As is with investing, from time to time, there will be losing positions in a portfolio in company to big winners. This is what happened among my ideas for my Premium PLUS members. Last week, I threw out Burberry after I lost patience due to deteriorating fundamentals. Today, I am looking back at how I formed my thesis, what happened in the meantime and I explain why I finally pulled the brake as well as why this decision was necessary.

Summary and key takeaways from today’s Weekly
– Burberry looked like a promising idea in a troubled sector with a seemingly low valuation.
– I expected everything bad to have been priced in – I was wrong.
– As no improvement is in sight and the financial situation worsened, it was time to let go.

The stock of British luxury house Burberry (ISIN: GB0031743007, Ticker: BRBY) was the in total fourth of my now six published ideas for my Premium PLUS members.

I am not making any secret out of it – it was by far my biggest loser.

Burberry was a drag on the otherwise well-above average, almost double average performance of my ideas in this membership and self-explanatory, it was under observation. Instead of selling automatically at for example –20%, I wanted to wait until the fiscal year’s results (per end of March) get published to see whether the situation shows signs of stabilization.

As a fundamental investor, I am assessing every case based on what’s happening in the business. My met coal stock idea for example had a period where it was down almost 30%. Today, it’s in the green zone. I stayed with it, as the overall thesis hadn’t changed.

In comparison to other and bigger luxury houses that have been suffering from weaker demand, too, the stock of Burberry already lost much of its market capitalization and I thought there’d be a decent chance everything bad could be already priced in.

As it seems, I was wrong and too optimistic.

Burberry continues to be a highly profitable business, even in the currently tough market environment for luxury goods.

However, the results, released on 15 May 2024, were even less than underwhelming.

As fundamentals worsened and my sweat spot for a make or break decision was slowly reached (–25% to –30%), the decision was clear. The results triggered me to finally step on the brake, as I am a firm believer in letting the winners run, while limiting the losses by realizing them and moving on.

I am not a fan of averaging down (personally, I only do it very rarely), because most often one averages down into losers, not winners.

I threw Burberry out, because further losses are anything than impossible, even likely.

Let’s have a look back at this former investment case of mine. Out of every mess, one should take the positives, in this case the lessons learned which I am sharing with you.

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^{both as per 22 May 2024 market close – since August 2022}

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Luxury always sells – until it doesn’t

Not too long ago, I remember having seen on Twitter and Youtube lots of folks writing such things like luxury stocks are always a good investment, because the rich don’t care about the economy. Buying more shares close to all-time highs at exaggerated cheap multiples was a pretend no-brainer.

As is almost always the case with such bubbles, valuations never matter, because there’s seemingly only one direction: up and upper.

The market has proven us all wrong – luxury is a cyclical business, too.

And as we’ve seen, the downswing can be really fierce.

Even powerhouses like LVMH (ISIN: FR0000121014, Ticker: MC) or Gucci-owner Kering (ISIN: FR0000121485, Ticker: KER) haven’t been spared from the slowdown in this sector.

Self-explanatory, their stocks are not at all-time highs, while many indexes are.

To be fair, LVMH suffered way less as it held up better operationally. Kering went in the same direction like Burberry, even though Kering’s decline started already in 2021.

Burberry made fresh new all-time highs exactly a year ago in spring of 2023, even.

The difference was that Burberry’s stock has lost not only disproportionately from its high at around 26 GBP. I published my report when it was at 14.99 GBP in last December, having thought that lots of bad expectations could be already baked into the stock, because the valuation looked to be pretty depressed while the then-numbers weren’t that bad.

As we know now and at the latest since the yearly results have been published last week, I couldn’t have been more wrong on this one.

But looking at the headlines is only half the truth.

At the time of writing my report, the company had a pristine balance sheet – unlike Kering – with a decent net cash position, excluding operating leases for its stores.

It’s then ~700mn. GBP in net cash compared to an equity market cap of ~5 bn. GBP.

Add to this a free cash flow of 500–600 mn. GBP (I expected it to drop towards 400 mn. GBP), my personal expected enterprise value to FCF multiple was ~10x. A multiple of ten, as a rule of thumb, means that no growth is expected. While true for the moment, rather unlikely for the future beyond the current slump – so I thought.

10x was certainly not a premium price for highly profitable company in a sector where stocks enjoyed multiples of even 30–50x not too long ago.

We can see below that Burberry had operating margins – with the exception of the weak last fiscal year 2024 – in excess of 15%, at the top even 20% (blue columns).

In comparison, the free cash flow margin was swinging back and forth between 6–7% in a weaker year like 2016 and above 15% on three occasions.

Though Burberry is way smaller and basically a one-brand luxury company, it is by no means a discount brand on the verge of bankruptcy due to razor-thin margins.

We can also see that, though not rapidly, sales (next blue columns below) have been growing steadily at a moderate pace, breaking 3 bn. GBP for the first time in the fiscal year prior to the current slump.

On the assumption of growing luxury markets in the US and especially China, the management had the goal to hit 4 bn. GBP in the mid-term which seemed reasonable – until reality hit.

Based on both points, a small valuation discount is even appropriate, but 10x seemed pretty pessimistic.

Framed on the next chart is the time post the 2020-crash and until the luxury market turned sour. 20x over the last ten years was rather a fair multiple.

I used here the market cap to FCF in order not to have the confusion with leasing.

On top, I thought, Burberry as a brand with a strong heritage, made for a great takeover target, because 5 bn. GBP (plus a decent premium) at that time for such a company would be no heavy-lifting for deep pocketed investors like either their direct competitors or for example wealth funds from Norway or Saudi-Arabia.

But, to make it clear, takeovers are better always seen only as a mere bonus. Possible bids should never be the investment theses themselves!

My point was that Burberry’s stock has fallen to a level where everything bad was already expected. The company would be able to pull out itself out of the mud due to strong financials.

And here we have the two deciding factors.

First, the negative environment has turned even more negative, as can be seen on the chart from Burberry’s investor presentation. No signs of a turnaround and the single most important market, China, even tilted from a slowdown into a deep slump. Sales in the last quarter have fallen by 19%!

The other key market, the US, barely improved, either.

Make no mistake about it, double digit shrinkage in a business with high fix costs due to most sales being conducted in their stores, is a heavy fist-punch in the face. I guess, I either read it somewhere or they said it themselves in the conference call in last fall, 80% of all costs are fixed in this business.

As management in their current outlook for the next fiscal year 2025 did not see any improvement for the first half (at the minimum), this was already a fragile ground for my thesis.

But then, the deteriorating financials made for the final nail in the coffin.

Sales held up even pretty well with only –4% on a reported basis and 0% on a currency-adjusted basis. But everything below declined disproportionately.

The operating margin was only 14% (a decline by a third). On a free cash flow basis, Burberry only achieved a small break-even. 63 mn. GBP does not read like a small break-even, but it’s a margin of only 2.1% on sales of 2.97 bn. GBP.

The reason: higher inventories as the stuff doesn’t sell.

I don’t care about earnings in the first place, but cash flows and also the cash position to assess liquidity!

Maybe for a better overview, Burberry as of 31 March 2024 has:

• 362 mn. GBP in liquidity (prior: 961 mn. GBP)
• of which 300 mn. GBP is a bond (299 mn. GBP market value, but 300 mn. principal to be paid back)
• net cash effectively is 63 mn. GBP (from 663 mn. GBP), down 90%

The problem is, this bond has a coupon of only 1.125% and it matures next year.

While certainly not an immediate threat, however, as the environment for luxury goods is still weak, I do not want to have this additional risk.

Burberry likely won’t go belly up on this, but it will massively increase their costs and lower cash flows due to higher cost of debt for a likely refinancing.

The net cash position (I want pure hard cash) declined by 90% because Burberry spent heavily on Capex (mainly store improvements and modernizations), the progressive dividend and on buybacks – the latter likely in hope to catch the bottom.

The repurchases were done very aggressively in late summer up until the half-year earnings release, when their entire buyback program was exhausted.

Free cash flow after Capex was only 63 mn. GBP. To arrive at this number, one has to rightfully as they’ve done subtract taxes, interest and lease payments.

The result was that shareholder distributions were done almost completely out of substance and not from cash generated.

Going a step further and knowing market conditions haven’t improved and are not expected to improve, management held the dividend roughly stable (it is minimally lower on an interim basis, but flat for the full year).

This means, they will again pay it out of substance as it looks like.

Even though painful, it would have been logical to suspend the dividend entirely and keep the balance sheet in shape. The final interim will cause a cash outflow of 160 mn. GBP. To finance this, they can:

• Hope for a turnaround which isn’t expected
• cut on Capex, but it was in total only 208 mn. GBP, so they’d need to cut it almost entirely which is unlikely
• take on debt

The latter is my point of concern.

Burberry has the choice between neglecting the business by dialing down reinvestments into its stores or to debt-finance the dividend, because they promised a progressive dividend policy.

The reality will likely be somewhere in the middle. Some cash will be generated from sales of inventories and maybe they’ll produce less stuff to lower costs.

But this is tight-knit.

After a loss of 25.2%, already including the small interim dividend, I had to face the hard and bitter truth.

We’ll need to see whether this was the right decision. For now, Burberry’s stock declined another almost 5% since closing this idea which in the short-term does not mean anything.

But I have lost confidence in this case – not a solid ground to hold onto it.

It is of course possible that now someone comes up with a bid, making me look like a fool. But it is also entirely possible that the stock drops further, first breaking through the 10 GBP barrier. Why not another –25% in total? There’s no reason this is not possible.

As of now, Burberry’s stock has continued to drop further. It is already below the 2020-low (!) and where it was around in the early 2010s. This is not a good sign.

Throwing good money after bad is not the solution — cut your losses and get out. Otherwise this will drag on your performance and on your mental well-being.

This is where I subscribed to – cutting the losses while keeping the winners, letting them flourish and outgrow the losses. The good thing is, if a loss is cut early enough, it’s easy even for a few big winners to more than compensate for such a bad pick.

All in all, though a bump in the road regarding all my Premium PLUS ideas, my approach proves that cutting the losers before the damage becomes too big is correct.

My winners more than compensate Burberry’s negative performance, as can be seen on the first chart below (the second shows my active Premium PLUS ideas without Burberry).

^{both as per 22 May 2024 market close}

My learning is that no matter how much a stock has fallen, it can fall even more. This goes hand in hand with a seemingly low valuation which can prove to be meaningless. As long as the situation hasn’t reversed, it’s too early to jump in.

Better going for tailwinds than headwinds.

If you want to see my winning horses, consider becoming a Premium PLUS member.

Below, you can see my two latest Premium PLUS ideas sitting in the starting blocks for market beating returns as the setups are favorable – without headwinds:

• by best gold mining stock idea
• a company sitting on more black gold than it can extract itself

Conclusion

Burberry looked like a promising idea in a troubled sector with a seemingly low valuation.

I expected everything bad to have been priced in – I was wrong.

As no improvement is in sight and the financial situation worsened, it was time to let go.

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