Farfetch (FTCH) has been an interesting story and an interesting business model. The company went public late in 2018 as a high-flier with shares trading around the $30 mark, as shares imploded in August of last year to just $10.
I looked at Farfetch following that move as I concluded that a combination of slower growth and mounting losses was the reason for an implosion in the share price, as my cautious stance around the time of the IPO indeed seemed the right one.
With expectations down a lot, and recognizing that the company made an interesting acquisition at the time, the situation could be stabilized given the still substantial net cash position, if and when expense disciple would become reality. Hence, the risk-reward was much better at those levels, yet I was still only holding a neutral stance on the shares.
Farfetch runs a platform on which luxury fashion goods can be bought, as the company is essentially connecting luxury brands, retailers and consumers on a single platform. There is an inherent tension in the model as luxury brands do not want to be associated with discounted sales and focus heavily on controlling own sales channels, yet the company has been doing something very good as it has gained quite some traction.
With a $4.8 billion operating asset valuation at the time of the IPO at $20 per share, I noted that expectations ran a bit high. In 2017, the year ahead of the initial offering, the company did report $386 million in sales and while this was up 70% year-over-year, the company did incur a $95 million operating losses. This was up in actual dollar terms, but down a bit on a relative basis.
What really drove my caution at the IPO was not the 55% growth slowdown in the first half of 2018, yet the fact that operating losses rose from $31 to $72 million for the six-month period. With shares trading at $28 on their opening day, the company traded at 14 times annualized sales while losses were ballooning, making me a bit cautious.
The other big risk was that the company took a 33% fee, defined as revenues divided by gross merchandise value processed on the platform, a very steep cut by all means. That could not only invite competition, but shoppers might look for alternatives if and once they learned about those fees.
What Went Wrong?
Early 2019 the company provided a guidance for 2019 with a 40% increase in gross merchandise value seen. EBITDA losses were seen stable at 18-19% of sales.
When the company reported a miss for the second quarter, all hell broke loose as the company guided for GMV to slow down to 37-40%. Based on the guidance the company was set to lose $140 million in EBITDA, yet that even excludes annualized $150-$200 million in stock-based compensation, creating very large realistic losses of $300 million, or more.
The $8 billion operating valuation at $30 had fallen to $2 billion at $10, as of course Farfetch continued to operate with a sizable net cash balance. On top of the 75% reduction in the operating asset valuation, the company announced a $675 million deal in August, with the purchase of New Guards Group. This was a sizable deal as the enterprise value of Farfetch had fallen to $2 billion at the time.
Given growth rates reported of 60% and $345 million in sales contribution, and the fact that the business was solidly profitable, that deal looked quite compelling at first glimpse. At the same time I had reservations as EBIT of New Guards reportedly came in just a few million short of $100 million in the twelve months leading up to the acquisition. This translates into a very low multiple, certainly given the growth, almost too good to be true.
Following the New Guards deal I pegged pro-forma net cash at $700 million and the share count at 345 million shares. At $10, this valued the company at $2.7 billion as I worried about the continued losses, as telegraphed by the market, yet given the urgency and sizable net cash balances, there were still many options.
Shares long traded around the $10 mark as the company reported its 2019 results in February. With New Guard being acquired in August, it contributed about $75 million in gross profits to the business in the remainder of 2019.
For the year the entire company grew total GMV by 52% to $2.14 billion with revenues up 70% to $1.02 billion. The company reported that EBITDA losses increased from $96 million to $121 million, as net losses rose from $156 million to $373 million. With stock-based compensation and D&A responsible for the gap between EBITDA and net losses, the reported net losses seem quite realistic unfortunately.
While the share count of 340 million was as expected, dealmaking and continued losses made that net cash fell to just around $320 million, indicating a $3.0 billion operating asset valuation around $10 per share.
Investors were not too worried with GMV seen up 40-45% in 2020 to $3.00-$3.10 billion and EBITDA losses seen narrowing to $70-$80 million, about a $50 million improvement from 2019. Furthermore, stock-based compensation results in big losses to investors, but do not involve cash outflows, although issuing a lot of stock at low levels creates additional dilution.
Shares lost half their value from $12 in February to a low of $6 during Covid-19 crisis as an initial reaction, but shares quickly have recovered as investors realized that this might actually be a silver lining.
First quarter GMS rose 46%, in line with the 44-51% guidance, yet EBITDA loss of $22 million was quite a bit better than the $30-$35 million guidance. Cash holding rose to $422 million which is compelling, yet was driven by a recent convertible issue which might further dilute the share count of course over time. With EBITDA losses narrowing quite a bit shares rose to their mid-teens and now even $17 as the company provided an update, guiding for 25-30% digital platform GMV growth for the second quarter.
That is actually an acceleration from the 19% growth reported in the first quarter, basically the growth rate of the legacy business, with remaining growth driven by New Guard, among others. The comment that margins are seen in excess of 30% (was 32.0% in the first quarter) is quite comforting as well, giving strong clues that the company is actually thriving in this environment.
Recent trends are quite encouraging by all means although the company was still posting realistic losses around $300 million a year in the first quarter. Further incremental improvements could be seen in the second quarter, as the company is not only maintaining, yet accelerating growth in this environment.
So basically these conditions are a validation of the fact that the business model might be more sustainable than I feared recently, yet the company is far removed from breaking-even, let alone turn profitable and justify a +$5 billion operating asset valuation. For now, I am comfortable with the recent topline performance, and after the recent momentum seen, shares still largely trade in my fair value rang/estimate, although I continue to look forward with great interest to future developments.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.