currently operates in Spain at a density of one store per 24,000 people. Density in Western Europe is one store for every 93,000 people. At 25% to 50% the density of Western Europe 15 years out, the BRIC countries alone could satisfy the ability of Inditex to grow the store base at much more than the 6-7% growth I have assumed as a base case estimate. India will open this year for Inditex and the company has grown its Brazil, Russia, and China store base by 18%, 170%, and 386% over the last three years.

Stores in emerging markets have grown by 65% in the last three years vs. 41% for developed markets, 14% for Western Europe, and 10% in PIIGS markets. The company's 27% distribution of stores in emerging markets has provided Inditex with process knowledge and platform strength to move up in size profitably while returning generous amounts of cash to shareholders.

My base case scenario has the company growing stores at a 5.8% rate over ten years with 3.9% comps, mid-cycle EBIT margin of 17.7%, 10-year EBIT growth of 11.7%, EPS growth of 11.7%, and FCF per share growth of 15.0%. FCF per share benefits from some share repurchase as well as the slowing rate of growth of new store investment in the later stages of the model.

The base case scenarios yield a range of values from €52.25 to €73.75 with a distribution of outcomes ranging from €33.00 on the low end to €108.50 on the high end.

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Exhibit 9: Inditex Decision TreeSource: VT

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Case Sales EBIT Margin Stores ROIC FCF / Share CAP Mult WACC Value Prob Total Prob Wtd Value

Best 20%

1 € 45,257 20.0% 9,831 20.1% € 10.87 15 14.4x 6.9% € 108.50 50% 10% € 10.852 € 45,257 17.7% 9,831 18.6% € 9.56 15 14.4x 6.9% € 94.75 50% 10% € 9.48

Base 50%

1 € 30,110 17.7% 8,106 17.9% € 6.23 10 14.4x 6.9% € 73.75 50% 25% € 18.442 € 27,200 15.0% 8,106 15.5% € 4.66 10 12.9x 7.7% € 52.25 50% 25% € 13.06

Worst 30%

1 € 18,757 16.7% 6,381 15.0% € 3.49 5 12.9x 7.7% € 46.00 30% 9% € 4.142 € 17,242 15.0% 6,381 13.5% € 2.81 5 12.9x 7.7% € 39.25 30% 9% € 3.533 € 13,254 15.0% 5,346 11.9% € 2.32 1 12.9x 7.7% € 33.00 30% 9% € 2.974 € 10,946 12.0% 5,346 8.8% € 1.17 1 10.1x 9.9% € 25.75 10% 3% € 0.77

Total € 63.24

Sum 100%Most Likely € 28,655 16.4% 8,106 16.7% € 5.45 10 13.6x 7.3% € 63.00Current € 11,084 15.6% 4,607 25.8% € 2.94

Exhibit 10: Value DistributionSource: VT

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Distribution (€33.00 Low, €63.25 Mid, €108.50 High)

X <= 89.9995.0%

X <= 43.535.0%

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How Could I Be Wrong?

Cyclically Wrong. The worst case scenarios in the decision tree hold the first answer: Spain and Western Europe could go back into recession, credit spreads could blow out, and market-implied competitive advantage periods could shrink back to nothing, as we saw in the 2007-2009 stock market blowups. With Spain having been in recession for at least five quarters and comps now up 14% in the first half of the fiscal year, this probability is remote in the very near term, but not unthinkable in the least.

Exhibit 11: Spanish GDP YoYSource: Bloomberg, VT

If Spain hits the same capital market turbulence Greece has hit, it won't matter that the current unemployment rate is 20%. It can go higher if the country is forced to take down its budget deficit from 11% of GDP to primary balance in 2-3 years. The macroeconomic dynamic in Europe currently is highly deflationary. Fiscal consolidation leads to deflationary recessions or worse. In that sort of environment, people are less apt to spend on discretionary items and more apt to pay down debt if they have a job. I have lower consumer discretionary spending in CY 2011 for Inditex's Western European markets in all cases, offset by better growth outside Europe. In the most extreme outcomes, occupying 12% of the decision tree, I have a mild to very bad recession in CY 2010-2011 with margins flat to down 350 bps and the market assigning no competitive advantage to the company. Downside in these scenarios ranges from €25.75 to $33.00. This is the sort of outcome that is easy to imagine and easy to model financially but hard to

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(6.0%)

(4.0%)

(2.0%)

0.0%

2.0%

4.0%

6.0%

8.0%

estimate the probability of occurrence. If a recession doesn't happen, then I will have been too pessimistic and if it does happen, I will have overestimated the value of the company relative to a likely low point of valuation. There is tons of room for me to be cyclically wrong on this.

Secularly Wrong.

Emerging markets could be a pig in a poke. Investors have always been in love with emerging markets stories, from the Mississippi Company of John Law through American canal and railroad securities to today. When addressable markets are expanding and a plausible case can be made for the continuation of the phenomenon, then it stands to reason leading companies will benefit when their products are well received and their business models and distribution allow them to access this growth. Among all the BRICs, China has the most diversified growth profile (is not overly dependent upon natural resources prices remaining firm) and the legislative and regulatory appetite for growth. Brazil and Russia are more exposed to commodities prices while India is a legal and regulatory nightmare. My case for Inditex's growth doesn't depend solely on emerging markets growth. I believe the company can compete in both developed and emerging markets given its competitive price points and differentiated production and distribution model. Furthermore, growth in China and India will be sourced more from the 200M person middle class in each country, not from the 70-80% of the populations with far smaller incomes who aren't even in the customer set currently.

I could be wrong about the business model, which can be replicated with enough capital and patience. Designers aren't in short supply in this world, nor are clothing manufacturers, and the model has been well documented as a huge success story. Furthermore, the flexibility of the business model could break down. While feedback comes in from each of the 4,607 stores on what customers want, that could be misinterpreted through bad process or groupthink at the designer level. With nine million square feet of distribution in Europe, logistics breakdowns could also foul up the business model. Finally, while Inditex has been run in a decentralized fashion for 30 years, the passing or retirement of the 75 year-old founder could lead to an executive or his daughter trying to consolidate power as an autocrat. That could ruin or impair the business model.

Variant Perceptions. This is not an information advantage opportunity, but it is a behavioral advantage opportunity and an analytical advantage opportunity. On analytical advantage, I believe the market is not fully discounting the competitive strengths of the Inditex model. The flexibility of the model sets it apart in maintaining its competitive advantage and its financial characteristics lead to a higher equity value vs. other growth retailers that consume cash as they grow, spit out far less cash as a percentage of net income, or have higher variability in their cash output. This is most clearly visible in Exhibit 8 on capital intensity.

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On behavioral advantage, this is a time arbitrage investment where this isn't cheap-looking, but it's not as expensive as its looks. Investors who focus on earnings multiples will miss the FCF yields of 5.0% and 4.9%, which are very high for a company generating location growth of 8% and 7% this year and next and EPS growth of 10%+. With net cash of €2.4B, the company's credit risk and beta are very low, which also leads to higher warranted equity valuations. This is a case where it makes sense to override the value investor's behavioral instinct to not pay up on earnings multiples.

Historical Multiples. Inditex is currently trading at 19.5x 2011E consensus EPS of €2.42, which is about 1x lower than its average FY1 multiple over the last ten years.

Exhibit 12: Historical P/ESource: Bloomberg, VT

Given Inditex has outperformed the IBEX (Spanish) index by 800+ bps annually over ten years (12.9% vs. 4.5%), the Dow Jones Euro Stoxx index by 1,200+ bps (12.92% vs. 0.18%), and its cost of equity by 400-500 bps, this has historically been too cheap. I believe the P/E (26.1x and 22.8x) and FCF yields (3.8% and 3.7%) implied by my €63.25 CTV are not out-of-line with a company coming off a cyclically-depressed earnings level, with 27% emerging markets exposure and growing, and looking at the 5-10 year fundamental growth rates discussed above.

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10.0x

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35.0x

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Conclusion. Inditex is a rare opportunity in that its business model is highly differentiated, it has proven its ability to expand in a capital-efficient manner to meet the demands of a growing addressable market, the company returns good amounts of cash to shareholders and is growing those cash returns, the balance sheet is pristine, and the company is controlled by a rational shareholder with a huge stake in the company's continued success. I believe the company can generate double-digit EPS and FCF per share growth for 5-10 years and that this is not fully discounted in the stock today. I recommend buying this with upside of 32% to my €63.25 CTV, for a 3-5 year IRR of 13.0% to 17.0%.

Inditex has 623M shares outstanding for a market cap of €29.9B, cash of €2.4B, and debt of €40M for an enterprise value of €28.0B. It is trading at 20.6x and 18.6x my 2011E and 2012E (Jan) EPS of €2.33 and €2.58, 19.8x and 17.3x consensus EPS of €2.42 and €2.77, at FCF yields of 5.0% and 4.9% on FCF per share of €2.41 and €2.35, and at a 2.5% dividend yield.

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