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The FarFetched IPO

Sometimes the title of an IPO note writes itself! 😉

FarFetch ($FTCH) is another online platform for “luxury goods” is preparing to test the IPO market this week. It’s a quality deal so it’ll get done. The question is what is the long-term potential for a company that provides online merchandising and sales. There’s been major growth in online “brands” that are are purveyors of a niche style segment with a curated and well-produced presentation of products. In some cases, they create some of their own or partner to create special “members only” versions of third-party products. Current examples include companies like Carbon2Cobalt, Bespoke Post, Huckberry, and Outerknown. There are also “micro-brands” like American Giant and Supreme.

The first time we covered a “merchandising IPO” was Zulily back in 2013. Zulily ($ZU) had a strong IPO then and focused initially on helping “moms shop” better with a daily email of curated items of special interest to them. They also typically offered items that were on sale or steeply discounted. At the time of their IPO, Zulily was doing $500M in revenue (up 100% YoY) and had 2.2 million active customers. Since they are not focused on the luxury market their average revenue per customer was lower – $214 versus over $600 for FarFetch. With their higher transaction sizes and larger “take rate,” FTCH has

Zulily diversified into different product areas and after some time as a public company had a successful final “exit” in a sale to IAC in 2015 for $2.4B. We’ve got relatively recent numbers from Zulily since IAC broke out results for 2017 -$1.6B in revenue across 5.8 “active” customers defined as buying something in that 12 months period. Even with their growth, Zulily generated a small loss of $129M.

Some other “marketplace” companies that have come public recently include Esty ($ETSY) [see “Can Etsy Survive an IPO?“] for arts and crafts, Wayfair ($W) for home furnishings and in China we have JD.com ($JD). All three of these companies have done very well in the public markets, although volatility has been high and it’s taken them a few years to establish their positions in the market.

JD.com led the last round of funding for FarFetch ($397M) in June of 2017. JD.com is a monster commerce platform in China. They had revenues of $55B in 2017 and will do something close to $75B in sales this year. JD operating margins are rather low at 1.1% during the most recent quarter. A JD.com investor and affiliate, Kadi Group, plans to purchase shares in the FarFetch IPO as a “concurrent private placement.”

JD is interesting enough for a separate note of its own. The shares have corrected sharply from $50 to $25 even as Google ($GOOG) invested $550M in June 2018 as part of a strategic partnership. The Google deal was done at $40/ADS. With a market capitalization of $38B, $JD is trading at about 0.5x revenues.

We also consider Stitch Fix ($SFIX) to be in this group of “new retail” models but since they are clearly not a marketplace we won’t focus on them here. They do however fit into the mix of the relationship between consumers and their fashion supply. At the end, we’ll also cover some of the well-funded but still private companies in this space.

These data points will inform us as we look more closely at $FTCH.

It is clear that there is demand for online purchasing of luxury brands and it’s not just the younger generation. The last PwC survey indicates that although the majority of purchasing demand is in-store a healthy portion (already 30-40%) is online. The so-called Millennials do skew more online at 42% versus 28% for Baby Boomers.

How does FarFetch Fit?

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[s2If current_user_can(access_s2member_level1)] FarFetch is focused on luxury brands – products from companies like Gucci, Versace, Prada and hundreds of boutique brands. A scroll through the latest “editor picks” reveals an array of $2000 jackets, $450 sneakers, $1000 sweatpants, $1000 backpacks, $250 baseball caps, $500 T-shirts and $250 flip-flops. It takes a special type of consumer to shop at this level.

FarFetch sees the following as their key advantages:

  1. Founding management team that combines expertise in fashion and technology with an innovative and friendly culture.
  2. A proprietary technology platform that is an end-to-end solution for merchandising, selling and delivering products.
  3. Meaningful relationships with luxury brands that include special status and joint innovation. Some of these would be hard to replicate.
  4. Largest possible selection of luxury products in one place for consumers. (Same argument as any online marketplace.)
  5. High margins and “take rate” on sales. Luxury products have much higher margin set aside for the channel to ensure the customer “experience” is right.
  6. The marketplace model affords them a negative cash conversion cycle (they get paid first) and is “capital light” for investors.

There are a few things that stuck out as well. The Founder/CEO Jose Neves owns all the Class B stock which gives him 78% of the votes so he will be in full control of the company post-IPO. Most of the employees are based in Europe with the vast majority (1,690 of the 2,818 total) in Portugal. Another 512 are in the UK. This is probably the reason why most people in the US haven’t heard of them.

FarFetch has only 1.1M active customers. That’s a fairly small user base for a company generating this level of revenue. There are millions of potential customers that represent some “low hanging fruit” to drive the next few years of growth. Their coverage on the seller side is good – a total of nearly 1000 with 60% retailers and 40% brands. So far the mix of strong supply and a small customer base has yielded attractive LTV/CAC ratios.

Consumers are typically willing to purchase luxury items through established retailers like Nieman Marcus but rather reluctant or even unwilling to do so using a general purpose marketplace like eBay or Amazon. Counterfeit goods are common on these platforms and nobody wants to spend a fortune on a fake. FarFetch offers a much safer and secure marketplace for these transactions.

The value for retailers and brands seems a little less clear, at least in the longer term. This is where the margins also come into play. The “retail margin” of over 50% really jumps out at you. It’s also eye-popping to see an item that costs $20 being sold for $100 and generally “discount proof” due to strong channel control.

Retailers make a lower margin on sales but they don’t have to build their own platform and handle their own fulfillment. For some, this can be a good solution and results in incremental sales and margin as long as they are not supply constrained. It also offers them a channel to sell merchandise that didn’t sell in their stores or via their own channels of distribution.

Right now it’s a good deal for brands. They get more customers and their original (or better) margins. Established brands like to be in more control over how their products are merchandised. Then can be relatively sure about how well Sak’s handles it but not as sure about Macy’s. Smaller emerging brands can get access to new customers more easily using FarFetch.

FarFetch also offers a “white label” solution called “Black and White” that can be used to create a custom feel while still leveraging the FarFetch technology platform and back-end infrastructure.

Pure direct competition is surprisingly limited. The main alternative is for large retailers and brands to build their own online strategy and marketplace but even then, all of them want to reach more customers so would probably still want to sell on FarFetch. You can find these products on sites like eBay and Amazon but the selection is typically very limited. There are some players in the market for used luxury goods like The Luxury Closet, and The RealReal which has raised a surprising amount of funding ($228M).

Some Numbers

Examining operating metrics shows consistent growth in both customers and average transaction size. FarFetch has also been able to maintain their 30%+ “take rate” on third-party sales. It appears that used or “vintage” as they are called sales have not grown nearly as quickly as the new product category. There are several other places where vintage clothing manages to get sold – eBay is probably the #1 despite the risks.

Customer economics have been good thus far and are improving. FarFetch has not spent heavily on CAC which is part of why the ratio is positive. Having high-cost goods also helps. The quarterly P&L below shows consistent gross margins and modest losses. Most of the scaling of SG&A costs have been in technology development and staffing.

The addressable market opportunity for FTCH is 1/3 of the 25% of the luxury goods market that is expected to be online by 2025 which is about $25B. That presumes that the 30%+ level of margin remains intact as luxury brands shift online. So far these high-end brands have done an excellent job of ensuring that their prices are maintained no matter what channel those products are offered in.

Intrinsic Valuation and Stock Conclusion

It’s easy to feel comfortable with future growth projections. It’s harder to believe that these kinds of margins can hold up but the luxury goods business has proven itself to be very insulated from both price pressure and even weak demand when economic growth dips.

The company long-term model is shown below. We’re not quite willing to go to 30%+ operating margins but given the high gross margins at FTCH and their marketplace business model, there’s no reason to believe that they can’t reach that level. Once the company is public for a few quarters we’ll be able to do a deeper dive on the numbers and recalibrate our IV model.

For now, it suggests good upside based on the $16 mid-point of the filing range. This is a good proxy stock to own for the luxury goods market. They sell all the major and emerging brands and benefit from the secular trend towards more online sales.

We would definitely buy around the IPO price range and in the aftermarket up to $25 or $30. The next several quarters should be strong for FTCH.

The company will also be able to make more acquisitions as a public company. In the past they bought Browns (a fashion brand) in 2015, Style.com in 2017 and CuriosityChina just this last July.

What are the main risks?

It seems unlikely that any of the major marketplaces like Amazon, eBay or Google will want to invest the time and energy in trying to unseat FarFetch in this market. The luxury brands insist on a fair amount of control which is not consistent with the operating model of most general marketplaces. So a specialized “boutique” approach is needed even in the online market. There are a few risks we think we’ll see impinge on the valuation at some point in time:

  1. The management team will need to establish themselves in the public market. It’s hard to know how this group will execute on a quarterly basis and how the earnings calls will go. It’s easy to get caught up in the quarterly earnings game and make mistakes.
  2. Trade is now a political topic and it’s possible that individual or country-specific actions in the US and China will have an impact on the luxury goods market. China is a key growth market for FarFetch and actions there are even more political.
  3. JD.com/Kadi has invested directly in FTCH and is buying more stock in concert with the IPO. Kadi is mentioned 43 times in the IPO filing but only in terms of their investment. What additional aspects there may be to the relationship are there? Will those change over time? How will that impact the new public shareholders?

Overall the biggest one is probably execution as a public company. The culture here is a bit different which can work for or against them once they hit the market.

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