Swedish affordable fashion retailer Hennes & Mauritz, or 'H&M' (OTCPK:HNNMY), has had a rough go of it over the last decade. The good news, though, is that light has emerged at the end of the tunnel, and since I last called for caution on the stock (see Hennes & Mauritz: Turbulence Ahead), H&M has proved me, and most other analysts wrong by cutting its way to earnings growth. Assuming this progress continues through this and next year, H&M now has a very real shot at hitting its 10% operating margin target and, more importantly, nearly doubling its 2023 earnings per share by 2025/2026.

Cutting its way to earnings growth will probably be enough for the stock to grind higher for now, but once the cost-out runway ends, H&M's next chapter will admittedly be a trickier one. Efforts to lean out the company have naturally come with a top-line trade-off, so it remains to be seen if management can leverage its reinvestments (the most notable being in omnichannel) into volume and pricing gains.

The good news is that success isn't fully priced in here, as the current high teens forward P/E is more than matched by a rapid pace of earnings growth and 3-4% dividend yield. The ample cash balance also means a buyback catalyst could well be on the cards at Q2 results later this month. Net-net, I like H&M a lot better at this juncture.

Margin Expansion Shines Through in Q1 Trading

H&M kicked off 2024 with a ~2% revenue decline in the first quarter - not great but a lot better than expectations heading into the print (note Q1 is also a seasonally weak quarter).

For now, the market is giving H&M a pass as long as the company trades lower sales for higher profits. And on this front, H&M has held up its end of the bargain, delivering a few additional points of gross margin in Q1 2024 (51.5% vs. 47.2% last year, see chart below). Note that this result also came despite a slight negative impact from markdowns (a ~0.5 percentage point drag YoY). The implication here is, therefore, that management has executed very well on cost discipline and efficiency.

Moving down to the operating expense line, the YoY improvement wasn't as clear due to last year's big one-off revaluation related to its stake in online second-hand marketplace, Sellpy. Adjusting for this gain, however, the turnaround from last year's operating loss shines through. Another caveat here is that H&M's ongoing reinvestments into digital is also a drag on operating margins, so the underlying profitability may even be slightly higher than the headline numbers suggest. In any case, online sales have already picked up quite significantly post-COVID, and further growth here (from the current ~30% of sales) should contribute positively to profits down the line.

Positive Q2 Read Through, Even if Margin Target Remains a Big Stretch

Importantly, heading into the Q2 report later this month, management disclosed some very solid results in the initial weeks of trading. The big surprise was sales running at +2% (local currency terms) through late March – a notable reversal from the Q1 decline and a positive omen ahead of easier YoY comparables through April/May. Stronger sales, together with momentum from cost out and efficiency, bodes well for H&M holding on to its margin gains; it also adds buffer in case we see some minor P&L headwinds from markdowns and pricing.

Still, H&M's 10% “margin ambition" won't be easy for this year. One key swing factor beyond management's control is freight prices (note that H&M sources its product from Asia), which has been rising lately. Raw materials pricing will also be key to keeping margins in check. In the meantime, the last twelve months have only seen operating profit margins of 6-7%, so it seems unlikely that H&M will achieve 10% in 2024. Yet, the direction of travel is positive, and depending on management's ability to execute on more cost efficiencies and, to a lesser extent, drive volume growth through 2025/2026, the company has a very real shot at hitting 10% by then.

Bigger Dividends and Buybacks on the Horizon

Margin expansion bodes well, not just for the P&L but also for the balance sheet. For context, the H&M core business is more than capable of generating cash without external financing; hence, the company maintains a strong cash position through the cycles. Yes, H&M does have some debt repayment obligations but there's more than enough cash generation to fund its liabilities.

For shareholders, a growing excess cash pile means there's plenty of upside to the current 3-4% dividend yield. Don't rule out an upsized buyback either, possibly as soon as next quarter, now that the SEK3bn program has ended. Either way, the founding Persson family has skin in the game, mainly by virtue of its outsized ownership of class A and B shares, so incentives are well-aligned here.

Reinvestments Could Extend the Long-Term Runway

Of course, when evaluating cash flow, there are also reinvestment needs to consider. H&M has guided to a SEK11-12bn capex outlay, with a large portion going toward tech. Partly offsetting this spend are plans for more net store closures.

The growth in online sales thus far, indicates this could be a positive ROI move long-term. And if it does get H&M to its high single-digit % long-term sales growth target, investors will likely be quite happy to forego incremental dividends/buybacks. In the meantime, valuations (high-teens forward P/E) are relatively undemanding vs a base case earnings per share growth trajectory (near double through 2025), so top-line success is a very cheap option at these levels.

A Margin Expansion Story with Legs

H&M deserves a lot of credit for riding out a challenging economic backdrop and growing its bottom line in the process. From here, there remain plenty of cost levers within the model, so as long as management continues to execute as well as they have, the stock should grind higher alongside earnings. While I'm not as keen about underwriting many of management's rather ambitious long run targets, the undemanding valuation (high-teens P/E vs. high double digits % 2024 earnings growth) and capital return on offer (mid-single-digit % dividend + buyback) implies not a lot of positives are priced in here anyway. Ahead of Q2 results later this month, where an upsized buyback announcement could be on the cards, I am a lot more upbeat about the stock.

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