Farfetch - Integrating the luxury value chain

Are you looking for a marketplace business with best-in-class technology whose value proposition makes every stakeholder better off? Well, I think I have just found it.

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Farfetch is another company very far from its all-time highs. Along with other COVID-19 winners, Farfetch stock has lost a tremendous amount of value despite incredible fundamental developments during this period. The Market Gods have not been kind to this stock, falling from a high of $73 a share to a low of $11,50 in recent weeks, a 84% drawdown. The shares have somewhat recovered but are still very close to the lows in March 2022. In this post, I will describe the company's activities, industry, opportunities and why I have added to the stock to the Partnership Investing Porfolio.

Why is Farfetch interesting?

In my opinion, the drawdown gives an opportunity to long-term investors to evaluate a business that is exposed to secular growth in an attractive industry. With its platform, Farfetch sits at the intersection of the growing e-commerce industry and the high-value luxury industry. Farfetch has attractive unit economics, a inspiring owner-operator at the helm and a long runway for growth.
The platforms' success in the last decade, the momentum it has from the pandemic and recent wins seem to indicate that Farfetch is set up for good future performances. The company is a bit more difficult to understand as it is a combination of a e-commerce, fashion, marketplace and technology business. This combination, however, is what makes the company interesting to me and at the very least makes for an interesting case study to follow.

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Business

The Farfetch business can be split into 4 parts:

• Digital Marketplace

• Farfetch Platform Services (FPS)

• Brand platform

• China / Alibaba - Richemont JV

These are a lot of moving parts which only increase the complexity of the business but that make for an unique offering in the luxury industry.

Digital Marketplace

Farfetch started from CEO and Founder Jose Neves' ambition to use technology to enable his own store to sell luxury online. This idea evolved into Neves aiming to build a marketplace and technology where boutiques from all over the world could sell their products.
The fragmented retail boutiques want to find a way to sell their inventory online, either to liquidate unsold inventory or simply to reach a broader customer base. This is a difficult task for the average boutique owner that has no particular expertise in building and managing a website, managing inventory, and logistics. By building a global platform, Farfetch was able to offer boutiques a global audience and the technology to manage this part of the business. Farfetch recently launched the Fulfilled by Farfetch program in collaboration with Clipper Logistics to offer sellers a better, more integrated logistics solution similar to the famous Fulfilled by Amazon (FBA).

"The Farfetch Marketplace also provides integrated, end-to-end services for luxury sellers, including content creation and end-to-end logistics and a localized luxury experience and customer care for Farfetch Marketplace consumers."

• Farfetch 20-F 2021

With a presence in 190 countries and about 1400 sellers on the platform offering 3400 brands, Farfetch has reached the broadest offering for the luxury buyer. The company currently boast ~3.7 million Active Customers on the platform, far more than any other competitors. The Digital Marketplace generated ~$3.6B of Gross Merchant Volume (GMV) in 2021.

With success came scrutiny from brands. Boutiques often offered large discounts on Farfetch as a way to liquidate inventory. For brands, where brand equity and the perception of value are paramount, that was a problem. Many brands have decided to adopt digital strategies and taking back more control over this channel by selling on Farfetch has been a step most brands have taken. The last few years have been characterized by more and more brands dedicating larger parts of inventory to Farfetch and the amount of full-price purchases rising sharply.

I believe the e-concession model, where Beauty brands own the inventory sold on the Marketplace, has unique benefits both for brands and consumers. By allowing brands to integrate their own inventory into the platform, brands have more control over pricing and the way their brand is presented. This control is incredibly important. In the traditional model, brands have incredible leverage over their wholesale buyers. Discounting is discouraged and there are strict parameters (e.g. what is the boutique allowed to buy together, discounting periods, how is the brand represented) that boutiques have to abide by to continue the relationship with the brand. These parameters are mostly collaborative in nature, but it is clear that the brands have the leverage in the relationship.
By having an e-concession model, Farfetch turns over the control over this channel to the brand for both their benefits. Farfetch can offer more desirable products in a more scalable way than any competitor and the brand can control its pricing, and brand representation, and has access to data it did not have when only boutiques were selling their brand on the platform. The customer benefits by having access to the widest range of brands and products anywhere on the Internet. Customers are known to prefer convenience and being able to do all their shopping in one place with a consistent experience certainly is.

Competition

Over the years, Farfetch has significantly outshined its primary competitors. Yoox-Net-A-Porter 2021 revenue has essentially been flat since Richemont acquired them in 2018. YNAP had a better 2020 but saw its revenue decline back to 2019 levels as supply chain issues and Brexit created complications. The latest results imply better growth since then, but the two-year stack pales in comparison to Farfetch.
Matchesfashion, a private company, has seen its revenue decline in 2021 after slowing dramatically the previous year. This is despite the COVID-19 pandemic that was such a boon for e-commerce across most categories.
However, Mytheresa has done very well. The company has seen revenue grow from $379M in 2019 to $612M in 2021. Mytheresa's business model is similar in nature to Net-a-Porter or Mr. Porter (both under the YNAP umbrella), Mytheresa and YNAP own their inventory and offer a more curated selection.

"For example, of the over 7,000 stock-keeping units (“SKUs”) we curate from our top 30 selling luxury designer brands, less than 21% of those items overlapped with our multi-brand competitors as of December 2019 according to an ongoing internal pricing analysis comparison." - Mytheresa 20-F

Mytheresa's selection is even more highly curated than YNAP and the Average Order Value looks more like Farfetch's. My humble assessment is that YNAP is caught somewhere in the middle without any unique value proposition to brands or customers.

In stark contrast to YNAP and Matchesfashion's problems, Farfetch's scalable business model has enabled them to scale Gross Merchant Volume from just under $2B in 2019 to ~3,7B in 2021, about 35% growth per annum.

Mytheresa and YNAP have announced initiatives to offer a marketplace/e-concession solution similar to Farfetch. This is a validation of the appeal of this model to both brands and consumers. I expect Mytheresa to stay true to its highly-curated and exclusive identity. The number of brands and SKUs available through e-concession should reflect this. Finally, the recent rumors about YNAP's acquisition and the partnership with Farfetch seem like signs of capitulation from Farfetch's closest competitor. I will talk more about this later, but Richemont partnering with Farfetch and the rumors about them divesting YNAP is a clear sign that they are not confident in their competitive positioning.

Marketplace economics

Now that we have some context about the Digital Marketplace and its scale, let's go into the economics of the marketplace.

Farfetch is similar to other marketplaces in the sense that it takes a fee for every purchase made. The total take rate for Farfetch is about ~28% of GMV. Note that this percentage is the revenue minus the shipping costs as those are charged at cost. This take rate works out similarly, if not slightly better for brands than selling wholesale. If a brand selling directly to the consumer would earn an 80-90% GM, it would earn about 50-60% wholesale. The ~28-30% take rate makes Farfetch just another distribution channel with wholesale-type margins.

The Gross Profit margin on this Digital Platform revenue is 50-55%. Farfetch spends ~20% of Digital Platform Revenue to acquire customers, this is referred to as Demand generation expense. This leaves a 30-35% Contribution margin on a consolidated basis.

Management has alluded to much higher Contribution margins for older customer cohorts (50-60%). This is very encouraging, but it is difficult to disentangle what portion of Demand generation is truly to acquire new customers and what portion is to retain existing ones. If I had to guess, I would put the terminal percentage of revenue spent on Demand generation somewhere between 10-15% of Digital Platform revenue. The lower end implies that customers need little advertisements to be maintained. In the end, this part of the business should be able to deliver a 20-30% EBITDA margin at scale. I don't expect Farfetch to reach this EBITDA margin level soon as they are still investing heavily in technology and customer acquisition.

Farfetch Platform Solutions

The Farfetch Platform Solutions (FPS) is one of the main reasons I find Farfetch particularly interesting and is a testament to the founder/CEO's vision. FPS is a white-label technology platform for retailers, brands, and department stores to manage their luxury e-commerce business as well as their physical stores and warehouses. FPS enables content creation and management, online marketing, global payments and logistics, inventory management and synchronization, and in-store technology. FPS also enables exposure to the coveted Chinese market through WeChat stores, local payments, logistics, and customer service.

"...our white-label enterprise offering to the luxury industry, which builds and operates e-commerce and technologysolutions for luxury brands and retailers, utilizing the proprietary Farfetch platform. FPS also offers our luxury sellers ancillary services,including digital marketing, production, and customer service."

• Farfetch 20-F 2021

These solutions are offered in modules, meaning potential clients can start out with just a certain part of FPS and take on other modules later on. This is the well-known "land and expand" strategy.

Current partners using FPS:

The advantages for many brands to opt for FPS instead of building their own technology are quite straightforward. FPS is currently the best technology out there and the investment required to build a similar infrastructure is significant. Luxury brands are not technology companies, unlike Farfetch, and do not possess the expertise to build a comparable product for themselves and most do not have the scale to justify such an investment.

If you do not believe me or Farfetch that FPS is the best technology on the market, you can believe one of their largest competitors:

"*I would not put our business into somebody controlled by an industry competitor, so it has to be neutral. So, I would envisage this as a neutral platform powered by the remarkable, truly remarkable, technology of Farfetch. When Alibaba told me in the beginning, when they introduced us, that they could not replicate that technology, that was a year and a half, two years ago. We had our teams, our techy teams, meeting with theirs, and this confirmed to us that they are the ideal partner.*"

• Johann Rupert, Chairman of Richemont (owner of competitor Yoox-Net-a-Porter)

One of their largest competitor, if not the largest competitor Richemont invested in Farfetch to use their FPS technology in a Chinese joint venture. There are also talks about Richemont looking to exit YNAP. Farfetch has been cited as a potential buyer, but there has been little news since the first rumors. This is a clear validation of Farfetch's technology and the advantage it has over Richemont. Over time, it wouldn't surprise me if the two companies find an agreement whereby Richemont offers their brands on Farfetch using their technology. This might happen by selling YNAP to Farfetch or through another type of agreement.

The economics around FPS a difficult to see through. There is nothing to be found in the 20-F filings about the revenues generated by FPS or what type of pricing structure is used. It is thus difficult to thoroughly evaluate its revenue potential. My understanding is that brands and boutiques using FPS for their website pay a lower take rate to Farfetch than through the marketplace. The margins are higher or similar to mature cohorts because Farfetch does not need to acquire customers/drive traffic. This gives Farfetch exposure to the DTC offering of many brands with strong incentive alignment and expands its Total Addressable Market beyond multi-brand environments.

The FPS part of the business has many synergies with the Digital Marketplace business. Partners that use FPS can sell on the marketplace much easier. This makes allocating inventory to Farfetch frictionless, stimulating more inventory depth and breadth for the marketplace. FPS creates a collaborative relationship with brands that were previously perhaps worried about the discounting that occurred on the platform.

What is clear is that FPS fits within the ecosystem is attempting to create. All the business units work to make the Farfetch Marketplace platform more valuable and attractive for both sellers and consumers.

Brand platform

Farfetch acquired New Guards Group (NGG) in 2019 for $675M. NGG is essentially an incubator for a collection of emerging brands.

"a platform that uses a single common infrastructure and model to incubate and grow emerging talent into highly sought-after brands. New Guards designs, manufactures and distributes sought-after luxury fashion brands including Off-White, Palm Angels, Ambush, and Heron Preston, among others"

• Farfetch 20-F 2021

This acquisition gives Farfetch access to some of the most exciting new luxury brands.

In 2015, Farfetch bought the iconic London boutique Browns with the intention of leveraging its technology and testing out ideas in the stores. This vision, Luxury New Retail, is to provide a modern and technology-enabled experience to luxury shopping. This acquisition gives Farfetch an insider perspective on the brick-and-mortar boutique and uses this as feedback for their technology.

In 2018, Farfetch bought the exclusive sneaker marketplace Stadium Goods for $250M. Shoppers can buy new or re-sold (but unworn) exclusive sneakers online or in their New York City store. With this acquisition and NGG, Farfetch is fully embracing the fast-growing luxury streetwear category.

In January 2022, Farfetch bought Violet Grey, a beauty retailer that sells upscale beauty brands and products. This acquisition will be important in Farfetch's strategy to add the Beauty category to its marketplace offering. Violet Grey once again secures access to the supply of exclusive and independent beauty brands.

The Brand platform part of the business has very similar economics to any other brand that you would find. Most of the NGG brands still rely on distribution outside of Farfetch. On an aggregated basis, the Brand platform business unit generates attractive gross margins (45-55%). As more of the distribution goes through the Farfetch platform, I'd expect the gross margins to rise as they take the gross margins usually earned by the retailer.

Between the acquisition of Violet Grey, Stadium Goods and NGG, it is clear that Farfetch wants first-party brands to further differentiate their offering. By controlling these entities, Farfetch can do exclusive releases and drive organic traffic to the marketplace which further fuels the network effect flywheel. Owning the NGG brands and having access to exclusive sneakers or beauty products through Stadium Goods and Violet Grey ensures Farfetch is the place where you can find all of your luxury needs.

China / Alibaba - Richemont JV

China is the biggest luxury market in the world and it is set to grow even bigger. Most of the growth in the industry has come from the Chinese consumer and will continue to do so, even in the face of government focus on limiting materialism and wealth inequality.

Farfetch has always been focused on this market through its partnership with JD.com and Tencent. The Tencent partnership has provided Farfetch the ability to offer brands WeChat stores. This has been more successful.

Alibaba's Tmall is the primary channel where Chinese consumers prefer to buy luxury goods. Tmall has over 500M customers on the platform and its Luxury Pavillion is the premier platform to buy luxury online. The platform features mono-brand stores as well as multi-brand stores.

Alibaba and Richemont invested $300M each in Farfetch and $250M in the Farfetch China Joint Venture. After this investment, Farfetch's partnership with JD.com will end. The lack of success from the partnership is due to a lack of intention to buy luxury on the JD.com platform, according to CEO Jose Neves. This intention to buy luxury is present on Tmall's Luxury Pavillion, which is why Alibaba is Neves' preferred partner.

In addition to these two powerful allies to capture the Chinese market, Artemis, the holding company of the Pinault family (controlling family of Kering), decided to increase its stake in the company by $50M.

The sheer scale of the Chinese market is an incredible opportunity for Farfetch to operate a highly scalable, capital-light business model. With support from key players in luxury and Chinese e-commerce, the stage is set.

Beauty

The Beauty category presents an incredible opportunity for Farfetch to keep growing at high rates and achieve financial success. Beauty is one of the most resilient companies and, much like other categories, spending is migrating online. The Beauty category is certainly a natural extension, luxury buyers are concerned about their appearance and are a natural pool for Beauty brands seeking high-spending customers. Beauty brands will be able to offer their products to a global audience at a similar, if not better, Gross Margin profile to their wholesale channels.

Farfetch hopes to entice Beauty brands to offer their high-end products on the marketplace and scale its beauty offering. The first steps have been taken with the acquisition of Violet Grey which gives them access to a selection of high-end inventory and relationships with brands. Farfetch has alluded to some curation in the selection available to preserve the Luxury aura of the Farfetch brand.

What is especially interesting about the category is that the purchases are more recurrent due to the consumable nature of beauty products. Someone may buy a luxury item from time to time, but they will buy their beauty products regularly. The opportunities to cross-sell and/or to increase purchase frequency (perhaps at the detriment of Average Order Value) have the potential to boost the Customer Lifetime Value.

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Unit Economics and Financials

Unit economics

The Farfetch Digital Marketplace has extremely good unit economics. Although the disclosures are not as thorough as Naked Wines, by piecing bits of information together, I am confident that Farfetch has very good unit economics and can reinvest cash flows at high rates of return.

To analyze this piece, we will look at a few key value drivers:

• Gross Merchant Volume. or GMV (total transaction value on the platform)

• Active Customers and net adds

• Average Order Value (AOV)

• Average order frequency

• Take-rate

• Gross Margin

• Contribution Margin

• Demand generation expense and by extension, Customer Acquisition Costs

This might sound a lot and somewhat messy, but we can look at the previous year's financials to have an idea about CAC and the costs to maintain a customer.

Source: company financials and own estimates

This is an analysis where I assume 70% of Demand generation expense is to acquire new customers. The remainder is to maintain existing customers. By dividing the Acquisition spend by Net new actives, we arrive at an estimate of CAC per new net add. We can see that CAC has been somewhere around $150-$175 for most years and recently grew as acquisition channels have become more expensive (something many companies found out, including Naked Wines). Note that this is not a perfect way to calculate CAC or maintenance spend (far from its), but it gets us close enough to have a ballpark estimate given the current information presented to us.

The LTV calculation looks as follows using the key value drivers mentioned earlier:

Source: own estimates informed by company financials

One might argue with the Order Frequency (which seems to tend towards 2x a year) or the CAC calculation, so I will add a table to reflect the LTV/CAC for different scenarios:

Source: own estimates

Farfetch gave a glimpse of their unit economics in their F-1 filing (S-1 equivalent for foreign issuers). Those seem to indicate even better economics than my estimates. These only follow cohorts until 2017 (F-1 was filed in 2018), so things might have changed somewhat in the meantime.

Here is how the cohort spend has evolved until 2017:

Source: Farfetch F-1

Here is the LTV/CAC development over 24 months:

Source: Farfetch F-1

This is the Marketplace Contribution Margin development and comparison between existing and new customers.

Source: Farfetch F-1

It is now clear that Farfetch has incredibly good unit economics (4-6x LTV/CAC seems like a decent estimate) which will only get better if the Beauty category and their Brand platform initiatives hit home.

Besides my own analysis of Farfetch's unit economics, I would highly recommend to you Theta Equity's Customer-Based Corporate Valuation of Farfetch. They have provided a few updates, unfortunately, the last one dates back to 2019.

Based on these unit economics, it is important for Farfetch to keep reinvesting. The management team has mentioned recently that their payback period is <6 months. This is incredibly profitable and it seems that if anything, my estimate of the unit economics might be too conservative either in LTV/CAC terms or in IRR terms.

Corporate costs

Farfetch has invested heavily in technology, reflected by its Technology expense, which has gone from ~10% of revenue in 2019 to 7-8% of revenue as of 2021. I expect Farfetch to have some operating leverage in this part of their cost structure, but it is imperative for them to keep investing. One of their major advantages as of right now is their technology and I expect them to keep investing in it until they achieve scale. Over time, Technology expense should not be much more than 5% of revenues at scale.

General and Administrative expense has gone from 40% of revenue in 2019 to ~33,5% of revenue in 2021. This is the cost center where I expect most operating leverage to come from. Farfetch has invested to support an enterprise at scale, but, even as they spend more in absolute terms, I expect to see this cost center come down to 10-15% of revenue over time. There is a long way to go until we reach that point and this is a metric I will surely keep an eye on.

The Stock-based compensation at Farfetch is a huge cost center. Although this part is sensitive to stock price performance, this expense has consistently been in the 15-20% of revenue range. This is a lot of dilution to take. Farfetch reports Adjusted EBITDA, which excludes SBC. I am not a fan of adjusting for such a significant and real cost to shareholders. I would also look for this metric to go down sharply over time.

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Management and Ownership

This is probably the part where I get most excited about Farfetch. The company is led by an owner-operator, José Neves, who founded the company in 2008 alongside a management team.
Neves owns about 15% of the company (Class B shares with extra voting power) and is the great force behind Farfetch's success. The myriad of partnerships mentioned before with heavy hitters like Richemont and Alibaba, Kering, Tencent, and JD.com is because of José Neves' ability to form relationships with people all over the industry and convince them to enter into those win-win relationships. All the accounts I have read describe Neves as an inspiring and approachable leader that is respected by industry peers and employees alike.

Jose Neves, founder, and CEO

Cipriano Souza, Chief Technology Officer, is the brain behind the technology. He essentially co-founded the company with Neves and is the architect of the technology the entire industry deems superior. Given his track record as CTO of Farfetch, I think the technology is in good hands.

Cipriano Souza, co-founder, and Chief Technology Officer

Elliott Jordan, Chief Financial Officer, has taken the company public and has been at the company since 2015. His track record at the company and previous experience at ASOS makes me confident he intimately understands the unit economics and what levers the company can pull to achieve superior ROI.

Elliott Jordan, Chief Financial Officer

Stephanie Phair, Chief Customer Officer, is a luxury e-commerce veteran with 20 years of experience. She was an executive a The Net-a-Porter Group until 2015 and clearly has an understanding of the industry.

Stephanie Phair, Chief Customer Officer

There are many more executives I could highlight, but the short version is that Farfetch has assembled a team of seasoned industry executives to take the platform to the next level.

Notable public shareholders include Baillie Gifford, T. Rowe Price, and Lone Pine Capital.

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Valuation

The recent price drop has given the investor with a longer time horizon an opportunity to buy a company that is able to grow at >20% per annum for the foreseeable future at ~2x sales. I will explain why I think Farfetch is attractively valued below.

With a $5B Enterprise Value and 2022 sales estimated at $2.3B (excluding fulfillment revenue), the valuation for a business with 20-30% EBITDA margin potential and these unit economics seems undemanding.

Lets play with some assumptions with some help from Altagamma/Bain market research:

• Luxury market 2027: ~$300B today, 4% growth p.a. = ~$360B

• Percentage online: expected to reach ~30% of the market

• Farfetch share of online: 10-15%?

Total GMV for Farfetch would be $12B-$16B in 2027.

With a 30% take rate, Farfetch's revenue from the marketplace would be $3.6B-$4,8B. At a 20% EBITDA margin, EBITDA would be $720-940M.

Using a 20x EBITDA multiple, the total EV would be in the neighborhood of $14B-$20B.
Based on these estimates and assumptions, even the dilution from the stock-based compensation would not stand in the way of great returns for shareholders.

These assumptions and expectations might seem high at first glance, but the company has constantly executed over the past few years and the expectations above do not include heroic performances from its Brand platform of FPS. José Neves has reiterated his confidence in 25%+ growth targets in the last few quarters. The launch of the China JV with Alibaba and Richemont, the launch of the Beauty category, and a deal with YNAP could be catalysts that prolong the growth period or even reaccelerates growth in the medium term.

While I usually believe the market is quite good a discounting expectations, I have seldom seen a company whose share price performance has been this disconnected from fundamentals. Remember that Farfetch can reinvest its cash flows in customers with an LTV/CAC >5x. To buy a business with these economics, market positioning, and growth prospects at 2x sales is what I'd consider a great opportunity for the next 5 years, maybe even longer.

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Conclusion

Farfetch is an incredibly interesting case. It was a high-flying stock after the COVID-19 outbreak and the shares are now down to levels seen in 2019 before the pandemic even happened. In the meantime, the company has grown GMV from $2B to $3.7B and is set to end this year with ~$4.5B in GMV.
Brands have seen the pandemic accelerate the need for a digital strategy and Farfetch is an integral part of the strategy. Brands are allocating more inventory to the platform and Farfetch is steadily moving along in further differentiating its offering to both consumers and brands. Lead by a respected owner-operator with an amazing track record, the company is in goods hands, something I have missed in previous investments.
The platform has opportunities to move into adjacent but complementary markets like Beauty and Second-Hand Luxury. Its privileged access to the Chinese online luxury market, the most important and fast-growing in the world, gives brands even more reasons to work with Farfetch.
Consider these fundamentals with a relatively undemanding valuation and you might have found a good investment. What I know is that I have initiated a position for the Partnership Investing Portfolio.

Disclaimer: Always do your own research. This is not investment advice and for informational purposes only. Partnership Investing is not a registered investment adviser and may or may not hold securities discussed on this blog.