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Tollymore Investment Partners’ Farfetch (FTCH) Bullish Thesis

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Tollymore Investment Partners, a long term private investment management firm, published its fourth-quarter 2020 Investor Letter – a copy of which can be downloaded here. A commendable net return of 77.1% was recorded by the fund for the year end 2020, outperforming its MSCI ACWI benchmark that returned 12.7%. You can view the fund’s top 5 holdings to have a peek at their top bets for 2021.

Tollymore Investment Partners, in their Q4 2020 Investor Letter said that Farfetch Limited (NYSE: FTCH) is one of their largest holdings. Farfetch Limited is a premier international platform in the grandeur fashion industry, that currently has a $20.1 billion market cap. For the past 3 months, FTCH delivered a bullish 80.57% return and settled at $59.40 per share at the closing of February 1st.

Here is what Tollymore Investment Partners has to say about Farfetch Limited in their investor letter:

"One of Tollymore’s largest holdings, Farfetch (FTCH), is a global luxury digital marketplace for brands, retailers, and consumers. The marketplace connects 2.5mn active consumers in 200 countries to 1.3k sellers across 50 countries, including 500 direct brand e-concessions. FTCH is the biggest online destination for luxury in the world.

The consumer proposition is predominantly range of merchandise and curation of supply. But also localised websites, multilingual customer support and same day delivery in 18 major cities. Accessibility to global products is evidenced by consistently >90% of transactions being crossborder. Shopping for luxury products via FTCH’s website or app enables customers to search by designer, category or keyword, is available in multiple languages and accepts multiple payment methods.

80% of products sold online are in a multi-brand environment. This is evident in brands’ historic willingness to have e-concessions in department stores – that is where the footfall is. But the value of a fashion marketplace goes beyond choice. As a marketplace, rather than an inventoryowning retailer, FTCH can better curate products for consumers. FTCH can more rapidly test and iterate messaging, content and SKUs; purchasing inventory would slow this down. A large SKU count also makes it easier to satisfy consumers’ desire for ‘newness’ via daily product additions and the ability to offer new/more extravagant products without inventory risk.

A compelling supplier proposition seems to be evidenced by: the large number and strong growth of brands and boutiques on the platform; that 98% of retailers have done so exclusively; and FTCH has retained all top 100 retailers and all but one top 100 brands over the last five years despite strong supply growth.

What are the reasons for this? Access to 2.5mn customers across the globe, on a fully managed basis; that is, everything from content creation to last mile delivery. An online offering helps brands reach new audiences, increase visibility, and expand their presence into new geographical locations without the need to invest in retail infrastructure.

The price for this is a 30% take rate to FTCH. This is high by the standards of marketplace business models. But it seems to economically be a better deal for brands, no longer required to pay the retailer margin. Under traditional linear industry economics, a product costing $20 may sell for $100. The retailer typically keeps most of the $80 mark-up, perhaps around two thirds of it. The brand margin is therefore c. 25%. For a brand selling directly on FTCH, this might double to 50%, what is left after the product cost and FTCH’s 30% take rate are deducted from the retail price. Brands can achieve incremental sales by making their inventory available to a global luxury audience without increasing their invested capital or diminishing their returns on capital.

Brands have full control over visual representation and pricing. FTCH allows access to a targeted luxury customer base, mitigating potential concerns around brand dilution. Increasingly FTCH is overcoming challenges faced by emerging brands such as brand exposure and limited reach.

FTCH’s marketplace offers a place alongside leading luxury brands, lending credibility to the emerging brand and providing access to luxury consumers, who, in turn, are attracted by the opportunity to discover under-the-radar, exclusive, emerging brands. This potential flywheel has opened because of FTCH’s purchase of New Guards Group, a brand incubator. The market reacted to this acquisition by cutting the stock in half, a price decline that piqued our initial interest. The NGG acquisition helps FTCH to provide more choice, including exclusive products from emerging brands. That is, to drive engagement through limited supply.

Like Next plc, Farfetch is embracing the omnichannel advantage. But unlike Next, FTCH’s distribution is largely decentralised and offline sales are made via partners’ stores. FTCH has c. $5bn of inventory available to its customers, which has two channels. For the online channel FTCH represents most online sales for sellers. There is also a compelling offline advantage to being on the FTCH platform: you become a distribution partner. That is, FTCH will distribute through those fashion boutiques that are on their platform, sending footfall into the stores, creating offline selling opportunities not available to non-FTCH partners.

Customer orders are directed to a boutique based on proximity, cost of delivery and fulfilment record. This model is scaling successfully due to the absence of strong local incumbents. FTCH has not needed to build supply and demand in each market; the distributed model arises from the value of SKU range. It is also resilient: 85% of SKUs are available from multiple sellers within FTCH’s supplier network. FTCH can therefore tap supply from wherever it is. However, it is more expensive than centralised logistics, in which multiple items ordered on the FTCH website arrive in one box when processed through a Fulfilment by Farfetch facility. FTCH has six Fulfilment by Farfetch warehouses, which are 3PL and therefore have no associated capex obligation. The main 10-20% of SKUs are available in these centralised warehouses.

The high take rate is supported by high gross profit products and a fragmented supply base characterised by family-controlled companies seeking to protect brand integrity. In addition, there are some more subtle characteristics of the luxury fashion industry that may be creating special unit economics. Typically, ecommerce marketplaces grow scale and compete partly on price. This is not how to build a sustainable ecosystem in the luxury industry, in which decisions are a function of emotion, personal identity and scarcity. This translates to a $600 AOV, a 30% take rate, and mature cohorts delivering > $100 per order contribution/55% order contribution margin. LTV to CAC payback of fewer than six months makes investing to grow the active customer base by 50% each year the right capital allocation choice. Finding luxury customers is a costly endeavour, but when they are found there is an immediate payback on CAC. FTCH has run promotions in the past, but today seems to be increasingly focused on increasing the loyalty and therefore value of the customer base and allowing the brand full control over price setting. This seems consistent with sustainable value creation vs. ephemeral but expensive revenue support.

Is this a symbiotic value chain? That is, is there a non-zero-sumness to the sharing of value creation in which suppliers, customers and owners enjoy win-win-win dynamics? It is not immediately obvious FTCH passes this test. The superior economics of FTCH to brands may result in pressure to disintermediate boutiques. There seems to be a clearly compelling proposition for brands and consumers, but the proposition for retailers seems to be less clear. In particular, the margin that needs to be surrendered (and ceded to brands) by being on FTCH’s platform vs. the traditional linear industry model. In return for this margin dilution the retailer receives a range of valuable services such as access to a global luxury audience (which also increases the probability of full price sell through), data insights, logistics, outsourced customer service, and the omnichannel offline footfall described earlier. But given the opportunity for the brand to disintermediate the boutique and take all the margin, why would a retailer happily sign up for this, and what sustains their future in the value chain under a marketplace model?

More brands seem to be bypassing retail partners and exploring a direct-to-consumer model. The reasons: larger profit margins and stronger customer relationships/insight. Brands have increased in FTCH’s mix, now 50:50, a trend which management expects to continue. One aspect of value chain symbiosis is FTCH’s supply chain capabilities provided to platform partners, such as content creation and global fulfilment, integrating global logistics partners in a single interface. Thus, as with Next plc, there are interesting comparisons to both Amazon and Shopify here.

The following anecdote, from Frederic Court of Felix Capital, FTCH’s earliest VC investors, suggests the presence of a non-zero-sum value chain:

“I am often asked for anecdotes about Farfetch and the story so far, there are many special moments but here is one that resonated particularly strongly when it happened, at one of the company’s “Gatherings”. José had pioneered the event early in the life of the company, to cement the relationship with our key partners, and create a stronger sense of community, gathering all the boutique owners and brands to Porto or London, once or twice a year for a couple of days (hundreds of people connecting). This was a great opportunity to meet many boutiques and brand owners, to explain the development of the Farfetch platform, and get feedback from users. A couple of years into the investment, one of the first boutique owners to have worked with Farfetch (and still a partner to this date) came to me at a Gathering and said: “thank you, for investing in Farfetch and saving my store”. Without Farfetch his store would have closed because of the recession and he was grateful that we had funded Farfetch, which ended up rescuing his business from the recession. This was an emotional moment illustrating how critical the platform had been for many boutiques at difficult times, reinforcing the mission of the company, and all its stakeholders, to connect fashion lovers and make those products more accessible”.

Unfair advantages are numerous and growing.

Network effects are two sided and global. More brands and boutiques on the marketplace increase the choices available to consumers, and more consumers increases the potential sales for sellers. The network effects are global. That is, the total global SKU variety is a factor in the consumer proposition, and the total luxury consumer base is a relevant factor in determining value to a seller. This makes these global network effects more difficult for entrants to overcome via clustering strategies. Consumers prefer to shop in a multi-brand environment, and FTCH offers more brands to consumers than any other luxury destination. In addition, the economics of distributing via FTCH are more appealing to brands than retail, which typically will take half of the retail price as a gross profit, vs. FTCH’s 30% take rate. Finally, they retain control over how their products are presented and priced with FTCH vs. a multi-brand retailer. The appeal of control is particularly strong in luxury because in times of depressed cyclical demand, retailers will seek to unload stock via discounting which erodes luxury brand value. Luxury brands therefore seeking to complement their brand.com presence with a multi-brand channel find FTCH to be the most appealing option. As more brands make this choice FTCH’s multi-brand proposition strengthens. Recent evidence supports the notion that this advantage is widening: FTCH’s top 10 brands, which includes Gucci, Prada and Fendi, have more than doubled their direct stock on FTCH yoy. And on the demand side active customers are increasing >50% yoy.

Fragmented supply increases value of a marketplace: 19 of the 20 largest luxury fashion brands by revenue are in Europe yet address global demand. Large brands access demand by building expansive networks of directly operated stores and through department stores. Emerging brands typically have no route to the global market. They rely on wholesale distribution through a network of independent fashion boutiques. As a result, luxury fashion inventory, from both larger and smaller brands, is distributed across a highly fragmented network of luxury sellers. FTCH has c. $5bn of third-party inventory (not owned but available for sale) sitting in thousands of stores across the >50 countries from which supply is sourced, leading to multiple combinations of shipping routes and logistics providers. The e-concession model means that the same warehouses that serve brand.com serve FTCH. This happens with 500 concessions and FTCH taps directly into the brand’s inventory without acquiring it. Thus, some of the acceleration in revenue that FTCH has recently experienced was a result of these brands prioritising their direct-to-consumer sales.

Established partner relationships are hard to dislodge. In seeking to preserve brand integrity, luxury brands have historically been reluctant to partner with an online retailer. FTCH has developed relationships with the leading luxury families to overcome this reluctance by, for example, allowing control over visual representation and pricing. As a result, these brands have agreed to partner with FTCH on an exclusive basis – 80% of items listed are exclusive to FTCH – and FTCH has 8x the number of SKUs of its nearest competitor. It is now likely much more difficult for a new entrant prise these relationships away.

FTCH is the only scaled luxury marketplace. However, it faces competition from technology companies enabling ecommerce e.g. Shopify; online luxury retailers which hold inventory and ship from centralised warehouses, such as YNAP.com; and multichannel retailers. Richemont, the owner of YNAP, removed YNAP founder and CEO Federico Marchetti in March 2020 amidst reported frustration in YNAP’s lack of profits. With seeming competitive disarray, FTCH continues to invest ever increasing dollars at widening its business model advantage.

There is another subtle but significant advantage of marketplace over retail: FTCH’s marketplace model confers an important and widening advantage vs. linear retail peers. FTCH’s technology is integrated with the stockpiles of its sellers. FTCH therefore has access to data from traffic and sales not only made through the FTCH platform, but also offline in its boutique and brand partners’ stores. This information can be used to make FTCH’s services more valuable to more engaged consumers, but also to provide aggregated feedback to sellers.

Like Next, Farfetch is investing in further integrating itself into the luxury value chain through Farfetch Platform Solutions (FPS), a white label ecommerce offering. On the front end, FPS creates global websites, apps or WeChat stores. Back end services allow retailers and brands to synchronize their websites with in-store and warehouse inventory, both from mono-brand stores and other suppliers in their distribution network and facilitate in-store pick-up and consumer returns. Layered on top are services such as marketing, localisation, production and warehousing. These white label solutions are being provided for Harrods in the UK and 20 other clients.

Also like Next, FTCH is demonstrating anti-fragile business qualities. FTCH’s boutique suppliers have faced mandated retail store closures due to COVID 19 restrictions, and have suffered from a material decline in tourists, particularly from China. FTCH’s revenue growth accelerated in 2Q20 as these boutique partners sought to access luxury fashion consumers across the globe. COVID has helped to increase demand too: FTCH saw a spike in app downloads in the first quarter, especially in China in which app downloads more than doubled yoy. Chinese consumers represent more than one third of luxury consumption, of which typically 70% is made while traveling. That is $70 bn of personal luxury goods purchased by Chinese nationals while traveling outside Mainland China. Demand, which, with all else being equal, seems to have been repatriated online with huge drops in international travel in 2020. Likewise, FTCH’s FPS customers, such as Harrods, were able to continue serving customers during lockdowns.

Expect high reinvestment rates and incremental returns.

FTCH has a large, growing addressable market driven by online penetration, opportunities to carry adjacent products, exceptional unit economics and evidence of operating leverage.

Luxury fashion transactions are increasingly online. Over the last decade online penetration of luxury sales was c. 2% and has grown 20-25% pa. According to Bain online now accounts for 12% of the global $330bn luxury sales market, with customers increasingly influenced and enabled by digital channels, including in their physical purchases. 75% of luxury transactions were influenced by the online channel, and almost a quarter of purchases were digitally enabled. Bain expects online to become the number one channel with 28-30% market share by 2025.

Bain expects the global luxury market to be worth >€350bn by 2025, driven by growth in Chinese consumers, online channel and consumers younger than 45. This might imply a >$30bn online commission pool, c. 85x FTCH’s revenues. FTCH’s current share of the global market for personal luxury goods is c. 0.3% of the estimated total addressable market.

FTCH has the right model for industry domination. FTCH does not compete with any other large luxury marketplace. Its competitors are online brand ecommerce, omnichannel multi-brand stores and online multi-brand retailers. Jose Neves is playing for winner take all: “I believe a single company will orchestrate this revolution in the conversion of offline and online luxury retail because, even if multiple retail-tech vendors emerge, the new technology will have to be adopted both by retailers and consumers. We believe consumers will always gravitate to one single app, forcing vendors to gravitate to one single platform, most likely a platform that has already built consumer-side critical mass and benefits the entire ecosystem. This all translates into a potential $450 billion addressable market for Farfetch, which, as the operating system for luxury, we want to transform, empowering individuality for consumers, curators and creators of fashion.”

Despite a clear understanding of FTCH’s advantages, attractive unit economics and long runway for demand generation investments, management does not have a ‘growth at all costs’ mindset. Jose and Jordan have frequently reiterated their focus on protecting margins and strongly growing the profitability of the business, which they expect to be EBITDA break even this year. So far, the demonstrable operating leverage in the business lends credibility to these ideals.

Despite more than quadrupling in value since we originally acquired shares at $14, the rates of returns we expect to earn on our ownership remain high. An estimated $500mn of owner earnings are being invested into demand generation efforts that are yielding materials ROIs. Assuming a three-year customer lifetime and one order per year would imply incremental returns north of 30% and an IRR on the equity of $20bn north of 20%. Assuming a five-year customer lifetime and one order per year would imply incremental returns north of 50% and an IRR on the equity of around 40%.

The quoted price remains inconsistent with the deep reality. FTCH has a large and growing addressable market, a differentiated business model, high barriers to profitable participation, a win-win value chain, great unit economics and a capable, aligned leader."

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