Portfolio shares: is it the right time to buy Burberry?

This week I want to look at luxury fashion group Burberry (LON: BRBY), which is a member of my quality dividend model portfolio and a personal shareholding.

Burberry's share price dipped on Friday after the company said that sales in mainland China fell by 35% during the most recent quarter, due to Covid lockdowns.

However, the bigger picture looked more reassuring to me. Excluding China, comparable store sales rose by 16%, with Europe and the Middle East performing significantly better still.

Key product lines such as leather goods and outerwear were said to have delivered double-digit sales growth outside China.

I think it's fair to assume that Covid lockdowns are a temporary problem, even in China. So why are investors so downbeat about Burberry this year?

I think one reason is simply that the stock's recovery in 2021 probably ran ahead of events.

However, I'd suggest a larger reason for the market's jaded reaction may be that Burberry has not really delivered any real growth since 2015:

I suspect this has contributed to the stock's severe underperformance against key European rivals:

Of course, there are differences between Burberry and its rivals. The UK firm is a single, independent brand, whereas juggernauts like LVMH and Kering own large portfolios of luxury names. This may give them more diverse and durable earnings.

There have also been key personnel changes at Burberry, resulting in changes to strategy and guidance. Creative chief Riccardo Tisci has only been in role since 2018. Since then, the pandemic has disrupted his efforts to move the brand upmarket and refine and expand Burberry's product range.

More recently, ex-CEO Marco Gobbetti (who recruited Tisci) has left the role and been replaced by Brit Jonathan Akeroyd.

My rationale for buying Burberry is that behind the changes I think it remains a durable, high-quality business.

As a patient long-term investor, my hope is that the disappointments of recent years have left Burberry shares trading at an attractive price, with potential to deliver marketing-beating gains and reliable dividend growth.

In the remainder of this review, I'll step through the different stages in my dividend screening system and drill down into Burberry's financial performance.

Unless specified otherwise, the financial data I use in this process is drawn from SharePad.

Disclosure: Roland owns shares of Burberry.

Burberry: crunching the numbers

Description: A FTSE 100 luxury fashion brand founded in 1856. Trademark  styles include trench coats and the Burberry check. Click here for an archive of past posts.

Latest accounts: preliminary results for the 53 weeks ended 2 April 2022

Dividend culture: made to last

Burberry has a 20-year history of unbroken dividend payments. Until the pandemic, the payout had never been cut and had risen almost every year since the company's 2002 IPO.

The company has a straightforward dividend policy of paying out "around 50%" of earnings. This is supported by a solid balance sheet.

I can't see any reason for this commitment to dividends to change. The only caveat to this is that a payout-based policy does not guarantee growth. If Burberry's sustainable earnings power falls for some reason, the dividend could be cut.

Nevertheless, I think Burberry has one of the stronger dividend cultures in the model portfolio.

Burberry scores 4/5 for dividend culture in my screening system.

Dividend safety: good

My screen scores stocks for dividend safety by focusing on earnings and free cash flow cover. Burberry scores well in this regard, with a wonderfully consistent (pre-pandemic) track record:

I also look at leverage in this calculation, but this isn't a concern here – I'll cover Burberry's balance sheet a little further down.

Burberry scores 4/5 for dividend safety in my screening system.

Dividend growth: a temporary setback?

Burberry scores surprisingly poorly in my screen for dividend growth. Let's see why.

The metrics I use to score for dividend growth are:

• 5yr average dividend growth
• 5yr average free cash flow growth
• 5yr average net asset value per share growth

Burberry's dividend has risen by an average of 3.9% per year over the last five years. That's not a bad result in my view, given the disruption caused by the pandemic.

For context, Burberry's dividend rose by a compound average of 13% per year during the 10 years up until March 2020.

Unfortunately, the pandemic isn't the only event to have disrupted Burberry's progress since 2017. Free cash flow was disrupted by changes made by then-CEO Marco Gobbetti after he started work in 2017.

Bumper cash generation in 2017 and 2018 appears to have been driven by a significant reduction in working capital over the two years following Mr Gobbetti's appointment:

Working capital inflows can provide useful one-time efficiency gains, but they're not generally repeatable, in my experience. Companies need a certain amount of working capital to operate.

With this in mind, my feeling is that Burberry's post-2018 free cash flow has resumed its historic trend and is not a cause for concern.

Net asset value per share is a more recent addition to my algorithm. I believe it has value in indicating business growth and successful capital allocation.

I feel that the evolution of Burberry's NAVps in recent years provides an example of why this metric can be useful. Here's the chart:

Again, we can see the impact of changes initiated by Mr Gobbetti.

For example, the FY18 accounts show that Burberry sold its beauty operations during that year. The company also recorded some other restructuring costs, including onerous lease obligations on some stores. There were also some other small impairment charges.

I don't think there's nothing particularly alarming about any of this. But in my view, it's an example of where previous capital allocation decisions – beauty and certain highly-rented stores – were less profitable than hoped. This was reflected in Burberry's NAVps performance.

The chart also highlights the impact of impairment charges on stores and inventory in FY20, due to Covid-19. These were partially reversed in FY21 and seem less of a concern to me, given the circumstances.

I'm reassured that NAVps has now returned to growth and hit a new high last year. However, the impact of restructuring in 2017-2019 means that Burberry scores poorly for NAVps growth over the five-year timeframe used by my screen.

Burberry scores 0.7/5 for dividend growth in my screening system.

Dividend yield: a little low

Burberry isn't a high yielder, but the stock's current forecast yield is the second-highest ever recorded, according to SharePad.

The only time when the yield was higher was in 2009, in the aftermath of the financial crisis:

Burberry shares were good value in 2009. The dividend wasn't cut and both the share price and the dividend payout have since risen by around 300%.

I don't think the situation today is the same as in 2009. But my feeling is that the stock's elevated yield could be a sign of value for patient investors.

I'm willing to accept a low yield from this stock, as I hope that Burberry will deliver above-average dividend growth over time.

Burberry scores 1.4/5 for dividend yield in my screening system.

Valuation: reasonable

Burberry is a high-margin luxury brand, so I'd be a little concerned if the shares were trading at bargain levels. I think the current valuation looks pretty reasonable, though.

I score shares for valuation using EBIT yield (EBIT/EV) and free cash flow yield, which I also calculate using enterprise value.

Looking at the chart below suggests to me that Burberry's current valuation is in line with, or slightly below, its historical average.

I've also added dividend yield to this chart to visualise the stock's historic free cash flow dividend cover:

In my view, an EBIT yield of 8% represents decent value for a business that should have growth potential. The free cash flow yield of 5% is also attractive, in my view.

Reassuringly, Burberry's free cash flow has almost always provided a solid level of cover for the dividend over the last 20 years.

On balance, I think Burberry shares look reasonably valued at current levels.

Burberry scores 3/5 for valuation in my screening system.

Profitability: healthy

I score stocks for profitability based on their return on capital employed (ROCE) and – for reasons explained previously – five-year net asset value per share growth.

We've already seen that Burberry's NAVps growth has been hit by restructuring and disposal charges in recent years.

The company's profitability also seem to have been affected by these events, but I think the truth isn't as bad as it first seems:

We can see that operating margins have stayed stable, while ROCE fell sharply in 2020.

I think that's happened here reflects the impact of adding Burberry's store leases to its reported assets, as "right-of-use assets". This change was required by the IFRS 16 accounting rules that came into force in 2019.

For a business with a large leasehold property estate, IFRS 16 typically resulted in a sharp increase in capital employed:

Increasing capital employed while keeping profits stable causes ROCE to fall. I guess this can be interpreted in two ways. Either Burberry was less profitable than it appeared to be pre-IFRS 16, or it's more profitable than it appears to be post-IFRS 16!

In either case, I'm happy with Burberry's profitability. A sustainable 18% ROCE is not to be sneezed at, in my view.

Burberry scores 3.2/5 for profitability in my screening system.

Fundamental health: strong

At the start of this piece I mentioned my view that Burberry has a strong balance sheet. I measure this in my scoring system using a combination of fixed charge cover and net debt/profit.

Here's how this looks in chart form:

Again, we can see the disruption caused by IFRS 16. Burberry appeared to move from a net cash to net debt position in 2020, due to the addition of lease liabilities to the net debt calculation.

Burberry's statutory net debt was £179m at the end of the 2021/22 financial year. However, excluding lease liabilities, I estimate the group would have had a net cash position of £879m, similar to the net cash reported pre-IFRS 16.

At over £1bn, Burberry's lease liabilities are a sizeable obligation. However, the group's profitability, cash reserves, and lack of ordinary debt mean that I have no concerns about its fundamental health.

Burberry scores 4.4/5 for fundamental health in my screening system.

Conclusion: quality at a reasonable price?

My quality dividend screening system awards Burberry an overall score of 56/100 at the time of writing (July 2022).

Burberry's quality dividend score is one of the lowest in my portfolio. Despite this I'm comfortable with the holding. Indeed, I expect the score to increase if trading remains stable over the next 12-18 months.

My main concern is not financial but commercial. Burberry's new chief executive must complete the transformation started by his predecessor and return the business to sustainable earnings growth.

One risk I can see is the company's dependence on Chinese shoppers. The Asia Pacific region generated 45% of revenue last year and is home to 55% of the group's stores.

This Asian growth theme has supported Burberry for much of the last 20 years. While I'm not worried about the temporary impact of Covid-19 restrictions, I do wonder if wider political and economic changes could affect future demand from China.

I suspect we'll  have to wait at least another 12 months to get a clear picture on these risks. For now, however, I remain very comfortable holding Burberry in the model portfolio and in my own holdings.

I think Burberry shares could be attractively priced at current levels.

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I'll be adding a comment facility to this site as soon as I'm able to; I look forward to your feedback over the coming months. In the meantime, you can always reach me on Twitter @rolandhead or by email at mail@rolandhead.com.

Disclaimer: This is a personal blog. The information provided is for information and interest. Nothing I say should be construed as investing advice or recommendations. The investing approach I discuss relates to the system I use to manage my personal portfolio. It is not intended to be suitable for anyone else.

Investors should carry out their own research and/or seek qualified advice before making investing decisions. Reasonable efforts are made to ensure that information provided is correct at the time of publication, but no guarantee is implied or provided. Information can change at any time and past articles are not updated.