Inditex (ITX.MC) Deconstructing the data. 21 March 2017 Europe/Spain Equity Research Apparel

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1 Europe/Spain Equity Research Apparel Rating UNDERPERFORM Price (20 Mar 17, ) Target price ( ) Market Cap ( m) 99,841.9 Enterprise value ( m) 93,364.9 Target price is for 12 months. Research Analysts Share price performance Simon Irwin simon.irwin@credit-suisse.com Pradeep Pratti, CFA pradeep.pratti@credit-suisse.com Ju l Ja n Ju l Ja n ITX.M C M ADRID SE INDEX The price relative chart measures performance against the MADRID SE INDEX which closed at on 20/03/17 On 20/03/17 the spot exchange rate was 1/Eu 1.- Eu.93/US$1 Performance 1M 3M 12M Absolute (%) Relative (%) Inditex (ITX.MC) RESULTS Deconstructing the data While Inditex's reports and conference calls tend to be short, with little colour on many key drivers, FY results do give a reasonable degree of data on a geographical and format basis. As the world's largest and most influential apparel retailer, this data does reward some considered analysis. While the picture for space growth is obscured by accelerating absorptions (165 last year), average space growth is slowing at c60bp pa, and new space conversion is not improving sustainably, despite the focus on higher quality flagship space in developed markets, which may help explain the lack of cost leverage. We have broken down the contributors of LFL sales, to exclude space maturity and online, since it doesn t appear to leverage costs. This measure was flat for 7 years, and has spiked to c5% over the past 2 years, driven we assume by RFID adoption, great collections and significant price reductions. In our view there is a real risk that as price cuts start to moderate, LFL sales growth will also start to moderate, especially as peers respond with price cuts of their own, which appears to have been the case in S/S 17 in particular. We are leaving current year forecasts unchanged and reducing 18/19 by c2%. The key is that, after two very good years of execution, we see no reason why margins and EPS growth are now suddenly about to accelerate, as is currently implied by consensus forecasts. We forecast 9.1% avg EPS growth over the next 4Y, and on 28x 12m FWD PER the shares trade at 2.4x PE/TSR vs 1.5x over the past decade. As with all high margin retailers we see risks to margins firmly on the downside particularly as they mature, however our DCF of 23.3x has cashflow/sales averaging 12% into perpetuity which is higher than it has averaged in its history. Given its size and maturity, its current rating discounts sales growth, margins and cash generation accelerating in perpetuity which seems very demanding. Financial and valuation metrics Year 1/16A 1/17A 1/18E 1/19E Revenue ( m) 20, , , ,435.4 EBITDA ( m) 4, , , ,129.9 Adjusted net income ( m) 2, , , , CS EPS (adj.) ( ) Prev. EPS ( ) P/E (adj.) (x) P/E rel. (%) EV/EBITDA (x) Dividend (01/18E, ) 0.58 Net debt/equity (01/18E,%) Dividend yield (01/18E,%) 1.8 Net debt (01/18E, m) -6,477.0 BV/share (01/18E, ) 3.1 IC (01/18E, m) 6,650.9 Free float (%) 33.0 EV/IC (01/18E, (x) 14.0 Source: Company data, Thomson Reuters, Credit Suisse estimates DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, LEGAL ENTITY DISCLOSURE AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit Suisse 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 Inditex (ITX.MC) Price (20 Mar 2017): ; Rating: UNDERPERFORM; Target Price: 25.00; Analyst: Simon Irwin Income statement ( m) 1/16A 1/17A 1/18E 1/19E Revenue 20,900 23,311 25,971 28,435 EBITDA 4,699 5,083 5,654 6,130 Depr. & amort. (1,022) (1,063) (1,168) (1,262) EBIT 3,677 4,020 4,486 4,868 Net interest exp Associates PBT 3,743 4,078 4,567 4,953 Income taxes (861) (917) (1,041) (1,129) Profit after tax 2,882 3,161 3,526 3,824 Minorities (8) (4) (4) (5) Preferred dividends Associates & other Net profit 2,875 3,157 3,521 3,819 Other NPAT adjustments Reported net income 2,875 3,157 3,521 3,819 Cash flow ( m) 1/16A 1/17A 1/18E 1/19E EBIT 3,677 4,020 4,486 4,868 Net interest Cash taxes paid (977) (798) (1,041) (1,129) Change in working capital 602 (275) Other cash and non-cash items 1,122 1,116 1,139 1,232 Cash flow from operations 4,434 4,073 4,789 5,220 CAPEX (1,552) (1,445) (1,528) (1,607) Free cashflow to the firm 3,616 3,223 3,855 4,210 Acquisitions Divestments Other investment/(outflows) Cash flow from investments (1,552) (1,445) (1,528) (1,607) Net share issue/(repurchase) 0 (35) 0 1 Dividends paid (1,626) (1,871) (2,119) (2,431) Issuance (retirement) of debt Cashflow from financing (2,488) (2,804) (3,017) (3,328) Changes in net cash/debt 1, Net debt at start (4,010) (5,301) (6,091) (6,477) Change in net debt (1,291) (790) (386) (368) Net debt at end (5,301) (6,091) (6,477) (6,846) Balance sheet ( m) 1/16A 1/17A 1/18E 1/19E Assets Total current assets 8,450 9,899 10,592 11,339 Total assets 17,358 19,622 20,558 21,751 Liabilities Total current liabilities 4,601 5,387 5,860 6,446 Total liabilities 5,906 6,870 7,370 7,984 Total equity and liabilities 17,358 19,622 20,498 21,692 Per share 1/16A 1/17A 1/18E 1/19E No. of shares (wtd avg.) (mn) 3,116 3,116 3,116 3,116 CS EPS (adj.) ( ) Dividend ( ) Free cash flow per share ( ) Key ratios and valuation 1/16A 1/17A 1/18E 1/19E Growth/Margin (%) Sales growth (%) EBIT growth (%) Net income growth (%) EPS growth (%) EBITDA margin (%) EBIT margin (%) Pretax profit margin (%) Net income margin (%) Valuation 1/16A 1/17A 1/18E 1/19E EV/Sales (x) EV/EBITDA (x) EV/EBIT (x) Dividend yield (%) P/E (x) Credit ratios (%) 1/16A 1/17A 1/18E 1/19E Net debt/equity (%) (46.3) (47.8) (49.3) (49.9) Net debt to EBITDA (x) (1.1) (1.2) (1.1) (1.1) Interest coverage ratio (x) (367.7) (402.0) (147.3) (151.7) Source: FTI, Company data, Thomson Reuters, Credit Suisse Securities (EUROPE) LTD. Estimates Company Background Inditex is the largest apparel retailer in the world through its Zara format and other brands which include Bershka, Pull & Bear. It is based in Spain (25% of sales) however it is present in 82 markets as it expands overseas and via e-commerce. Blue/Grey Sky Scenario Our Blue Sky Scenario ( ) Our blue sky scenario involves increasing 2017 EPS by 5%, increasing the terminal EBIT margin by 100bp and increasing TGR by 100bp. We then apply higher valuations than our core ie 1.75x PE/TSR and 25x PER. This gives a valuation of Our Grey Sky Scenario ( ) Our grey sky scenario involves decreasing 2017 EPS by 5%, reducing the terminal EBIT margin by 100bp and decreasing TGR by 100bp. We then apply lower valuations than our core ie 1.25x PE/TSR and 20x PER. This gives a valuation of Share price performance May- 15 Sep- 15 Jan- 16 May- 16 Sep- 16 Jan- 17 ITX.MC MADRID SE INDEX The price relative chart measures performance against the MADRID SE INDEX which closed at on 20/03/17 On 20/03/17 the spot exchange rate was 1/Eu 1.- Eu.93/US$1 Inditex (ITX.MC) 2

3 Key Charts Figure 1: Price momentum the shares are still oversold vs the market 40% 30% 20% 10% 0% Overbought 3% -10% 2% Oversold -20% 1% Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Mar-17 ITX % dev from 6m ave, lhs Average (+/-1SD) ITX rel to Eurostoxx 10% 9% 8% 7% 6% 5% 4% Figure 2: Earning momentum remains flat EPS (EUR) Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Mar-17 FY12 FY13 FY14 FY15 FY16 FY17E FY18E FY19E Share Price Inditex Share Price ( ) Source: Thomson Reuters Datastream Source: Thomson Reuters Datastream Figure 3: 12M Fwd PE the shares have started to de-rate Figure 4: the de-rating is notable particularly relative to the local market Mar-07 Mar-09 Mar-11 Mar-13 Mar-15 Mar-17 ITX Fwd PE average +1 SD -1 SD 1.0 Mar-07 Mar-09 Mar-11 Mar-13 Mar-15 Mar-17 Source: Thomson Reuters Datastream Source: Thomson Reuters Datastream Figure 5: Almost all components of growth are slowing vs its history -10y Avg +4Y Avg Space Growth (% chg pa) 11.1% 6.7% Space Contbn (% chg pa) 9.7% 5.2% LFL Sales (avg) 4.7% 5.0% Gross margin (bp) Opex as % sales Tax rate change (bp) EPS growth 12.6% 9.1% Figure 6: However the valuation of that growth is considerably higher -10y Avg +4Y Avg 65% P/O EPS Growth 12.6% 9.1% Avg Yield 2.24% 2.3% TSR 14.8% 11.4% 12m FWD PE PE/TSR Inditex (ITX.MC) 3

4 Breaking down sales, LFL and space contribution is becoming quite complex If nothing else 4Q was notable as being the first quarter when the number of Zara stores actually fell (-8 Q/Q) while net store openings (+46) were near record lows: Figure 7: Net store openings are falling rapidly Q Zara* Group Q Zara* Group H Group Q Zara* Group Q Zara* Group H Group FY Zara * Group Gross openings are slowly falling (444 in 16/17 vs an average of 507 in the prior 4Y), but another major feature is the amount of churn in the store estate as it increasingly focuses on Flagships. There were 165 absorptions in 16/17 vs an average of 135 in the prior 3Y, and guidance for the current year is another , giving net store openings of c300: Figure 8: Store park churn is accelerating Stores 2013/16 13/16 Avg FY 16/ /17 Gross Openings Refurbs Enlargements Absorptions Net Openings With fewer larger openings, and more closures, net new stores averaged 1,161sm in 16/17, double the chain average: Figure 9: Net new stores of 1,161sm were double the chain average however average space growth is slowing at c60bp pa and conversion isn t increasing sustainably Stores, space & sales E 2019E 2020E 2021E Net new stores Year end stores 4,607 5,044 5,527 6,009 6,340 6,683 7,013 7,292 7,598 7,920 8,260 8,616 % chg 8.0% 9.5% 9.6% 8.7% 5.5% 5.4% 4.9% 4.0% 4.2% 4.2% 4.3% 4.3% Increase in selling space (sm) 167, , , , , , , , , , , ,720 YE selling space 2,348,708 2,587,647 2,838,980 3,161,448 3,441,969 3,786,099 4,086,904 4,410,896 4,726,786 5,033,731 5,332,066 5,639,786 % chg 7.7% 10.2% 9.7% 11.4% 8.9% 10.0% 7.9% 7.9% 7.2% 6.5% 5.9% 5.8% Growth in average selling space 10.0% 10.0% 10.0% 10.6% 10.1% 9.6% 8.9% 8.4% 7.2% 6.9% 6.3% 5.9% New space contbn 8.5% 7.5% 7.7% 8.0% 6.4% 7.0% 6.5% 6.5% 5.6% 5.4% 5.0% 4.7% conversion 85.1% 75.3% 77.2% 75.1% 64.0% 73.2% 72.9% 77.8% 78.0% 79.0% 80.0% 80.0% Average store size (sqm) Avg size of net new stores , ,161 1, As % chain avg -5% 7% 0% 29% 61% 87% 63% 101% 73% 55% 39% 34% Inditex (ITX.MC) 4

5 This is particularly true of Zara, where net new stores were 3,569sm (37,500sf) Figure 10: Zara stores are getting large, but sales densities haven t changed much in the past 5 years Zara stores, space & sales E 2019E 2020E 2021E Net sales Growth (%) 3.7% 14.3% 10.5% 17.9% 2.5% 7.3% 17.5% 13.0% 11.9% 11.4% 10.8% 10.5% New stores Year end stores Increase in selling space 93, , , , , , , , , , , ,500 YE selling space 1,541,291 1,687,949 1,824,753 2,009,717 2,150,517 2,352,826 2,523,388 2,705,417 2,873,167 3,035,417 3,192,917 3,360,417 Space growth (%) 6.5% 9.5% 8.1% 10.1% 7.0% 9.4% 7.2% 7.2% 6.2% 5.6% 5.2% 5.2% Avg size of net new stores 1,068 1,192 1,279 1,947 2,133 2,152 2,215 3,569 3,050 2,750 2,500 2,500 Average store size (sqm) ,044 1,080 1,128 1,167 1,223 1,267 1,304 1,336 1,368 Sales/m2 (EUR) 4,812 5,126 5,190 5,634 5,283 5,267 5,689 5,974 6,272 6,586 6,915 7,261 % chg -3.2% 2.8% 0.1% 4.5% -4.7% -1.1% 5.9% 2.9% 3.0% 2.4% 1.9% 2.1% Given the number of extensions, absorptions and closures, net store openings by region or country no longer give quite the real picture of space change, nevertheless the breakdown of top countries for net new openings shows a familiar picture, with the Top 5 countries making up 60% of net new openings, and Russia, China and Mexico making up the top 3 as usual: Figure 11: Store growth remains concentrated - Top five markets for net new openings remain 60% of total, but the absolute numbers are much lower Country Stores % Total Country Stores % Total Country Stores % Total Country Stores % Total Country Stores % Total China % China 61 18% Russia 69 20% China 65 20% Russia 56 20% Russia 75 16% Russia 55 17% China 44 13% Mexico 34 10% China 54 19% Poland 38 8% Poland 37 11% Mexico 32 9% Russia 30 9% Mexico 22 8% Mexico 17 4% Mexico 26 8% Turkey 26 8% Italy 18 5% Italy 22 8% Romania 16 3% Turkey 21 6% Japan 25 7% Poland/France 17 5% Romania 14 5% Total openings % % % % % While store numbers in Spain continue to shrink (1,787 vs 1,826) it represents the highest number of absorptions, particularly of smaller formats so we assume that overall space remains broadly flat, given openings of some very significant flagships (ie Zara Barcelona in 2016 and Madrid in 2017). Figure 12: Sales split by region suggests 24bp positive mix in gross margin FY 15/16 m % chg 1H 16/17 m % chg 2H 15/16 m % chg FY 16/17 m % chg Europe ex Spain 44.0% 9, % 43% 4, % 44.6% 5, % 43.9% 10, % Spain 17.7% 3, % 17% 1, % 16.8% 2, % 16.9% 3, % Asia/ROW 23.5% 4, % 25% 2, % 23.0% 2, % 23.9% 5, % Americas 14.7% 3, % 15% 1, % 15.5% 1, % 15.3% 3, % Total 20, % 10, % 12, % 23, % In the US, store numbers grew by 10 to 81, which is roughly in line with the past three years. We still think that Inditex's US and Canadian exposure (and suitability for mass market rollout) tend to be over-estimated by the market we assume they represent 6.7% of sales, while exposure to Latam (est 8.7% of sales) is often ignored. Inditex (ITX.MC) 5

6 Figure 13: Updated geographical breakdown % sales Stores % total of which Zara* % total Staff (15/16) % total Staff per store Sales per store ( m) Sales per Zara ( m) Americas 15.3% % % 18, % Mexico 4.2% % % 6, % US 5.2% % % 5, % Brazil 1.5% % % 3, % Canada 1.5% % % 1, % Rest 2.9% % % 1, % Asia & Africa 23.9% 1, % % 19, % China/HK 8.0% % % 9, % Japan 5.0% % % 4, % S. Korea 2.0% % % 1, % Rest 8.9% % % 3, % E. Europe 16.0% 1, % % 26, % Russia 6.0% % % 10, % Poland 3.0% % % 4, % Turkey 2.2% % % 4, % Romania 1.5% % % 2, % Rest 3.3% % % 5, % Other Europe 27.9% 1, % % 43, % Portugal 3.2% % % % Italy 5.5% % % % France 6.4% % % % UK 4.4% % % % Germany 4.4% % % % Greece 2.0% % % % Rest 2.0% % % 9, % Spain 16.9% 1, % % 46, % Group 100% 7,292 2, , New space contribution remains surprisingly low: We continue to be surprised by the relatively low contribution from net new space. The 6.5% contribution over the past 2 years looks to be c73% and 78% of average net increase in space. This is broadly in line with historic levels, when growth was more focused on less productive, but cheaper EM space. However given the closure of smaller unproductive space, and the focus on prominent, and expensive, flagships then we would have expected the NSC to be nearer 100%, which may explain the ongoing lack of cost leverage. With stores not going into the LFL pool for two years after opening or being modified, c20% of space falls outside the LFL calculation. This makes a material difference to several lines, if we assume that stores open at 70% of mature sales densities and ramp up at c10% pa for the next 3 years. - The NSC also includes the c10% ramp up in immature space in Year 2 ie c1% benefit. - The LFL calculation includes the benefit of ramp up in Years 3 and 4, which should give % benefit. - The reported LFL (10% last year) only contributes to 80% of space, so its contribution to group sales last year would have been 8%. Inditex (ITX.MC) 6

7 Figure 14: Space conversion is lower than we would expect Year end January E 2019E 2020E 2021E LFL - reported 5.0% 0.0% 0.0% 3.1% 4.3% 6.5% 3.0% 5.0% 8.5% 10.0% 6.0% 5.0% 4.0% 4.0% LFL contribution to sales 3.3% 0.0% 0.0% 2.5% 3.4% 5.0% 2.2% 3.9% 6.6% 8.0% 4.8% 4.1% 3.3% 3.4% inc LFL from space ramp up 2.4% 2.2% 2.4% 2.0% 1.8% 2.1% 2.3% 2.2% 2.1% 2.0% 1.7% 1.6% 1.4% inc Online contbn - gross 0.5% 1.2% 1.3% 1.0% 1.7% 1.8% 1.9% 2.0% 2.0% 1.8% 1.5% Online contbn - net 0.5% 0.8% 1.0% 0.8% 1.3% 1.3% 1.5% 1.5% 1.5% 1.4% 1.1% LFL ex online & ramp up -2.4% -2.2% 0.2% 1.1% 3.4% -0.2% 1.1% 4.5% 5.9% 1.9% 1.3% 0.6% 1.1% Avg space growth 14.4% 14.3% 10.0% 10.0% 10.0% 10.6% 10.1% 9.6% 8.9% 8.4% 7.2% 6.9% 6.3% 5.9% Conversion 83.6% 75% 85% 75% 77% 75% 64% 73% 73% 78% 78% 79% 80% 80% Sales contbn from new space % Contbn from new space 12.0% 10.7% 8.5% 7.5% 7.7% 8.0% 6.4% 7.0% 6.5% 6.5% 5.6% 5.4% 5.0% 4.7% Currency -2.0% -1.4% -2.0% 2.5% -1.0% 1.6% -3.0% -2.1% 0.6% -3.0% 1.0% 0.0% 0.0% 0.0% Net sales % change 15.1% 10.3% 6.5% 13.0% 10.1% 15.6% 4.9% 8.3% 15.4% 11.5% 11.4% 9.5% 8.3% 8.1% Figure 15: Online Model Should online be in LFL? Finally we have added the online contribution to our LFL model. Inditex, and most peers include online within LFL which we believe is incorrect. - The point of LFL is that it is supposed to leverage fixed store costs through having minimal incremental opex. - Online sales largely do the opposite by having lower fixed costs but a high degree of marginal costs. One third of deliveries are apparently collected through store and two thirds returned to store, however orders still need to be picked in 1 of the 15 online stockrooms, and then distributed individually to the store of home. We also assume that Inditex has higher than average return rates due to its global sizing model and "fitted aesthetic". Online is the main cause of "Other operating expenses" increasing from 9.3% of sales to 9.9% over two years, and largely offsetting staff and rent leverage. - Online cannibalizes stores. We assume that 25% of online sales are cannibalized from stores, and this could be conservative. Year to Jan E 2019E 2020E 2021E Total Sales 12,527 13,793 15,946 16,724 18,117 20,900 23,311 25,971 28,435 30,803 33,295 % chg 13.0% 10.1% 15.6% 4.9% 8.3% 15.4% 11.5% 11.4% 9.5% 8.3% 8.1% LFL 3.1% 4.3% 6.5% 3.0% 5.0% 8.0% 10.0% 6.0% 5.0% 4.0% 4.0% Fashion Retail SA (Spain) ITX Fashion* Total Online % chg 259% 87% 42% 51% 39% 35% 30% 25% 20% 15% Gross contbn from online 1.2% 1.3% 1.0% 1.7% 1.8% 1.9% 2.0% 2.0% 1.8% 1.5% Cannibalisation as % online 25% 25% 25% 25% 25% 25% 25% 25% 25% 25% Net contbn to LFL 0.5% 0.8% 1.0% 0.8% 1.3% 1.3% 1.5% 1.5% 1.5% 1.3% 1.1% as % total sales 0.5% 1.5% 2.4% 3.3% 4.6% 5.5% 6.7% 7.8% 8.9% 9.9% 10.5% Source: Company data, Companies Registration House, Credit Suisse estimates We also calculate LFL ex ramp up and (gross) online contribution. It is notable that this was largely flat, or negative, for 7 years, until the past two years, when it spiked. So the good news is there is a higher degree of "sustainable LFL" from ramp up and online in future years than we had expected, which starts and 4% pa and declines to 3%. Half of this is online and (in our view) doesn t lever costs. Inditex (ITX.MC) 7

8 On the other hand, the sudden acceleration of the past two years requires some explanation. We believe there are three principal causes: - RFID adoption should have improved availability and service, but this is now largely complete - Zara can be quite contra-cyclical. The past couple of years have seen a dearth of strong fashion trends. When fashion trends are big and sustainable, all retailers jump on them and with widespread availability of the same trends, there is more competition. Zara's shorter time to market and better read of trends means that it has less competition when times get tough. - Price cuts. Our apparel pricing surveys over the past two years have consistently shown Zara to be lowering the prices of its upper end ranges, and consequently narrowing its range architecture. Even for S/S 17 (when we had expected price cuts to moderate) top end prices declined c10% in the UK and >-20% in Europe. See: European Apparel Pricing: No let-up in spring deflation Figure 16: Upper price basket shows ongoing price investment, despite weakness, especially M&S & H&M Apr-14 Sep-14 Nov-14 Mar-15 Jun-15 Sep-15 Nov-15 Mar-16 Jun-16 Sep-16 Nov-16 March-17 H&M Zara New Look Mango Gap Next River Island Primark M&S Source: Company data, In our view this process had led to significant improvements in Zara LFL sales over the past two years, however little cost leverage due to the significant increase in volumes. The key is what happens to LFL when this process stops? In our view there is a real risk that as price cuts start to moderate, Inditex's LFL sales growth will start to moderate, especially as peers respond with price cuts of their own, which appears to have the case in S/S 17 in particular. What does this mean for gross margins? Given its consistent regional pricing differentials, Inditex's gross margins should theoretically be mixing up by c25bp pa, as the share of sales in Spain and Continental Europe declines. Figure 17: Regional price differences should imply gross margins mixing up Spain UK France Russia Japan USA China Mexico Upper basket relative pricing Lower basket relative pricing Indicative GM 46% 60% 53% 70% 68% 74% 64% 48% Inditex (ITX.MC) 8

9 However 2012/13 was the last time reported gross margins increased. The company has blamed FX for GM declines in recent years, and while it has historically guided to "stable gross margins +/-100bp", for the current year it is guiding to gross margins between bp. Figure 18: Gross margins by half year it's not just about FX Y/E Jan H 54.2% 56.1% 55.0% 55.7% 56.5% 55.4% 59.4% 58.4% 59.6% 58.6% 57.6% 58.1% 56.8% Chg (bp) $/EUR lagged -11.7% 2.6% 3.8% -18.2% 1.7% 2H 56.4% 56.3% 57.2% 57.6% 57.1% 58.4% 59.2% 60.1% 59.9% 60.0% 58.9% 57.7% 57.1% Chg (bp) $/EUR lagged -1.5% 3.8% -11.8% -8.4% -1.8% FY 55.4% 56.2% 56.2% 56.7% 56.8% 57.1% 59.2% 59.3% 59.8% 59.3% 58.3% 57.8% 57.0% Looking at some of the GM components may support some stability: - FX has been quite negative and should be flat this year, - Geographical mix should remain positive - We believe that there is less US$ cost mitigation for buying apparel due to higher raw materials prices and significantly higher transport costs. - The company never discusses markdown, but inventory looked quite high through much of last year, and S/S clearance looked quite substantial, so the company's confidence may relate to lower markdown. Figure 19: Inventory looked high last year - is there an opportunity in reducing markdown? Inventory (Y/E Jan) Q Q Q Q % chg Y/Y 1Q 21% 34% 16% -12% 24% 3% 27% 11% 12% 27% 2Q 12% 19% 6% -3% 26% -1% 15% 21% 8% 22% 3Q 17% 13% 1% 11% 25% 12% 7% 20% 13% 18% 4Q 22% 5% -6% 22% 5% 24% 6% 11% 18% 16% Days sales 1Q Q Q Q However the industry is likely to remain deflationary with pressure on margins: - Our recent apparel survey noted a surprising degree of deflation for S/S in UK and Europe, despite adverse exchange rates. - Demand is likely to remain weak, given the lack of strong fashion trends, growth in discount channels, and a much reduced participation by millennials. - The industry continues to add capacity both online and offline. - The need to offer a seamless multi-channel experience implies that retailers need to continue investing development spend and opex in the channel. Inditex (ITX.MC) 9

10 So in most respects, we believe it is largely irrelevant if margins are +/-50bp in any given year when the longer term trends are so well established. The margin impact of online is very clear in Inditex's P&L. While it has levered Personnel and Rental expenses, this has been largely offset by Other expenses (+60bp) in 2Y, which includes the cost of online development and fulfilment. Figure 20: Margin drivers virtually no opex leverage despite high LFL's because of online costs Year end January E 2019E 2020E Contbn from new space 7.5% 7.7% 8.0% 6.4% 7.0% 6.5% 6.5% 5.6% 5.4% 5.0% LFL 3.1% 4.3% 6.5% 3.0% 5.0% 8.5% 10.0% 6.0% 5.0% 4.0% Gross margin (%) 59.2% 59.3% 59.8% 59.3% 58.3% 57.8% 57.0% 57.0% 56.7% 56.5% Personnel expenses 16.0% 16.2% 16.0% 16.1% 16.2% 16.0% 15.6% 15.6% 15.5% 15.6% Rental expenses 10.2% 10.1% 9.6% 9.9% 10.2% 10.0% 9.5% 9.5% 9.4% 9.4% Other operating expenses 9.3% 9.3% 9.6% 9.8% 9.3% 9.4% 9.9% 10.0% 10.1% 10.2% Opex as % sales 35.5% 35.7% 35.1% 35.9% 35.6% 35.4% 35.2% 35.2% 35.1% 35.2% Opex growth 12.6% 10.5% 13.9% 7.0% 7.7% 14.4% 10.9% 11.5% 9.2% 8.6% Opex growth (cc) 10.1% 11.5% 12.3% 10.0% 9.8% 13.8% 13.9% 10.5% 9.2% 8.6% Depn as % sales 5.4% 5.3% 5.0% 5.1% 5.0% 4.9% 4.6% 4.5% 4.4% 4.4% EBIT margins (%) 18.3% 18.3% 19.5% 18.4% 17.7% 17.6% 17.2% 17.3% 17.1% 16.9% The biggest source of cost leverage has been depreciation, however this now looks as if it moderate as capex and depreciation gradually align. Figure 21: Depreciation has been the biggest source of cost leverage (120bp over 7Y), however this will now lessen as Capex and Depreciation slowly align Year to January E 2019E 2020E 2021E Net TA NTA psm Capex (ex F/H) Capex as % sales 10.0% 9.0% 4.6% 5.8% 6.3% 7.0% 7.5% 7.4% 7.3% 6.2% 5.9% 5.7% 5.5% 5.3% D&A Depn as % GTA 9.8% 10.1% 10.6% 10.2% 9.4% 9.1% 9.0% 8.4% 8.7% 7.9% 7.7% 7.5% 7.2% 7.0% Depn as % NTA 15.6% 16.7% 19.5% 19.8% 18.0% 16.8% 16.4% 14.8% 15.4% 14.6% 14.9% 15.2% 15.4% 15.6% DD&A as % sales 5.3% 5.6% 5.8% 5.4% 5.3% 5.0% 5.1% 5.0% 4.9% 4.6% 4.5% 4.4% 4.4% 4.4% Capex as % depn 190% 162% 79% 108% 117% 141% 146% 149% 149% 136% 131% 127% 124% 122% Likewise, after 15/16's exceptional cash inflow, it moderated in 16/17 as WC normalized: Figure 22: Working capital trends have normalized after 15/16's unusual inflow E 2019E 2020E 2021E Inventories Days of COGS Accounts receivable Trade accounts payable Days COGS Total WC Days COGS WC Change Cash conversion therefore moderated to a relatively normal 85%, and as the dividend payout gradually increases, the net cash build starts to moderate quite materially. Inditex (ITX.MC) 10

11 Figure 23: The net cash build is moderating E 2019E 2020E EPS % chg 24.9% 0.4% 4.6% 31.4% 11.6% 22.1% 0.7% 5.1% 15.0% 9.8% 11.5% 8.5% 6.7% DPS - ordinary DPS - special DPS - total % change 25% 0% 14% 33% 13% 22% 10% 7% 14% 14% 15% 10% 9% Ordinary payout ratio 52% 52% 52% 50% 52% 50% 50% 51% 51% 49% 51% 51% 51% Total payout ratio 52% 52% 57% 58% 58% 58% 63% 65% 64% 67% 69% 70% 71% Cash conversion 70% 67% 138% 104% 72% 84% 60% 56% 103% 85% 95% 97% 95% Net Cash Net cash less prop div Dividend Yield 0.8% 0.8% 0.9% 1.1% 1.3% 1.6% 1.7% 1.9% 2.1% 2.4% 2.8% 3.1% 3.3% Y/E net cash/share Net cash post dividend Net cash generated We are making minimal changes to current year forecasts, and cut subsequent years by c2%, due to slightly lower space contribution and margins. Figure 24: Old & New forecasts we are making modest changes to forecasts but see little reason to expect margins or growth rates to accelerate Old E 2018E 2019E 2020E Revenue 2,321 26,014 28,712 31,550 LFL Sales 7.5% 5.0% 4.0% 4.0% GM mvt bp EBIT 4,057 4,498 4,984 5,466 % sales 17.4% 17.3% 17.4% 17.3% Net Profit 3,171 3,529 3,910 4,287 EPS New E 2019E 2020E Revenue 20,900 23,311 25,971 28,435 31,039 LFL Sales 8.5% 10.0% 6.0% 5.0% 5.0% GM mvt bp EBIT 3,677 4,021 4,486 4,868 5,329 % sales 17.6% 17.2% 17.3% 17.1% 17.2% Net Profit 2,875 3,157 3,521 3,819 4,178 EPS EPS growth 15.0% 9.8% 11.5% 8.5% 9.4% % chg forecast -0.7% 0.0% -1.9% -2.5% Consensus EPS CS vs cons -3.4% -7.1% -9.4% Cons sales 26,133 28,836 31,702 Cons EBIT 4,682 5,288 5,906 % sales 17.9% 18.3% 18.6%, consensus Thomson Reuters The key is that, after two very good years of execution, we see no reason why margins and EPS growth are now suddenly about to accelerate, as is currently implied by consensus forecasts. We are making no change to our valuation matrix, which gives a 12m FWD target price of 25/share. Inditex (ITX.MC) 11

12 Figure 25: Target price matrix Metric Current TP 12m FWD Grey Sky 12m FWD Blue Sky 12m FWD 1.5x PE/TSR x TSR x TSR 20.9 DCF Margin -100bp 21.2 Margin +200bp x PER x PER x PER 33.4 Average Figure 26: The key element of our DCF (WACC 7.5%, TGR 2%) is that C/F as a % of sales stays flat at near peak levels into perpetuity- that seems quite optimistic Year end Jan E 2019E 2020E 2021E 2022E 2023E 2024E Revenues % growth 15.6% 4.9% 8.3% 15.4% 11.5% 11.4% 9.5% 9.2% 8.1% 6.0% 4.0% 2.0% Gross profit Margin 59.8% 59.3% 58.3% 57.8% 57.0% 57.0% 56.7% 56.5% 56.3% 55.8% 55.3% 54.8% Operating costs % chg 13.3% 6.9% 7.6% 14.1% 10.1% 11.3% 9.1% 8.5% 8.0% 6.0% 4.0% 2.0% % sales 40.2% 41.0% 40.7% 40.3% 39.7% 39.7% 39.5% 39.3% 39.3% 39.3% 39.3% 39.3% Operating profit Margin 19.5% 18.4% 17.7% 17.6% 17.2% 17.3% 17.1% 17.2% 17.0% 16.5% 16.0% 15.5% EBITDA margin 24.5% 23.5% 22.6% 22.5% 21.8% 21.8% 21.6% 21.5% 21.3% 20.8% 20.2% 19.7% Tax Tax rate (%) 24% 22% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% NOPAT Depreciation % sales 5.0% 5.1% 5.0% 4.9% 4.6% 4.5% 4.4% 4.4% 4.3% 4.3% 4.2% 4.2% Capex % sales 8.4% 8.4% 10.2% 7.4% 6.2% 5.9% 5.7% 5.4% 5.2% 5.5% 5.0% 4.2% Change in working capital % sales 1.0% -0.5% 0.3% 3.4% 0.8% 0.6% 0.7% 0.3% 0.4% 0.3% 0.2% 0.1% Cash flow C/F as % sales 12.4% 10.6% 8.7% 14.4% 12.5% 12.6% 12.7% 12.5% 12.6% 11.8% 11.8% 12.1% PV of cashflow Perpetual growth % 2% Terminal multiple 16.7 PV of cashflows 17,697 PV of terminal multiple 43,574 Total firm value 61,271 Net cash (ex dividend) 6091 Equity Value 67,361 Value per share (EUR) m FWD DCF 23.3 Inditex (ITX.MC) 12

13 Figure 27: P&L Year end January E 2019E 2020E LFL - reported 5.0% 0.0% 0.0% 3.1% 4.3% 6.5% 3.0% 5.0% 8.5% 10.0% 6.0% 5.0% 5.0% LFL contribution to sales 3.3% 0.0% 0.0% 2.5% 3.4% 5.0% 2.2% 3.9% 6.6% 8.0% 4.8% 4.1% 4.2% inc LFL from space ramp up 2.4% 2.2% 2.4% 2.0% 1.8% 2.1% 2.3% 2.2% 2.1% 2.0% 1.7% 1.6% inc Online contbn - gross 0.5% 1.2% 1.3% 1.0% 1.7% 1.8% 1.9% 2.0% 2.0% 1.8% Online contbn - net 0.5% 0.8% 1.0% 0.8% 1.3% 1.3% 1.5% 1.5% 1.5% 1.3% LFL ex online & ramp -2.4% -2.2% 0.2% 1.1% 3.4% -0.2% 1.1% 4.5% 5.9% 1.9% 1.3% 1.7% Avg space growth 14.4% 14.3% 10.0% 10.0% 10.0% 10.6% 10.1% 9.6% 8.9% 8.4% 7.2% 6.9% 6.3% Conversion 83.6% 75% 85% 75% 77% 75% 64% 73% 73% 78% 78% 79% 80% Sales contbn from new space % Contbn from new space 12.0% 10.7% 8.5% 7.5% 7.7% 8.0% 6.4% 7.0% 6.5% 6.5% 5.6% 5.4% 5.0% Currency -2.0% -1.4% -2.0% 2.5% -1.0% 1.6% -3.0% -2.1% 0.6% -3.0% 1.0% 0.0% 0.0% Net sales % change 15.1% 10.3% 6.5% 13.0% 10.1% 15.6% 4.9% 8.3% 15.4% 11.5% 11.4% 9.5% 9.2% Gross profit Gross margin (%) 56.7% 56.8% 57.1% 59.2% 59.3% 59.76% 59.33% 58.34% 57.84% 56.96% 57.0% 56.7% 56.5% Personnel expenses % chg 17.7% 15.6% 5.2% 12.1% 11.2% 14.1% 5.9% 8.7% 13.7% 9.2% 10.9% 9.1% 8.7% as % of sales 15.6% 16.4% 16.2% 16.0% 16.2% 16.0% 16.1% 16.2% 16.0% 15.6% 15.6% 15.5% 15.4% Rental expenses % chg 19.1% 20.2% 10.3% 12.2% 10.0% 9.4% 8.2% 11.7% 12.8% 6.4% 10.9% 8.6% 8.2% as % of sales 9.1% 9.9% 10.2% 10.2% 10.1% 9.6% 9.9% 10.2% 10.0% 9.5% 9.5% 9.4% 9.3% Other operating expenses % chg 7.9% 8.7% 5.2% 14.0% 9.8% 18.7% 7.7% 1.9% 17.5% 17.4% 12.0% 10.7% 9.2% as % of sales 9.5% 9.4% 9.3% 9.3% 9.3% 9.6% 9.8% 9.3% 9.4% 9.9% 10.0% 10.1% 10.1% Total operating expenses as % of sales 34.2% 35.6% 35.7% 35.5% 35.7% 35.1% 35.9% 35.6% 35.4% 35.2% 35.2% 35.1% 34.9% Yoy growth 15.2% 14.9% 6.6% 12.6% 10.5% 13.9% 7.0% 7.7% 14.4% 10.9% 11.5% 9.2% 8.6% Depreciation & Amortisation as % of sales 5.3% 5.6% 5.8% 5.4% 5.3% 5.0% 5.1% 5.0% 4.9% 4.6% 4.5% 4.4% 4.4% Total operating costs as % of sales 39.2% 41.4% 41.5% 41.0% 41.0% 40.2% 41.0% 40.7% 40.3% 39.7% 39.7% 39.5% 39.3% EBIT EBIT margin (%) 17.5% 15.5% 15.6% 18.3% 18.3% 19.5% 18.4% 17.7% 17.6% 17.2% 17.3% 17.1% 17.2% Yoy growth 21.9% -2.6% 7.3% 32.5% 10.1% 23.6% -1.5% 4.1% 15.0% 9.4% 11.6% 8.5% 9.5% EBITDA EBITDA margin (%) 22.8% 21.0% 21.4% 23.7% 23.6% 24.5% 23.5% 22.6% 22.5% 21.8% 21.8% 21.6% 21.5% Net financial Pre tax Pre tax margin (%) 17.4% 15.3% 15.6% 18.5% 18.6% 19.6% 18.3% 17.9% 17.9% 17.5% 17.6% 17.4% 17.5% % chg Y/Y 22.9% -3.5% 9.0% 34.1% 10.2% 22.3% -2.5% 6.3% 15.4% 8.9% 12.0% 8.5% 9.4% Tax Tax rate (%) 23.6% 20.5% 23.7% 25.0% 24.0% 24.4% 22.0% 22.7% 23.0% 22.8% 22.8% 22.8% 22.8% Minorities Attributable profit EPS (EUR) growth (%) 25% 0% 5% 31.4% 11.6% 22.1% 0.7% 5.1% 15.0% 9.8% 11.5% 8.5% 9.4% DPS - ordinary DPS - special DPS - total % chg 25% 0% 14% 33% 13% 22% 10% 7% 14% 14% 15% 10% 11% Total payout ratio 52% 52% 57% 58% 58% 58% 63% 65% 64% 67% 69% 70% 71% Inditex (ITX.MC) 13

14 Companies Mentioned (Price as of 20-Mar-2017) Hennes & Mauritz (HMb.ST, Skr228.5) Inditex (ITX.MC, 32.04, UNDERPERFORM, TP 25.0) Marks & Spencer (MKS.L, 327.9p) Next (NXT.L, p) The Gap, Inc. (GPS.N, $23.4) Disclosure Appendix Analyst Certification Simon Irwin and Pradeep Pratti, CFA, each certify, with respect to the companies or securities that the individual analyzes, that (1) the views expressed in this report accurately reflect his or her personal views about all of the subject companies and securities and (2) no part of his or her compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report. 3-Year Price and Rating History for Hennes & Mauritz (HMb.ST) HMb.ST Closing Price Target Price Date (Skr) (Skr) Rating 14-Apr O 26-Sep Dec Jan Mar N 16-Dec Mar Jun Jul Sep Dec U 01-Feb * Asterisk signifies initiation or assumption of coverage. 3-Year Price and Rating History for Inditex (ITX.MC) O U T PERFO RM N EU T RA L U N D ERPERFO RM Target Price Closing Price HMb.ST 01- Jan Jan Jan ITX.MC Closing Price Target Price Date ( ) ( ) Rating 20-Mar U 13-Mar Sep Mar Sep Sep Mar * Asterisk signifies initiation or assumption of coverage Target Price Closing Price ITX.MC 01- Jan Jan Jan U N D ERPERFO RM Inditex (ITX.MC) 14

15 3-Year Price and Rating History for Marks & Spencer (MKS.L) MKS.L Closing Price Target Price Date (p) (p) Rating 11-Apr U 17-Oct Mar May Jul Dec Jan Apr May Jun Jul N 25-Jan * * Asterisk signifies initiation or assumption of coverage. 3-Year Price and Rating History for Next (NXT.L) U N D ERPERFO RM N EU T RA L Target Price Closing Price MKS.L 01- Jan Jan Jan NXT.L Closing Price Target Price Date (p) (p) Rating 30-Jun N 31-Dec Mar Aug U 14-Sep Dec Jan Mar May N 24-Jun Nov U 05-Jan N * Asterisk signifies initiation or assumption of coverage. 8,500 7,500 6,500 5,500 4,500 3,500 N EU T RA L U N D ERPERFO RM Target Price Closing Price NXT.L 01- Jan Jan Jan Year Price and Rating History for The Gap, Inc. (GPS.N) GPS.N Closing Price Target Price Date (US$) (US$) Rating 11-Aug N * 22-Aug Nov Feb U 27-Feb May Jun Nov Feb May Aug Feb N EU T RA L U N D ERPERFO RM Target Price Closing Price GPS.N 01- Jan Jan Jan * Asterisk signifies initiation or assumption of coverage. The analyst(s) responsible for preparing this research report received Compensation that is based upon various factors including Credit Suisse's total revenues, a portion of which are generated by Credit Suisse's investment banking activities As of December 10, 2012 Analysts stock rating are defined as follows: Outperform (O) : The stock s total return is expected to outperform the relevant benchmark* over the next 12 months. Neutral (N) : The stock s total return is expected to be in line with the relevant benchmark* over the next 12 months. Underperform (U) : The stock s total return is expected to underperform the relevant benchmark* over the next 12 months. Inditex (ITX.MC) 15

16 *Relevant benchmark by region: As of 10th December 2012, Japanese ratings are based on a stock s total return relative to the analyst's coverage universe which consists of all companies covered by the analyst within the relevant sector, with Outperforms representing the most attractive, Neutrals the less attractive, and Underperforms the least attractive investment opportunities. As of 2nd October 2012, U.S. and Canadian as well as European ratings are based on a stock s total return relative to the analyst's coverage universe which consists of all companies covered by the analyst within the relevant sector, with Outperforms representing the most attractive, Neutrals the less attractive, and Underperforms the least attractive investment opportunities. For Latin American and non-japan Asia stocks, ratings are based on a stock s total return relative to the average total return of the relevant country or regional benchmark; prior to 2nd October 2012 U.S. and Canadian ratings were based on (1) a stock s absolute total return potential to its current share price and (2) the relative attractiveness of a stock s total return potential within an analyst s coverage universe. For Australian and New Zealand stocks, the expected total return (ETR) calculation includes 12-month rolling dividend yield. An Outperform rating is assigned where an ETR is greater than or equal to 7.5%; Underperform where an ETR less than or equal to 5%. A Neutral may be assigned where the ETR is between -5% and 15%. The overlapping rating range allows analysts to assign a rating that puts ETR in the context of associated risks. Prior to 18 May 2015, ETR ranges for Outperform and Underperform ratings did not overlap with Neutral thresholds between 15% and 7.5%, which was in operation from 7 July Restricted (R) : In certain circumstances, Credit Suisse policy and/or applicable law and regulations preclude certain types of communications, including an investment recommendation, during the course of Credit Suisse's engagement in an investment banking transaction and in certain other circumstances. Not Rated (NR) : Credit Suisse Equity Research does not have an investment rating or view on the stock or any other securities related to the company at this time. Not Covered (NC) : Credit Suisse Equity Research does not provide ongoing coverage of the company or offer an investment rating or investment view on the equity security of the company or related products. Volatility Indicator [V] : A stock is defined as volatile if the stock price has moved up or down by 20% or more in a month in at least 8 of the past 24 months or the analyst expects significant volatility going forward. Analysts sector weightings are distinct from analysts stock ratings and are based on the analyst s expectations for the fundamentals and/or valuation of the sector* relative to the group s historic fundamentals and/or valuation: Overweight : The analyst s expectation for the sector s fundamentals and/or valuation is favorable over the next 12 months. Market Weight : The analyst s expectation for the sector s fundamentals and/or valuation is neutral over the next 12 months. Underweight : The analyst s expectation for the sector s fundamentals and/or valuation is cautious over the next 12 months. *An analyst s coverage sector consists of all companies covered by the analyst within the relevant sector. An analyst may cover multiple sectors. 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Credit Suisse research products may also be made available through third-party vendors or alternate electronic means as a convenience. Certain research products are only made available through CS PLUS. The services provided by Credit Suisse s analysts to clients may depend on a specific client s preferences regarding the frequency and manner of receiving communications, the client s risk profile and investment, the size and scope of the overall client relationship with the Firm, as well as legal and regulatory constraints. To access all of Credit Suisse s research that you are entitled to receive in the most timely manner, please contact your sales representative or go to Credit Suisse s policy is to update research reports as it deems appropriate, based on developments with the subject company, the sector or the market that may have a material impact on the research views or opinions stated herein. Credit Suisse's policy is only to publish investment research that is impartial, independent, clear, fair and not misleading. For more detail please refer to Credit Suisse's Policies for Managing Conflicts of Interest in connection with Investment Research: Credit Suisse does not provide any tax advice. Any statement herein regarding any US federal tax is not intended or written to be used, and cannot be used, by any taxpayer for the purposes of avoiding any penalties. Target Price and Rating Valuation Methodology and Risks: (12 months) for Inditex (ITX.MC) Method: We use a weighted basket including 22.5x 12m FWD PER, a DCF of 23.7 with a WACC of 7.5%, and 5Y PE/TSR of 1.5x, giving a target price of 25. The stock trades at a c30% premium to its long term average, and as the world's largest apparel retailer we believe that its medium term growth prospects are inevitably slowing while margin are already high. Our target price implies significant downside over the next 12 months so we rate the share Underperform relative to the European General Retail sector. Risk: On the upside, the main risk to our 25 target price and Underperform rating is that earnings continue to beat market expectations and that either LFL sales or gross margins are stronger than we currently forecast. On the downside, Inditex can only maintain such elevated valuations for as long as earnings meet or exceed expectations. Given the weakness in consumer demand in key markets and increasing competition, and deterioration in demand, or any weakness in execution would impact forecasts and valuation. Inditex (ITX.MC) 16