We are bullish on Farfetch (NYSE:FTCH) at the current price of $10.5/share. We believe the potential upside of 40-50+% over the next 12-18 months in the stock is well worth the downside risk. We will list out our investment thesis, starting at the macro level, followed by company analysis, including a review of the company's long-term strategy, valuation, and risk factors.
Let's begin with a top-down approach.
If we were to ask you to name the person, other than Jeff Bezos and Bill Gates, with a total net worth over $100B, would you have said Bernard Arnault (source)? At $105B, the LVMH CEO out-rich Warren Buffett and Mark Zuckerberg. In recent years, his company has posted record sales/profits after record sales/profits, thanks to the powerful growth of the luxury goods industry. LVMH (OTCPK:LVMHF) is not the only one, of course, almost every single luxury goods player - Kering (OTCPK:PPRUF), Richemont, Estee Lauder (EL), Ferrari (RACE) - are posting stellar financial results. You get the point, the rich get richer, and they don't shop at Walmart. This is a $300B+ market, and it's getting bigger (source).
So, what's fueling this growth? Are we that much wealthier than we were before? We think the answer has something to do with income inequality and the wealth gap. In the past decade, we saw the acceleration of technology advancement and proliferation. While this has improved many aspects of our lives, it has also greatly increased wealth and social inequality. It's unfortunate, but it's the reality. The rich will continue their expenditure, and they are spending them on luxury goods.
Traditionally, the luxury goods industry was seen as undisrupted by the move towards e-commerce. How could you purchase an $800 pair of shoes without trying them on? Would you be comfortable placing a $3,000 order on your phone without seeing the actual product? Well, thanks to technology advancements and convenient shipping and return policies, buying luxury goods digitally has become a norm (especially for the millennials). Does anyone still go to department stores? Sorry, Barneys. Luxury brands have finally realized the importance of the shift and are putting efforts towards online.
For much of the past decade, luxury fashion brands have struck a sensible balance between exclusivity and accessibility resulting in strong financial results. They were slow to adopt digital media to grow sales, fearing they might become too visible. However, as luxury consumers began spending more online, brands were left with no choice but to adapt to their customers' new purchasing patterns." (source)
Undeniably, the trend in luxury spending is towards online. The representation of online share as % of the total market went from 2% in 2008 to 12% in 2019, a 24% CAGR compared to 5% for the overall industry. From what we are seeing, the market is likely to break into the $350-$400B size in the next few years, and the online share could go from 12% today to the 15-20% field. By 2025, we could be looking at a $420b market size where 25% of luxury shopping takes place digitally.
The bottom line is, luxury brands need and want to target customers online, and they can't do it by themselves. Brands are good at craftsmanship, but they lack the know-how (catalog, inventory management, fulfillment, customer service) that Farfetch provides. At the end of Q31029, Farfetch marketplace's top 10 brands, including Gucci, Prada, and Fendi, had doubled their stock on the site versus a year ago (source).
Thus far, we have listed out two clear trends - 1) the overall luxury goods industry is growing steadily, 2) luxury spending has gone from offline to online - and Farfetch will benefit from both tailwinds.
Founded in 2008, Farfetch is a luxury-goods focused technology company that currently runs the #1 e-commerce platform in the world. Its moat is that is it the ultimate one-stop-shop for luxury shoppers.
Farfetch breaks down its operations into three segments: digital platform, brand platform, and in-store.
1. Digital Platform
2. Brand Platform
What Farfetch is good at is that it brings shoppers the "boutique" shopping experience online. The best shopping experience is the one that can provide a selection of numerous in-season products, from a variety of brands, in one place. From famous brands to stylists that you've never heard of, shoppers across the globe gain direct access to 300,000 SKUs from over 3,000 brands. In terms of breadth and depth, there is nothing better than Farfetch, and that's why it is the #1 luxury e-commerce site.
But it gets better. The story expands further after the NGG acquisition, which we will talk about next.
Jose Neves founded Farfetch in 2007 when he was 35. Prior to that, the Portuguese entrepreneur, who started coding at 8 years old, had founded and exited multiple startups already (source). Since Farfetch's IPO on the NYSE back in 2018, the company has made several acquisitions:
The list of acquisitions has generated doubtfulness from the public, with investors wondering about the company's cash-burning streak and the path to profitability. After the announcement of the NGG acquisition and less-than-stellar Q22019 earnings, Farfetch's stock tanked to an all-time low, from $17 to sub-$10, and a class-action lawsuit was filed against Farfetch from its investors.
Does the current share price present an opportunity? We think so. Besides the industry tailwind and behavior change already described, we think the benefit of the NGG acquisition is not being realized by the street, as well as the potential of China, which will be discussed in the subsequent section.
The vision for Farfetch, since the beginning, is to become "the world's leading platform for the luxury fashion industry". It has achieved quite a lot already. Per the previous section, Farfetch is already the #1 online marketplace for luxury goods globally.
However, something is missing - Farfetch's own brands. In order to become a successful retailer, you must have your own labels or original contents. Having "private labels" makes a company stronger because of the benefits of better margins, differentiation, and control of your own products, just to name a few. Look at Amazon (AMZN), Costco (COST), or Netflix (NFLX), these successful players are not only distributing third party goods, but also building their own, and that is what Farfetch aims at accomplishing through the NGG acquisition.
What is NGG, really?
The New Guards Group is a fashion house, currently owning 8 brands, and is estimated to contribute about $500M in revenue for Farfetch in 2020. Out of all the brands under NGG, the most famous label is Off-White. It represents over half of NGG's 2019 revenue and is considered fashion's hottest label.
The New Guards Group is known for having developed and elevated the aforementioned brands from their infancies. For Farfetch, this addition adds a new layer to its business model - dubbed "brand platform" in a press release. Farfetch will have the group's design, production and brand development capabilities. And now, the retailer can leverage its retail network and data about customers, as well as experience powering brands' e-commerce sites, to ultimately enable what it's calling the "brands of the future." (source)
Jose's vision is for Farfetch to not just be the #1 digital marketplace for fashion, but also a fashion house that's able to design, manufacture, and distribute the next greatest thing. The NGG acquisition gives Farfetch such ability and the potential to become the Netflix of Fashion.
The brands of the future will have three core elements. First, a creative tastemaker able to leverage digital channels to engage a global community; second, best-in-class design, planning and manufacturing; and third, direct-to-consumer global online distribution, complemented by a connected wholesale presence in the most prestigious physical boutiques. This is what the combination of Farfetch and New Guards brings to the industry. Together, we can not only continue to develop New Guards's current portfolio, but will also be uniquely positioned to bring many new talents to life with the combined layers of the Farfetch platform."(Jose Neves)
A really good report done at GQ further dissects the acquisition. The author believes that the Farfetch + NGG + Stadium Goods combo will become the streetwear-focused conglomerate that levels with LVMH and Kering. The network effect is certainly imaginable if the marriage between Farfetch and its acquisitions turns out to be a fruitful one.
The most obvious reason is that streetwear has become symbolic and it's a bigger part of our culture than ever before. We are seeing a change of taste in the land of fashion, with the path towards less formal wear. The streetwear style is nothing new - the casual, hip-hop, sporty look has been around for a long time - but the rise in recent years has solidified the influence. In 2017, when Supreme, a streetwear brand that sells mostly t-shirts and hoodies, sold a stake to Carlyle Group at a valuation of $1B, it further proved the acceleration of the fashion style.
Farfetch has a strong partner in China in JD.com (JD). We all know that China is the world's biggest market, and the growth of luxury goods spending will be heavily dependent on Chinese consumers. Based on research done by McKinsey & Company, by 2025, Chinese consumers will represent 44% of the total luxury good spending across the world, compared to just 12% back in 2008.
JD is one of the biggest players in the Chinese e-commerce market, with more than 300 million active customers. JD and Farfetch first began their strategic partnership back in 2017, but not until 2019, did Farfetch launched a flagship store on JD.com (source). Although the partnership is young and the potential monetary reward is yet to be determined, the potential ceiling is quite high.
I am delighted to be able to offer JD.com's customers direct access to the broadest selection of luxury fashion online, and to be able to offer luxury brands the Premier Luxury Gateway to China for executing on their digital strategy in China. We have been able to do this, in significant part, thanks to the enthusiasm and support from our brand partners. Brands crave ever-better access to the Chinese market, and we are thrilled to deliver this for them." (source)
Through the partnership with JD, Farfetch essentially eliminates its demand generation expenses while sharing a cut with JD. Assuming a 1% customer conversion rate and a $300 order value annually, the added GMV of this partnership would be at $900 million, basically 50% of the total GMV from 2019.
Also starting in 2020, Harrods, the famous British department store, will begin its exclusive partnership with Farfetch. In this partnership, Farfetch will essentially be running Harrods' e-commerce platform, leveraging its online expertise to better Harrods' e-commerce offering and solution (source).
Harrods sells more than $2.5B worth of luxury goods annually (source). Assuming just a 10% online penetration and a small take rate for Farfetch, this is a high-margin project that, if managed well, could expand into other partnerships.
Recent App Download & Traffic:
According to BAML, in October 2019, Farfetch apps were downloaded 600k times. Yoox, an off-price online platform was second, downloaded c. 250k times. Net-A-Porter's app, Farfetch's closest competitor, was downloaded 85k times. When comparing with brick & mortar peers Nordstrom and Selfridges, Farfetch's app was downloaded 6-10x more in October.
We believe the current price point presents a good entry opportunity. The biggest worry for Farfetch, and for every other newly IPO'd tech company, is profitability. We think Farfetch's distance to being EBITDA positive is 1 year away, and it is 2 years away from operating income positive.
At the current price level, Farfetch is valued at 2x 2020 Sales and 4.3X 2020 Gross Profit. With a realistic projection, we see the revenue jumping to $2B in 2021 and $2.4B in 2022, fueled by a 27% growth in digital revenue and 20% growth in NGG brand revenue. We think this is highly achievable and in-line with management guidance, most recently at Credit Suisse's technology conference. We believe Farfetch has reached scale and will temper down on promotional spending. The customer base is strong and sticky, and the previously mentioned upcoming events - NGG integration, JD partnership, Harrods partnership - makes this a very exciting business. Looking 2 years out, there is a real chance that it reaches $100M in operating income in 2022. We think the stock is worth more than $15/share.
On a separate note, the closest competitor to Farfetch, Yoox Net-a-Porter (YNAP), was acquired by Richemont in 2018 at a valuation of $6B. The acquisition put a 2.5X PS ratio for YNAP at the time of the acquisition. With Farfetch projected to bring in $1.5B in sales this year and growing at a faster pace than YNAP at its time of the acquisition, we see no reason why Farfetch should be trading below a $3.75B market cap or $12.5/share.
At $10-11/share or $3B in market cap, based on a conservative estimate, we think Farfetch is a good buy.
There are two potential risks to this investment. First, if there is a recession or a slowdown, luxury spending will be the first to be impacted. This is not a company-specific risk, if there is a downturn, the whole stock market will decline. The second risk, which is company-specific, is the future of NGG. How much longer would Off-White's popularity last? Just look at what happened to A Bathing Ape or Abercrombie & Fitch, when a brand fails, it fails miserably. We are betting on a successful integration of NGG and Jose's vision of creating the future of fashion. If the plan turns out to be a failure, so will the stock price.
Whenever looking at a new investment, we'd like to go through a list of criteria and see how the stock checks the boxes. It's not often that we come across an investment that meets all the criteria. It certainly doesn't correlate with returns, but this investment idea belongs to the high conviction bucket:
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Disclosure: I am/we are long FTCH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.