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3 Reasons To Avoid ASOS plc Now

Online fashion retailer ASOS (LSE: ASC) looks tempting.

The shares touched 7000p at the beginning of 2014, but trade around 3300p today. A 14% decline in operating profits on the back of operational problems caused last year’s share-price decline.

Why the shares may go back up

Despite the company’s challenges, earnings were good last year — a £47million operating profit is nothing to be sniffed at, especially when delivered by a firm so young. ASOS started its life in June 2000.

Since then, ASOS’s growth punched the lights out. The firm’s aim to be the world’s number one online fashion destination for the twenty-somethings looks like it may just come true. During 2014, just 14 years after establishment from a standing start, ASOS turned over revenue of £975.5 million, up 27% on the year before despite the profit fall, which suggests growth remains at full throttle. Indeed, world domination seems on course with 38% of revenue coming from the UK, 10% from the US, 27% from the EU and 25% from the rest of the world last year.

The bull case is clear.

Reasons to be wary

Yet every bull has its bear and today I want to focus on why we might want to avoid buying shares in ASOS right now.

1) Valuation

The forward P/E rating for ASOS runs in excess of sixty for 2016, even after adjusting for the firm’s cash pile. Now, it’s possible for ASOS to get earnings’ growth back on track and rising with revenues but, even if it does, that kind of valuation seems unsustainable.

It seems unlikely that ASOS will keep trading on a P/E rating of sixty-plus years from now, even if earnings continue to grow. As all firms become larger growth rates tend to reduce. More likely is a steady valuation compression occurring as the underlying business grows and matures. Such dynamics could result in a range-bound or static share price and an unsatisfactory outcome for shareholders.

2) Low margins

There isn’t much room for error or setbacks in ASOS’s financial model. With the recent full-year results, the firm revealed a profit margin running at about 3.75%. Any further operational challenges, or poorer economics resulting from scaled-up revenues, could see the firm’s £47 million in earnings disappear at a stroke, and that would be catastrophic for the share price, no doubt

3) Fashion risk and cyclicality

What if ASOS makes a hash of its marketing in the future, or becomes un-hip for whatever reason with the world’s twenty-something fashion consumers? Fashion sales depend upon being fashionable. If ASOS gets the cold shoulder from the young in the future, everything will plummet: sales, profits, the share price… Fashion retailing strikes me as a high-risk game to play.

Then there’s the cyclicality that all non-essential retailers face. When economic times are tough, fashion spend inevitably falls.

Whichever way we look at it, despite the firm’s high sales growth, ASOS is very far from a certain ticket to riches for believing investors.

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Kevin Godbold has no position in any shares mentioned. The Motley Fool UK owns shares of ASOS. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.