Don’t touch Boohoo with a bargepole – here’s what I’d buy instead

Online retailer Boohoo (LSE: BOO) was one of the pandemic’s big winners, but it has failed to keep investors on board as the world has reopened. Shares in the group have dropped a staggering 80% over the past 12 months, wiping out all of the stock’s pandemic gains and then some. Rival Asos (LSE: ASC) is not far behind.

Investors are jumping ship as the company’s challenges grow. For the financial year ended 28 February 2022, profits tumbled from £125m to £7.8m even though sales rose by 14%. Rising costs, namely a jump in returns from customers, have damaged profit margins.

Management expects these pressures to fall back over the coming year, but they’re also forecasting a slowdown in sales. Current projections suggest sales growth will fall to the “low single digits” as consumer confidence deteriorates.

Sector challenges dominate the story

Boohoo’s challenges are not unique to the company. The retail sector is brutally competitive, and businesses have to work flat out to stay ahead of the competition.

Seventeen years ago, TopShop and its parent company, Arcadia Group, dominated the UK retail landscape with nearly 2,000 shops around the world and around 20,000 employees. In 2005, the year Philip Green paid himself a dividend of £1.2bn, the organisation generated an operating profit of £326m (two and a half times Boohoo’s 2021 reported operating profit of £124m).

That was the peak of the company’s success. Last year Boohoo and Asos carved up the corpse of Arcadia between them, paying £355m in all.

The irony is that Arcadia fell behind because it took its position in the market for granted. It was blindsided by companies such as Boohoo, which was one of the first UK retailers to harness the power of e-commerce.

However, Boohoo is not the nimble start-up it once was, and now its competitors are catching up, so it needs to keep investing to stay on top.

Last year, the company forked out £262m on new infrastructure, including a significant investment in the further automation of its distribution network. This spending consumed all of the group’s available cash resources –it started the financial year with net cash of £276m and by the end of February, the figure was £1.3m.

That’s not to say that the firm is at risk of running out of money any time soon. It isn’t. In March, management inked a new £325m loan facility to provide funding for growth.

Still, this level and pace of spending is a tad alarming. It has outlined plans to invest £500m and create over 5,000 jobs over the next five years, with up to £120m of this spending falling due in the next 12 months.

Boohoo’s challenges in the US illustrate the problems it is facing. It wants to expand its footprint in the region, but it is currently stuck with a ten-day delivery service. That’s not good enough for consumers who want to order an outfit on Wednesday to wear on the weekend.

So the firm is having to build its own infrastructure to manage demand, which piles on the costs. If Boohoo wants to grow in the US and stay ahead of the competition, it needs to keep spending.

Boohoo’s reputational issues are lingering too

The combination of falling profits and rising spending is never a good look for a business, especially one that's also been hit by reputational issues.

Indeed, Boohoo’s problems go far beyond the numbers. Over the past couple of years it has been accused of relying on suppliers in Leicester that underpay their workers. There is also a growing movement against so-called “fast fashion” brands due to the effect these clothes can have on the environment.

To its credit, Boohoo is trying to improve its reputation. It has opened a model factory in Leicester with 180 new jobs for workers on guaranteed 40-hour-a-week contracts with holiday. And it’s also manufacturing clothing from recycled materials.

Unfortunately, it will take time for the company to rebuild its reputation. Until it does, for many investors it will be uninvestable.

Performance is expected to improve, but uncertainty prevails

Management believes Boohoo’s operating performance will improve in the second half of its current fiscal year as consumer demand normalises and some of the logistical challenges the firm has suffered over the past year fall back.

These projections may turn out to be on the money, but uncertainty is the name of the game right now. Consumers are being battered from every angle, and analysts expect the outlook for the economy to get worse before it gets better.

Considering these factors, I wouldn’t touch Boohoo with a barge pole. As well as having to navigate economic challenges, the group also operates in a viciously competitive market – that’s not going to change.

Based on adjusted earnings per share of 4.4p for fiscal 2022, the stock is trading at a historical price/earnings ratio (p/e) of 15.4. While that is below its five-year average of 42, I think it would be misleading to compare the Boohoo of two or three years ago to the company today. Headwinds are growing, the market is getting more competitive, and Boohoo’s growth is slowing.

In comparison, peer Next (LSE: NXT) – which I believe is ahead of Boohoo in the race to build the infrastructure required to support a world-beating aggregation business – trades at a p/e of 11. Granted, Boohoo’s valuation gives no credit for potential growth and earnings upgrades in the months ahead, but based on this valuation gap, Boohoo looks expensive to me.

I’d buy Next instead: Why Next is the only retailer I’d want to own in my portfolio