Farfetch - Richemont Partnership to Deliver Industry Changing SaaS, 50% Upside

Farfetch (FTCH) is a leading technology platform for the global luxury industry, specializing in e-commerce and brick-and-mortar sales and infrastructure. The company was founded in 2007, and since then, has grown to be a dominant retailer in luxury clothing and accessories, with over 700 stores worldwide, and a leading international online marketplace.

FTCH’s long-discussed partnership expansion with Richemont was officially announced on August 24th. This transaction financially transforms FTCH’s business, validates its preeminent technology, and furthers its ambitions of becoming the unassailable platform solution for the entire luxury goods industry ($300B TAM).

FTCH will license the technology that underlies its marketplace architecture to power the e-commerce operations of Richemont’s entire brand roster (i.e., Cartier, Van Cleef & Arpels, Panerai, among 15 other maisons) and long-time online competitor, Yoox Net-a-Porter (YNAP) (collectively, Net-a-Porter, Mr. Porter, Yoox, and Outnet), which has been majority-owned by Richemont up until this transaction.

These B2B partnerships will add over $3.5B of Gross Merchandise Value (GMV) – nearly equivalent in size to FTCH’s existing business – at high incremental margins (+60%), driving significant fixed cost leverage and accelerating the path to heightened profitability. The deal will close in 2023.

FTCH already has 20+ existing enterprise clients, most notably, English department store Harrods. But with this landmark transaction, in addition to recently announced partnerships with Neiman Marcus, Bergdorf Goodman, Salvatore Ferragamo, and Reebok that are set to launch in 2023, FTCH is rapidly expanding the size and credentials of its SaaS business.

However, the market does not appreciate the value-creating effects from FTCH’s business model evolution from a B2C marketplace to a tech enablement platform that is leveraged by brands and retailers competing for online market share.

FTCH's focus on enabling its perceived competitors, while simultaneously building its proprietary marketplace, is a counter-intuitive, yet brilliant strategy. Instead of vying, albeit very successfully for share under its namesake marketplace, FTCH saw an opportunity, as the industry’s singular technology platform, to license its infrastructure to third parties to better enable their online capabilities. This strategy carries benefits to FTCH:

1) improves brand relationships by becoming an integrated, revenue-generating, mission-critical service provider;

2) enables competing online retailers to perform e-concessions, thus enabling brands integrated with FTCH to distribute their supply through several multi-brand online platforms simultaneously; this helps brands capture incremental demand at higher margins and online retailers to unlock working capital and improve supply; and

3) positions the company to be a toll-taker on a much larger pool of online transactions and to do so with increasing efficiency.

Transaction Structure

The online luxury market is large enough for multiple players, as GMV is expected to double to $100B by 2025. This represents a market opportunity 25x that of FTCH’s business pre-Richemont. As a white-label solution, enterprises are responsible for aggregating demand for their online properties, which means FTCH does not incur any marketing expenses.

Instead, FTCH is responsible for performing back-end e-commerce functions such as cross-border payments and coordinating logistics, among other services. As a result, the enterprise business model generates substantially higher variable profit margins relative to the B2C marketplace. Since FTCH can onboard large quantities of GMV without incremental General and Administrative (G&A) expenditures, the returns to scale should be extraordinary.

Another feature of the deal includes all Richemont brands ($16B of GMV), which have historically avoided third-party online and offline distribution, exclusively joining Farfetch marketplace as e-concession partners.

These additions will augment FTCH’s unrivaled supply positioning – 8x more SKUs than its closest competitor, thus further differentiating its value proposition while unlocking access to the elusive jewelry and watch market. This category accounts for 20% of luxury TAM but only 3% of Farfetch’s GMV.

Lastly, Farfetch will issue 10%-11% of its equity to Richemont in exchange for a 48% minority stake in YNAP. Not only does this equity swap align financial interests, as Richemont will be FTCH’s second-largest shareholder after CEO and founder Jose Neves but will also enable Richemont to deconsolidate YNAP from its books.

Richemont will also receive $250 million (expected to be settled in Farfetch Class A ordinary shares) at year five of the transaction. The credit risk exposure to FTCH 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, the upside optionality from successfully turning YNAP into an asset-lite, growing, and profitable marketplace that is complementary to FTCH’s marketplace is substantial.

This is especially so given that FTCH’s equity swap for a 48% stake implies YNAP is being valued at $1.2B (<0.5x LTM revenue) based on FTCH’s current share price. Richemont had previously marked YNAP at $5B on its books.

While issuing equity at currently depressed prices would otherwise be unpalatable, the incredible financial returns to FTCH (+50% cash-on-cash from the Richemont and YNAP contracts alone) and strengthened strategic positioning by effectively consolidating its largest competitor, strongly justifies this capital allocation decision.

FTCH will have the option to acquire the remaining shares of YNAP at its discretion in years 1 through 5 or could be put the remaining stake by Richemont in years 3 through 5 post consummation of the deal at fair market value, provided that YNAP is profitable (currently losing $25MM EBITDA). FTCH believes the most probable outcome will be its consolidation of YNAP in years 3 through 5.

Mohamed Alabbar will acquire a 3.2% interest in YNAP in exchange for its shares in the joint venture with YNAP in the Gulf Cooperation Council region. As a result of this share swap, YNAP will own 100% of its business in the region.

Widely acknowledged as the driving force behind Dubai’s economic growth, Mohamed Alabbar is the Founder and Chairman of Emaar Properties, the leading developer of iconic assets such as Burj Khalifa, the tallest tower in the world, as well as the Dubai Mall, one of the world's largest and most prestigious shopping malls.

Mohamed Alabbar said:

“I am delighted at the opportunity to build further on my long-standing relationship with Richemont and YNAP, and participate, this time, in the realization of their Luxury New Retail vision. YNAP is one of the most coveted global luxury shopping destinations and the partnership with FARFETCH, by continuing to develop YNAP’s marketplace business, will further enhance the experience for its brand partners and discerning clientele.

I am also confident that our deep understanding of the Middle Eastern luxury market, with its tech-savvy and influential customers, will be of great value to YNAP going forward.”

Branding

Brands win by being able to distribute inventory directly to consumers through several multi-brand online channels (FTCH + YNAP) that service complimentary demographics (~30% customer overlap) at a higher margin and with full control.

By replatforming YNAP, FTCH will enable it to become a hybrid first-party/third party (1P/3P) marketplace versus a 1P retailer today. This will be a win-win-win for all stakeholders.

Consumers win from increased access to inventory unlocked by FTCH’s superior supply positioning. And YNAP, which will be pro forma owned by FTCH, Richemont, and Alabbar with no majority shareholder, wins from not only improving its value proposition to suppliers and consumers but also by streamlining working capital, driving higher-margin 3P revenue, and rationalizing its cost structure vis-à-vis operational and technology synergies with FTCH.

Replatforming YNAP is undoubtedly complicated. Managing the working capital requirements of a large 1P business that is not currently profitable and is undergoing a technology replatforming is a tall order, especially for a FTCH management team with a lot on its plate.

Despite the foray into B2B SaaS, FTCH is not substantially changing its business model. Since its IPO, FTCH has stated its mission is to be the global platform for luxury. Its namesake marketplace and platform solutions (FPS) businesses have always been critical growth vectors towards realizing this objective.

Valuation

FTCH will not have to incur much if any variable tech or G&A investments to onboard this $3.5B+ of GMV, which should flow through at a +60% incremental margin and drive fixed cost leverage. FTCH generated $2MM of EBITDA in 2021, having improved margin from -19% in 2018 to breakeven in a matter of three years by scaling attractive unit economics.

FTCH generates a 70% gross margin on 3P GMV (85% of total) but has wisely elected to reinvest much of these gross profit dollars into acquiring new customers at attractive LTV/CAC ratios (payback under 6 months) to achieve supply/demand critical mass.

It’s important to note that achieving operating leverage as a marketplace that earns only 30 cents of revenue for every dollar that flows through its platform takes time, especially given the substantial upfront investments required to build a global platform that offers end-to-end services for sellers and localized UX for customers.

Nonetheless, FTCH has demonstrated meaningful operating leverage, with tech and G&A expenses declining from 59% of revenue in 2018 to 38% in 2021. Since FTCH is now at breakeven and benefits from negative working capital, with the reacceleration of revenue in 2023 and 2024, we expect the business to be a meaningful free cash flow generator.

It is hard to have a precise view on the near-term profitability outlook given several moving factors like regulatory approval, onboarding timeline of the Richemont deal, as well as specific take rates for these new deals, but it is conceivable that FTCH could be generating over $700MM of EBITDA by 2025.

This would imply the business when adjusting for its net cash position and a minority stake in YNAP, is trading at approx. 4.5x EBITDA. Although operating leverage is difficult to accurately estimate, with the business nearly guaranteed to double in size in the next few years at accretive margins, the prospect for substantial profit acceleration appears to be a high likelihood, which should de-risk the equity at current depressed levels.

It is possible that cash flows from the enterprise contracts, when capitalized at a modest multiple for a high-growth, durable earnings stream, support Farfetch’s entire market cap.

In other words, at the current valuation, investors are getting the B2C marketplace business for free, which is likely worth multiples of the current equity value, or the financial implications of the Richemont deal are not fully appreciated.

We speculate it’s the latter given limited financial disclosure to date. However, we expect this inefficiency to not exist for very long as investors dive deeper and apply simplistic assumptions to size the financial impact of this deal.

At $3.5B of trailing GMV between Richemont and YNAP could grow to nearly $4.5B by 2024. Richemont ($1B of the $3.5B) is growing rapidly (+30% YoY) with only 5% online penetration vs 15%-20% for the luxury industry.

Applying a 10% take rate yields $450MM of revenue. FTCH has confirmed that its enterprise business generates 65% contribution margins currently, or 2x the rate of the marketplace at the current scale.

While variable profit margins should strengthen with scale, a conservative assumption of a 50% operating margin yields $225MM of EBITDA. Applying a 20x multiple to this cash flow would imply $4.5B of value.

As a reference, with 438 million fully diluted shares, FTCH’s current market cap is $4.4B. Factoring out nearly $700MM of net cash (excluding the convertible notes which despite being out of the money are included in the diluted share count), the enterprise value is $3.7BB.

In 2022, a year in which several exogenous events have posed substantial growth headwinds in China, FTCH’s second largest market with its zero-covid policy, and in Russia, FTCH’s third largest market where FTCH has ceased business activity, the business will still deliver positive GMV growth YoY.

When factoring in significant FX headwinds (+500 bps headwind in 2Q) and excluding China and Russia which were growing significantly faster than the corporate average as of 2021, the underlying business is growing mid-to-high teens in 1H 2022 on top of +40% YoY comp.

According to consensus estimates, FTCH is expected to generate $2.5B of revenue in 2022, implying the business should be valued at 1.5x revenue. This revenue figure is depressed given those headwinds, even as China extends its zero-Covid policy with the shutdown of Beijing. Farfetch currently trades at a 32% discount to enterprise value.

The company already intentionally operates at break-even to reinvest gross profit dollars to grow share at attractive LTV/CAC Despite the aforementioned macro headwinds which have reduced operating leverage, the expected reversion of China headwinds, continued organic growth in the marketplace and the onboarding of the transformational enterprise backlog – Richemont, YNAP, Neiman Marcus, Bergdorf Goodman, Salvatore Ferragamo, and Reebok – should supercharge FTCH’s growth, profitability, and cash generation in 2023 and 2024.