Description

Farfetch (FTCH) | Share Price: $9

Background

Farfetch is a platform company serving the global luxury ecosystem. In our view, the business has durable competitive advantages, a scalable economic model, and significant reinvestment opportunities to deploy capital at high rates of return yet is currently trading as if it’s permanently impaired.

Personal luxury goods is a $300bn+ industry that is underpenetrated online. Covid accelerated the luxury industry’s shift online, with penetration increasing to +20% in 2020 vs. 12% in 2019. Nevertheless, the industry remains in the middle innings of a secular shift online. Bain estimates that online sales will account for over 30% of total luxury sales by 2025.  It should be underscored that e-commerce represents over 40% of sales among many high-end department stores, evidencing consumers’ proclivity to purchase luxury goods online.

Luxury is a highly resilient industry, having compounded at a 6% CAGR over the past 20 years through many global economic cycles. During the Great Financial Criss, global luxury sales declined by 7% YoY in 2009 before recovering to 105% of its 2007 peak one year later in 2010. When applying a similar rate of growth, luxury sales could grow to $400bn by 2025, implying that online luxury, at 30% penetration, could represent a $120bn opportunity – double its present size. If this comes to pass, we estimate there could be an incremental $60bn of online sales available for capture between luxury brands and retailers over the near to medium term.  

As a channel-agnostic platform that enables mono-brand and multi-brand e-commerce capabilities, we believe Farfetch is well positioned to become the leading operating system for the luxury ecosystem. Farfetch has two main businesses: 1) a B2C marketplace that connects nearly 4mm consumers across 50 countries and over 1,400 luxury brands and retailers; and 2) an enterprise business known as Farfetch Platform Solutions (FPS) that licenses the marketplace infrastructure to brands and retailers to upgrade their global e-commerce capabilities.

Farfetch has roughly 6% share of online luxury currently. We estimate the company could capture 10%-12% share over the medium term driven by 1) continued marketplace share gains as Farfetch expands into beauty and jewelry and watches that collectively comprise 40% of luxury sales but account for 5%-10% of its GMV; 2) abating of Covid headwinds in China – Farfetch’s second largest market – and a return to its secular growth trajectory. Farfetch is well positioned in China – a market that is expected to account for 50% of luxury sales by 2025 – through its joint-venture with Alibaba; and 3) most importantly, the onboarding of the FPS backlog that should, independent of the macro, double the business over the next 12 to 24 months. Farfetch has secured deals to power their e-commerce efforts of Richemont, Yoox Net-a-Porter (YNAP), Neiman Marcus, Bergdorf Goodman, and Salvatore Ferragamo in 2022. We estimate these contracts represent approx. $4bn of GMV.    

We think these growth vectors should supercharge Farfetch’s topline as it exists 2022, a year in which several exogenous events (China and Russia) disrupted reported revenue growth and deleveraged the P&L. Farfetch has used this period of slower growth to rearchitect its corporate organization, shedding 15% of its workforce. Notably, the mix of future growth is increasingly orientated toward FPS, a business that supports a variable profit margin (65%) that is 2x that of the corporate average (30-35%). As these high-margin revenue streams are onboarded against a streamlined cost structure, we believe Farfetch will leverage fixed costs and drive significant cash generation. We estimate the enterprise is trading at mid-single FCF multiple on our 2025 estimates.

Farfetch is a founder-led company with CEO Jose Neves owning 11% of the business. Jose will earn no compensation beyond the performance-based RSUs that were granted to him in mid-2021. These RSUs vest over an 8-year period only when the share price reaches $75 to $250 per share. Put simply, the stock has to 7.5x from here before Jose begins to collect his remuneration.

Marketplace

Investors have questioned the value of an online marketplace in luxury. Why would luxury brands, whose value is predicated upon a perception of scarcity, distribute through a third-party intermediary alongside competitors and lose control over the customer experience? The answer: a marketplace is consistent with consumers’ preference for a multi-brand shopping experience. In the physical world, over 70% of luxury sales take place in multi-brand settings reflecting: 1) consumers’ tendency to shop by category, not by designer; 2) the utility of an aggregator to facilitate product discovery amid a long tail of supply; and 3) the fact that brands choose to co-locate to benefit from the supply halo and footfall generated by other brands. The existence of department stores and brands’ co-location of retail stores (e.g., Madison Ave in NYC) is the physical manifestation of the online multi-brand concept.

While brand ownership is consolidated among luxury conglomerates, the industry is highly fragmented at the brand level. Consider the average LVMH brand across fashion and leather goods, watches and jewelry, and perfume and cosmetics generated $1.1bn of revenue in 2021. This implies that its average brand has a market share of less than 0.3% of the overall luxury industry ($300bn+). This characteristic supports the need for an aggregator to organize the long tail of supply to facilitate product discovery, especially in a digital economy that is increasingly mobile. Switching between a multitude of brand apps is highly inconvenient for the shopper.   

While some of the highest caliber brands will draw traffic directly to their digital properties, most brands will struggle to efficiently attract and retain traffic due to a lack of consumer monogamy to a singular brand. By contrast, the multi-brand platform can showcase thousands of brands and thus has an inherent conversion and lifetime value advantage vs brand.com. This advantage enables it to outbid for the marginal online buyer at favorable economics. A dispersed set of buyers and sellers confers value to the distributor.

Thus, the need for multi-brand distribution is essential to the success of most luxury brands competing online. While online luxury retailers (e.g., Net-a-Porter) have been around for decades to address this need, luxury brands are increasingly reluctant to distribute through the traditional wholesale model employed by these entities. This is due to several reasons 1) brands want to retain control over end-of-season clearance activity. If third parties own the inventory, they can discount the product as they choose and promotions are antithetical to brand equity. As a result, luxury brands have been actively reducing exposure to wholesale channels (both offline and online) to limit brand risk. This ongoing paradigm has weakened the inventory position among many of Farfetch’s competitors; and 2) brands want to retain a greater percentage of the retail economics that are earned by the distributor.  

Farfetch’s e-concession model solves these challenges for luxury sellers and creates a win-win for all stakeholders.  By partnering with Farfetch, brands can simultaneously showcase product in first-party channels and in an online multi-brand setting with no opportunity cost. Importantly, brands maintain full control over pricing and visual representation on Farfetch. Since Farfetch’s platform aggregates demand in many geographies where even the largest brands have no physical presence, brands benefit from incremental customer demand without high-cost retail or marketing expenditures.  In exchange for providing an end-to-end e-commerce solution that includes demand generation, content creation, cross-border logistics and payments, localized customer service, among other services, Farfetch earns a 30% take rate. While this take rate is very strong by e-commerce standards, it is significantly less than the wholesale margin of 50%. Farfetch’s take rate has increased over time as it leverages its pricing power and upsells more services to its supply partners, particularly advertising solutions.

Because Farfetch aggregates supply from luxury sellers’ stock points without having to buy the inventory, the platform hosts unrivaled product breadth – 8x more SKUs than its closest competitor.  We believe Farfetch’s supply advantage is durable due to its competitors being unable and/or unwilling to adopt e-concessions. This is because such a shift would require a full-fledged restructuring of their centralized, inventory-based model to a technology-enabled, distributed model operating on leaner profit margin (a highly complex transition). In fact, many leading luxury retailers including Harrod’s, Neiman Marcus, Bergdorf Goodman, and Net-a-Porter are now licensing Farfetch’s marketplace architecture (FPS) to upgrade their e-commerce capabilities globally (discussed further in section below). Other retailers, at the behest of brands who are focused on reducing wholesale exposure, are attempting to imitate Farfetch’s e-concession model. However, without the technology expertise, these retailers such are employing an e-consignment model. In this model, brands consign inventory to the retailer who returns unsold product to the brand at the end of the season. In exchange bearing all the inventory risk, brands take a greater cut of the retail economics. However, this model does not unlock any incremental supply for the consumer and is structurally less profitable to the retailer which earns a lower absolute margin yet still bears the fixed costs of warehousing inventory.

Many would-be competitors are encumbered with a counter positioning dilemma. But why can’t technology companies like Amazon compete with Farfetch using a similar e-concession model? Amazon has tried numerous times to break into luxury with no success. Given the central importance of preserving brand image, working with Amazon, which is known for selling non-special goods, is untenable to luxury brands. But what about other technology companies with less reputational baggage? The answer reveals a highly valuable intangible asset in Farfetch’s possession that cannot be purchased: brand trust.

Cultivating trust with luxury brands, which are often family-controlled, generational businesses that prioritize first-party distribution, is extremely difficult. When Farfetch launched its marketplace in 2007, it only had access to supply from boutiques. It wasn’t until 2017, after 10 years of building its marketplace and nurturing industry relationships, that it signed its first tier-1 brand, Gucci. This win had a cascading effect on its business, with now over 600 brands engaged in e-concessions with Farfetch. We believe it would be nearly impossible for an upstart with no reputation, installed customer base, or supplier relationships to unlock a critical mass of brands needed to build a marketplace.

But what about following Farfetch’s roadmap of aggregating supply from boutiques as a precursor to targeting brands? Well, nearly 100% of Farfetch’s boutique relationships are exclusive.  Moreover, we believe brands are wary of undermining perceived scarcity through over-representation, thus are likely to consolidate supply relationships with a select few multi-brands partners – benefitting Farfetch.  

Farfetch Platform Solutions (FPS)

Farfetch is evolving from a pure B2C marketplace to a channel-agnostic platform company as its enterprise business (FPS) grows rapidly with the announcement of many new deals, most notably with Richemont.

Announced on August 24^th, Farfetch’s partnership with Richemont will financially transform its business, validate its preeminent technology, and further its ambitions of becoming the operating system for the luxury industry. Farfetch will license its marketplace technology to power the e-commerce operations of 1) Richemont’s entire brand roster (i.e., Cartier, Van Cleef & Arpels, Panerai, etc.) and 2) long-time online competitor, Yoox Net-a-Porter (YNAP), which has been majority-owned by Richemont up until this transaction. These enterprise partnerships will add over $3.5bn of GMV – nearly equivalent in size to FTCH’s business – at high incremental margins (65%), driving significant fixed cost leverage and accelerating the path to heightened profitability. The deal will close in 2023.

Farfetch already has +20 existing enterprise clients under the FPS banner, most notably Harrod’s. But with this landmark transaction, in addition to the recently announced partnerships with Neiman Marcus, Bergdorf Goodman, and Salvatore Ferragamo that are set to launch in 2023, Farfetch is rapidly expanding the size and credentials of its platform business.

We think investors do not appreciate the value-creating effects from Farfetch’s business model evolution. Farfetch’s focus on enabling its once perceived competitors, while simultaneously building its marketplace, is a counter-intuitive, yet brilliant strategy. Instead of vying, albeit successfully for share under its marketplace, Farfetch sees an opportunity to become a channel agnostic platform for the entire luxury ecosystem by licensing its technology to retailers and brands competing for online share.  

This strategy carries many benefits to Farfetch: 1) improves brand relationships by becoming a mission-critical, revenue-generating service provider; 2) enables competing online retailers to perform e-concessions, thus facilitating brands that are integrated with Farfetch to distribute their supply through several multi-brand online platforms simultaneously; this helps brands capture incremental demand at higher margins and reduce wholesale exposure (further improving brand relationships); and 3) becoming a toll-taker on a much larger pool of online transactions that occur outside of its namesake marketplace, and to do so with increasing efficiency.

For brands and retailers, there are many reasons to consider licensing FPS: 1) maximize global distribution as Farfetch’s API enables internationalization of e-commerce capabilities across 190 countries, including China. This includes cross-border logistics, payments, and even localized customer service; 2) remove operational complexity by variabailizing cost structure and reallocate resources to augmenting core competency; 3) for brands, creating an omni-channel view of inventory across first and third-party channels with the ability to dropship; and 4) for retailers, the ability to adopt e-concessions, essentially turning into a marketplace overnight.

By technologically enabling competing brands and retailers’ e-commerce capabilities, Farfetch can participate in the secular growth of online luxury across multiple channels, capturing greater share of the $120bn market opportunity by 2025. Further, as a white-label solution, Farfetch will not have to spend money to acquire and retain the customer. While Farfetch earns a significantly lower take rate in enterprise deals (10%-15% depending on volume), the variable profit margins (65%) are nearly 2x higher than that of the marketplace (30%-35%). We would note that mature marketplace contribution margins are north of 50%, but the corporate average is weighed down by reinvestments to grow active buyers to spin the supply-demand flywheel. Given Farfetch can onboard large quantities of FPS GMV without a proportional increase in tech expense, the returns to scale are extremely strong.

Another feature of the deal involves all Richemont brands ($15bn of GMV), which have historically avoided third-party distribution (both offline and online), exclusively joining Farfetch’s marketplace as e-concession partners. These additions will augment Farfetch’s unrivaled supply positioning, further differentiating its value proposition while unlocking access to the elusive jewelry and watch market. This category accounts for 20% of the luxury TAM but only 3% of Farfetch’s GMV.  Lastly, Farfetch will issue 10%-12% of its equity to Richemont in exchange for a 48% minority stake in YNAP, aligning financial interests. Farfetch will have the option to acquire the remaining shares of YNAP at its discretionary in years 1 through 5 or could be put the remaining stake by Richemont in years 3 through 5 at fair market value, provided that YNAP is profitable (currently losing $25mm annually at EBITDA level). Farfetch is intent on acquiring the remaining shares of YNAP in years 3 through 5. 

By replatforming YNAP once the transaction closes in 2023, Farfetch will enable it to become a hybrid 1P/3P marketplace. We believe this will be a win-win for all stakeholders. Brands win by being able to distribute inventory directly to consumers through several multi-brand online channels (FTCH + YNAP) servicing complimentary demographics (30% customer overlap) at a higher margin and with full control. Consumers win from increased access to inventory on YNAP unlocked by Farfetch’s brand integrations. And YNAP, which will be pro forma owned by Farfetch, Richemont, and Alabbar with no majority shareholder, wins from not only improving its value proposition to consumers and suppliers but also by streamlining its working capital, driving higher-margin 3P revenue, and rationalizing its cost structure vis-à-vis operational synergies with Farfetch.

Replatforming YNAP is undoubtedly complicated. However, the risk to Farfetch is substantially reduced by Richemont delivering YNAP with at least $290mm of cash, no debt, and access to a $450mm credit line for up to 10 years. Further, while YNAP’s business model undergoes transformation, FTCH will earn a high margin take rate on every transaction, de-risking its equity investment. Further, if Farfetch can successfully turn YNAP into an asset-lite, growing, and profitable marketplace complimentary to its platform, we think the upside optionality is enormous. This is especially so considering Farfetch’s equity swap for a 48% stake implies YNAP is being valued at an enterprise value of approx. $800mm (0.3x LTM revenue) based on the former’s current share price. Richemont had previously marked YNAP at $5bn on its books.  

While issuing equity at currently depressed prices would otherwise be unpalatable, the 1) incredible financial returns to Farfetch (+50% cash-on-cash from the Richemont and YNAP contracts alone) and 2) strengthened strategic positioning by consolidating its largest competitor, strongly justifies this capital allocation decision. We estimate the cash flows from the enterprise contracts alone, when capitalized at a modest multiple for a high-growth, durable earnings stream, support Farfetch’s entire market cap. In other words, at current valuation, we think investors are getting the Farfetch marketplace and brand portfolio (New Guards Group) for free or potentially a negative value. We think these businesses collectively are worth multiples of the current equity value.

We believe investors greatly underestimate the financial significance of the Richemont transaction. Here is some simple math: $3.5bn of trailing GMV between Richemont brand.com and YNAP could grow to nearly $4.5bn by 2024. Richemont brand.com ($1bn of the $3.5bn) is growing rapidly (up over 5x since 2018) with only 6% online penetration today vs 15%-20% for the luxury industry. Applying a 10% take rate yields $450mm of revenue. Farfetch has confirmed that FPS generates 65% contribution margins currently. While variable profit margins should strengthen with scale, if we conservatively assume a 50% operating margin, this yields $225mm of EBITDA. Applying a 20x multiple to this durable and recurring cash flow stream would imply $4.5bn of value, meaningfully greater than Farfetch’s current enterprise value of $3.5bn.

Financial Outlook and Valuation

With 438mm fully diluted shares + 53mm to-be-issued shares to Richemont, FTCH’s pro forma market cap is $4.9n. Factoring in $700mm of net cash (excluding the convertible notes which despite being out of the money are included in the diluted share count) and equity stakes in YNAP ($530mm) and Neiman Marcus ($200mm), the pro forma enterprise value is $3.5bn. In 2022, a year in which several exogenous events have posed headwinds to growth in China (second largest market) with its zero-Covid policy and in Russia (third largest market) where business operations have ceased, we believe Farfetch will still deliver positive GMV growth YoY and breakeven EBITDA. When factoring in significant FX headwinds (+500bps headwind in 2Q) and excluding China and Russia (which were growing significantly faster than the corporate average as of 2021), we think the underlying business is likely growing mid-to-high teens in 2022 on top of 30%-40% YoY growth in both 2021 and 2020.

According to consensus estimates, Farfetch is expected to generate $2.5bn of revenue in 2022, implying the business is valued at less than 1.5x current revenue (when removing the to-be-issued Richemont shares). This low multiple could be interpreted as an indication of a permanent growth impairment and/or structurally weak profit margins. We think neither are the case. In fact, with the onboarding of the FPS backlog alone, Farfetch’s GMV should more than double by the end of 2024 at accretive contribution margins.  With high visibility into reacceleration of margin accretive growth, a demonstrated history of operating leverage, and negative working capital benefits, Farfetch should be generating meaningful free cash flow in 2023 and beyond.

By 2025, we estimate the business could generate $500mm to $750mm of free cash flow, implying investors can participate in the business at 4.5x to 7.0x. Importantly, we estimate Farfetch’s EBITDA margin would be only 15% by 2025. This compares to its LT target of +30%, suggesting pro forma earnings could grow rapidly as corporate margins (15%) converge with incremental margins (40%-50%) over time.

Farfetch has durable competitive advantages, a scalable economic model, and significant reinvestment opportunities to deploy capital at high rates of return yet is currently trading as if it’s permanently impaired. We think the shares represent tremendous value as growth and profitability reaccelerate over the next 12-24 months from the onboarding of the FPS pipeline. These high-margin and contractual growth contributors should constrain fundamental downside even if the macro environment worsens. Over the medium term, we see enormous upside to investor profit expectations and expect a material revaluation in the shares if management executes.

Feel free to reach out with feedback or questions should you wish to discuss.

Jordan 

Email: jf@scpinvestment.com

Disclaimer:

This post is for informational purposes only and should not be construed as investment advice. It is not a recommendation of, or an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Our research for this post is based on current public information that we consider reliable, but we do not represent that the research or the report is accurate or complete, and it should not be relied on as such. Information regarding a company or security may be obsolete by the time it is published on Value Investors Club and investors must therefore independently verify updated information regarding a company or investment. Our views and opinions expressed in this report are current as of the date of this report and are subject to change. Investing is inherently risky and comes with the potential for principal loss. Past performance is not indicative of future results.

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Catalyst

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